Sunday, December 23, 2007

Where the Money Goes

The other night I attended a dinner party with the folks. Since the caucus is just a few weeks away, politics was on everyone's lips. One guest was particularly angry about outsourcing. While he has no problem with it in general, he disapproves when firms outsource (or employ illegal immigrants) but the price of the good does not fall. This is an interesting concern and one worth exploring. Let us consider some of the possibilities where these savings go to and if/how that improves social welfare.

Quality. If you can spend three dollars to increase the value of a good by four dollars, that's a lot better than dropping the price by three dollars (two ways to spend three bucks). Quality's harder to measure since you actually might never experience it: the product could be offered in more colors, have better consumer service, be more durable, and so on.

Investment. Related to quality but more general, the savings from product A could be used to better or even create product B. This, I imagine, becomes particularly common as firms become bigger since their assets are spread out more.

Dividends. Perhaps the money is instead sent outside the firm to stockholders as a payment for holding their stock (called a dividend). Smart investors know that good dividend payments mean a stable company. Increasing the dividend will attract new investors, encouraging existing holders to buy more stock and discourage them from selling what they have. This is ultimately a form of investment: a way to secure even more funds to finance things like investment and quality. It's just more long term than the direct approach.

Bonuses. This is a lot like dividends--the best way to secure a good CEO is to pay the CEO (and underlings) a good hunk of money. However, this could also be a bad sign in the form of a principal-agent problem: the CEOs don't need the additional incentive to keep working at the firm, or they are not worth the additional payment. However, since--to my knowledge--bigwig bonuses rarely/never equal total savings, the effect is likely ambiguous. Note also, bonuses are one time increases in pay, while outsourcing/immigrant savings accrue every year. And again, it is possible the upper management deserved the payment.

Material costs/Debt. Contrary to popular belief, firms don't like increasing their price. It can ruin a reputation and give the competition a sudden leg up (for most products, people are very sensitive to price). Thus when costs begin to creep up, or sudden expenses appear, the firm tends to foot the bill in hopes it can weather the storm without increasing its price. Thus, in a round-about way, lowering costs through outsourcing can effectively lower the price, not by actually lowering it but by not raising it despite the pressures to.

Setting aside the real, but small, impact of functional embezzlement, there are real social gains to corporations lowering their costs. Even if we assume that the costs mostly translate into profits, those gains generate an incentive for entrants to compete, offering opportunities for more choice, lower prices, better products, and smarter management. And we haven't even touched on the gains to the new workers.

1 comment:

The Whited Sepulchre said...

Brilliant. Especially the section under Material Costs/Debt. I did price quotes (actually "cost" quotes) for about two years. Raising prices at that time was unthinkable. We could only maintain the relatively low prices by finding lower cost processes and materials for the same products.