WEBVTT NOTE Explaining Persistence in Cost Efficiency Indices 1 00:00:00.000 --> 00:00:30.000 Okay, it's an honor to be here. So I'm very happy to be here. This is my first conference. I'm enjoying it very much, and I've learned quite a bit, and I've been studying Austrian economics for quite a while, but I also study other things, including agriculture economics. I'm an agriculture economist. My background is primarily farm management. I work with agribusinesses and farmers, and so I get a first-hand glance of entrepreneurs, and I can tell you right now that neoclassical theory falls on its face when you 2 00:00:30.000 --> 00:01:00.000 Neoclassical theory leaves no room for the entrepreneur. 3 00:01:00.000 --> 00:01:30.000 Efficiency and Productivity Indices 4 00:01:30.000 --> 00:01:42.000 The standard discussion of cost efficiency in neoclassical economic textbooks and journal articles suggests that the firm's advantages are very fleeting. 5 00:01:42.000 --> 00:01:59.000 What I mean by that is if a firm does have an advantage, either just by luck, they did something that someone else didn't do, or they were a good manager and they did something well and they actually make more profit than one of their competitors, 6 00:01:59.000 --> 00:02:17.000 The empirical research indicates that some firms have sustained competitive advantage. 7 00:02:17.000 --> 00:02:20.640 I'm not going to go into that literature, but there's literature in strategic management, 8 00:02:20.640 --> 00:02:24.680 there's literature in finance, there's literature in economics, and there's literature in ag 9 00:02:24.680 --> 00:02:29.560 economics that suggests that some firms actually do have a sustained competitive advantage. 10 00:02:29.560 --> 00:02:34.320 What I mean by that is they earn above normal profits over a long period of time. 11 00:02:34.320 --> 00:02:37.600 Neo-classical theory absolutely cannot explain that. 12 00:02:37.600 --> 00:02:42.080 If this was not the case, if we didn't see the sustained competitive advantage, some 13 00:02:42.080 --> 00:02:46.560 of the things that I like to do, specifically benchmarking, would be a lot less useful. 14 00:02:46.560 --> 00:02:49.880 That's a little strong statement to say it's irrelevant, because it probably would still 15 00:02:49.880 --> 00:02:54.520 have some relevancy, but it would be a lot less useful, because we wouldn't have targets 16 00:02:54.520 --> 00:02:58.340 to shoot that firms that are not doing so well to shoot for. 17 00:02:58.340 --> 00:03:06.180 And I work with farmers specifically, but I work with farmers in workshops where we specifically 18 00:03:06.180 --> 00:03:09.440 talk about these benchmarks, and we spend all this time calculating these benchmarks. 19 00:03:09.440 --> 00:03:14.020 Why do we do that if that's not important? 20 00:03:14.020 --> 00:03:19.100 So the objective of this paper is to examine how Austrian economics can be used to explain 21 00:03:19.100 --> 00:03:22.220 this persistence or the sustained competitive advantage. 22 00:03:22.220 --> 00:03:26.020 The sections of the paper, I'm just going to have to touch on those very briefly here. 23 00:03:26.020 --> 00:03:29.540 Role of the entrepreneur, entrepreneurial heir, I won't spend much time on that because 24 00:03:29.540 --> 00:03:31.940 that's pretty standard to the Austrian literature. 25 00:03:31.940 --> 00:03:35.880 I want to talk a little bit about defining cost efficiency for those of you that are 26 00:03:35.880 --> 00:03:41.060 not so familiar with that term and then I'll try to relate all of this to persistence and 27 00:03:41.060 --> 00:03:43.620 efficiency which is the main topic. 28 00:03:43.620 --> 00:03:48.440 So the role of the entrepreneur, this is from Bredo, a book in 1989, he basically had four 29 00:03:48.440 --> 00:03:55.100 different categories, entrepreneur as coordinator, entrepreneur as arbitrager, that's Kirzner, 30 00:03:55.100 --> 00:04:00.140 entrepreneur as innovator and entrepreneur as uncertainty bearer, Knight and others, 31 00:04:00.140 --> 00:04:04.020 there's quite a few in that last category there, but these are some of the people that 32 00:04:04.020 --> 00:04:08.540 have been involved in these different theories of the entrepreneur, I'm going to focus on 33 00:04:08.540 --> 00:04:13.580 on Kirzner, entrepreneur as arbitrager. 34 00:04:13.580 --> 00:04:15.540 And so Kirzner talks about entrepreneurial error. 35 00:04:15.540 --> 00:04:20.980 In his early work, he primarily focused on entrepreneurial profit, but in later work, 36 00:04:20.980 --> 00:04:25.420 he said yes, it is possible for entrepreneurs to make mistakes, and so entrepreneurs can 37 00:04:25.420 --> 00:04:30.820 also have losses because they're dealing with uncertainty, and the scenario that they thought 38 00:04:30.820 --> 00:04:33.420 was going to play out may not have played out. 39 00:04:33.420 --> 00:04:35.360 And so certainly there's entrepreneurial error. 40 00:04:35.360 --> 00:04:39.080 He notes that the market offers incentives for discovery of errors and so if there are 41 00:04:39.080 --> 00:04:45.400 errors people try to discover those and make adjustments to their plans. However, this 42 00:04:45.400 --> 00:04:50.160 error does generate what I call inefficiency, which I'll define here in a little bit. It 43 00:04:50.160 --> 00:04:57.960 does cause the firms to have losses when they have these entrepreneurial errors. Entrepreneurial 44 00:04:57.960 --> 00:05:01.760 error is not necessarily the same thing as X-in-efficiency, I can't get into that in 45 00:05:01.760 --> 00:05:04.960 in detail, but I get into that in the paper. 46 00:05:04.960 --> 00:05:10.880 But excellent efficiency is a much narrower concept than Kirzner's entrepreneurial air. 47 00:05:10.880 --> 00:05:11.880 Much narrower. 48 00:05:11.880 --> 00:05:18.440 In fact, excellent efficiency primarily deals with what Liebenstein calls gaps in knowledge 49 00:05:18.440 --> 00:05:20.080 for like oligopoly firms. 50 00:05:20.080 --> 00:05:23.040 Well, here I'm talking about forms. 51 00:05:23.040 --> 00:05:27.680 And so it's a much narrower concept than entrepreneurial air. 52 00:05:27.680 --> 00:05:31.680 I would like to note that entrepreneurs have differing abilities to gauge profit opportunities, 53 00:05:31.680 --> 00:05:39.680 This is related to resource-based theory of the firm, resource advantage theory, strategic management. 54 00:05:39.680 --> 00:05:47.680 All of those strategic management theories have noted that, that there is a lot of differences in entrepreneurs' ability to gauge profit opportunities. 55 00:05:47.680 --> 00:05:53.680 But this is particularly true, I would argue, in industries dominated by small businesses like agriculture. 56 00:05:53.680 --> 00:06:08.680 And again, anecdotal evidence, working with numerous farmers, there's a lot of difference in their ability to gather information, to process information, to really think about scenario analysis and on and on and on. 57 00:06:08.680 --> 00:06:18.680 And so there's just a lot of difference between the producers and therefore that leads to entrepreneurial profits and entrepreneurial losses, I would argue. 58 00:06:18.680 --> 00:06:25.680 So let's talk a little bit about cost efficiency before I tie this into persistence in cost efficiency. 59 00:06:25.680 --> 00:06:31.680 Cost efficiency is really fairly simple concept. It's usually measured using cost returns to scale. 60 00:06:31.680 --> 00:06:36.680 And all we're doing is we're looking at the minimum cost to produce a given level of output. 61 00:06:36.680 --> 00:06:43.680 And so if you're thinking about a cost frontier, we're trying to produce on the cost frontier, the total cost frontier. 62 00:06:43.680 --> 00:06:48.680 Firms that are inefficient are not producing on the cost frontier. 63 00:06:48.680 --> 00:06:56.680 Cost inefficiency can be due to numerous things, including technical inefficiency, allocative inefficiency, or scale inefficiency. 64 00:06:56.680 --> 00:07:03.680 But I want to tie this cost efficiency to Austrian economics, and so let me have a couple slides here to attempt to do that. 65 00:07:03.680 --> 00:07:05.680 I've got more detail in the paper. 66 00:07:05.680 --> 00:07:11.680 First of all, there's persistence and efficiency is related to organizational competence or sustained competitive advantage. 67 00:07:11.680 --> 00:07:28.680 I think it's pretty easy to relate persistence and efficiency to these theories, but I would argue that Austrian economics can add to those theories and can add additional information that's not in these strategic management theories that helps us explain this persistence and efficiency. 68 00:07:28.680 --> 00:07:38.200 Before I do that in the next slide, increases in firm productivity can result from increases 69 00:07:38.200 --> 00:07:41.700 in either efficiency or effectiveness. 70 00:07:41.700 --> 00:07:46.520 We can more efficiently create value or we can efficiently create more value. 71 00:07:46.520 --> 00:07:51.920 And so this is the idea that we can improve our costs or we can have product differentiation 72 00:07:51.920 --> 00:07:52.920 and improve our price. 73 00:07:52.920 --> 00:07:58.600 This is very standard in strategic management literature. 74 00:07:58.600 --> 00:08:03.520 So tying this back to Austrian economics, again, resource-based theory is the primary 75 00:08:03.520 --> 00:08:06.520 theory that I'm relating to here in strategic management. 76 00:08:06.520 --> 00:08:13.640 I think it does lend us some ability to begin to figure out why some firms are more successful 77 00:08:13.640 --> 00:08:19.380 than others, and conversely, why some firms really don't do very well. 78 00:08:19.380 --> 00:08:22.120 And you can ask yourself, well, how in the world could they do that? 79 00:08:22.120 --> 00:08:28.440 Well, I have evidence of firms that haven't made any money in 20 years. 80 00:08:28.440 --> 00:08:39.440 How can they do that? Well, if you own your land and you're willing to take a crappy return on your land and a crappy return for your labor, you can farm for a long time. 81 00:08:39.440 --> 00:08:47.440 Conversely, there's farms that are very successful, have very high profits over a long period of time, and are growing very rapidly. 82 00:08:47.440 --> 00:08:53.440 And so it leads to a lot of differences in an industry like farming that I'm dealing with. 83 00:08:53.440 --> 00:09:12.440 The key Austrian insights here that are related to this. Relevant knowledge is local and tacit. This makes it very difficult for those that have been less successful to mimic those that have been successful. The knowledge is tacit. 84 00:09:12.440 --> 00:09:22.440 What are you going to do? How are you going to pick the guy's brain? It's just not possible to get some of that information and to mimic what the successful producers are doing. 85 00:09:22.440 --> 00:09:28.200 Also, the firm, like the entrepreneur, learns about local facts, and so there's learning 86 00:09:28.200 --> 00:09:29.640 involved here. 87 00:09:29.640 --> 00:09:33.920 And I think it's obvious that some entrepreneurs are probably better than others in terms of 88 00:09:33.920 --> 00:09:37.680 their ability to learn, particularly related to new technology. 89 00:09:37.680 --> 00:09:41.840 In production, agriculture, technology is very important, and if you don't adopt the 90 00:09:41.840 --> 00:09:46.160 right technologies, what I mean by right is those that have the most benefit over the 91 00:09:46.160 --> 00:09:51.440 cost, you're going to fall behind in terms of your efficiency or your productivity. 92 00:09:51.440 --> 00:09:56.720 And so that's also important, a lot of differences between entrepreneurs related to that fact. 93 00:09:56.720 --> 00:10:01.240 Also firms incorporate market routines, and so people do the obvious. 94 00:10:01.240 --> 00:10:04.360 They look around and do the obvious things. 95 00:10:04.360 --> 00:10:10.600 If, for example, if I'm from Indiana, if some farms are adopting a different tillage 96 00:10:10.600 --> 00:10:14.120 system and it's successful, they're going to see that, okay? 97 00:10:14.120 --> 00:10:20.700 And so the market routines are incorporated, however, firms also adapt to changing environment. 98 00:10:20.700 --> 00:10:23.300 That's where some entrepreneurs really fall behind. 99 00:10:23.300 --> 00:10:27.780 You know, when the environment is changing, some people say, well, what I've done in 100 00:10:27.780 --> 00:10:32.220 the past has been okay, so I'll just stay with what I've done in the past, may not adopt 101 00:10:32.220 --> 00:10:36.340 new technologies, new methods, and therefore fall further behind. 102 00:10:36.340 --> 00:10:41.060 Also, this is the one most closely related to strategic management, not all routines 103 00:10:41.060 --> 00:10:43.900 or capabilities are equally efficient. 104 00:10:43.900 --> 00:10:46.300 And so some people are just better managers. 105 00:10:46.300 --> 00:10:55.300 I've tried to talk to some of my colleagues that are really fond of neoclassical economics and just ask them that question. 106 00:10:55.300 --> 00:10:58.300 You think everybody has similar managerial ability? 107 00:10:58.300 --> 00:11:02.300 Does professors have similar ability? 108 00:11:02.300 --> 00:11:09.300 Well, they do. Maybe I should get paid the same as you, or maybe you should get paid, or vice versa kind of thing. 109 00:11:09.300 --> 00:11:17.300 I think that's such an obvious thing, but it's something that neoclassical economics really doesn't do very good in terms of explaining. 110 00:11:17.300 --> 00:11:26.300 You really need a theory that's related to entrepreneurs, and I think tying that with strategic management literature to really help explain that. 111 00:11:26.300 --> 00:11:34.300 And so I think it's key that we make room in the theory for the entrepreneur, in addition to tying in some of the strategic management. 112 00:11:34.300 --> 00:11:39.900 Over time, entrepreneurs tried to catch up to their rivals. There's a tendency for earlier 113 00:11:39.900 --> 00:11:44.280 entrepreneur heirs to be replaced by profit-seeking entrepreneurial corrections. However, this 114 00:11:44.280 --> 00:11:50.860 process is not static, so inefficiency can persist. So even if we could figure out these 115 00:11:50.860 --> 00:11:55.020 entrepreneur heirs, if someone that's less successful could figure out these entrepreneur 116 00:11:55.020 --> 00:11:59.580 heirs that they've made and say, that wasn't a very good decision, I'll make that correction, 117 00:11:59.580 --> 00:12:05.060 This isn't static. I don't know how many of you are familiar with Michael Porter's work. 118 00:12:05.060 --> 00:12:10.380 He changed his work over the years from more of a static to a dynamic analysis because of 119 00:12:10.380 --> 00:12:15.860 this. Competitive advantage and efficiency is not a static concept. I always think of 120 00:12:15.860 --> 00:12:24.980 it as a moving target. Right now, farming has a pretty high profit margin. That doesn't 121 00:12:24.980 --> 00:12:29.180 mean five years from now it's going to have the same profit margin or you need to do the 122 00:12:29.180 --> 00:12:59.180 and the same things to be successful, you know, five years from now, and so it's a moving target, it's very difficult, quite frankly, to be on that cost frontier, because it is a moving target, and even if you're on the cost frontier one year, if you don't continually make changes adapting to the new environment, you're going to fall behind the cost curve, and so that's a point that's very important to make, is the reason that this is so complicated is the fact that this is not static. 123 00:12:59.180 --> 00:13:14.180 Summary and Conclusions, the following two problems are often ignored or glossed over in efficiency and productivity literature. 124 00:13:14.180 --> 00:13:18.180 I mentioned earlier that there are two things that we have a hard time explaining. 125 00:13:18.180 --> 00:13:22.180 These are the two things that we have difficulty explaining. 126 00:13:22.180 --> 00:13:26.180 One of them is the large differences in efficiency among firms. 127 00:13:26.180 --> 00:13:29.620 Why is there so much difference among firms? 128 00:13:29.620 --> 00:13:35.380 I remember presenting a paper about 20 years ago and one of my colleagues, somebody I got 129 00:13:35.380 --> 00:13:39.980 a PhD with, University of Nebraska-Lincoln, University of Nebraska-Lincoln, he was getting 130 00:13:39.980 --> 00:13:45.220 a PhD, I was getting a master's, I got my PhD at Purdue, but we were together in graduate 131 00:13:45.220 --> 00:13:49.660 school and I was at this meeting, we were both at this meeting and I was showing these 132 00:13:49.660 --> 00:13:52.160 results and he says, this can't be. 133 00:13:52.160 --> 00:13:58.360 How can one person have an efficiency index that's 60% and so has a 40% difference in 134 00:13:58.360 --> 00:13:59.360 cost? 135 00:13:59.360 --> 00:14:02.360 And he says, well, look at the data. 136 00:14:02.360 --> 00:14:07.160 What's wrong, the data or your neoclassical theory? 137 00:14:07.160 --> 00:14:10.640 He didn't have a very good response to that, at least I didn't think he did. 138 00:14:10.640 --> 00:14:13.240 And so this is something that we've been trying to explain for a long time. 139 00:14:13.240 --> 00:14:17.440 I think Austrian economics can help us explain this, okay? 140 00:14:17.440 --> 00:14:21.960 There's nothing in entrepreneurial theory that suggests that all entrepreneurs are equally 141 00:14:51.960 --> 00:15:07.280 The difference in the profit margin between those that had above average performance and 142 00:15:07.280 --> 00:15:11.320 below average performance was about 25%. 143 00:15:11.320 --> 00:15:17.640 The above average was like 20% profit margin and the below average for souls were negative 144 00:15:17.640 --> 00:15:18.640 5%. 145 00:15:18.640 --> 00:15:21.640 They were having very low return on their labor, for example. 146 00:15:21.640 --> 00:15:30.040 and so there is huge differences both in a particular year but there's also large differences over time. 147 00:15:30.040 --> 00:15:36.040 I've argued here and I argue in the paper that Austrian economics along with strategic management 148 00:15:36.040 --> 00:15:41.040 can be used to help explain these two artifacts of efficiency and productivity literature 149 00:15:41.040 --> 00:15:47.440 and so when we get these results we can more fully support and explain why these results look the way they do 150 00:15:47.440 --> 00:15:55.040 which I think is very important to be able to do if we're going to continue these efficiency of productivity studies, which we're going to, 151 00:15:55.040 --> 00:16:04.040 because it is a very effective way to get a little better idea of how firms are doing vis-à-vis other firms in the industry.