A review of George Szpiro’s 2011 book on the history of the Black-Scholes option-pricing formula uses Southwest Airlines’famous fuel-price-hedging strategy as a key piece of its explanation for why firms might want to use options. Southwest’s hedging has received a lot of attention; the gains and losses on these financial trades have rivaled operating profits and losses on its income statement. Most commentators have applauded this aggressive trading activity, merely cautioning that sometimes Southwest guesses wrong about future oil prices and loses a lot of money.
What no one seems to ask is why Southwest shareholders would want the firm to be speculating in the fuel market in the first place. Unless these hedges materially reduced the risk of bankruptcy–and Southwest’s balance sheet is typically stronger than its rivals’–the classic argument applies: Shareholders should not want corporate managers to hedge industry-specific risks, such as swings in fuel prices, because they can very easily deal with these risks themselves by holding a diversified portfolio of stocks (including oil firms) or even by buying their own options on oil prices. Southwest’s financial risk reduction via hedging conveys little or no benefit to the owners of the firm.
But wait, many will object–doesn’t hedging give Southwest a cost advantage over its rivals when oil prices go up? And since these hedges are often accomplished by options, isn’t there an asymmetry, since when Southwest guesses wrong, it only loses the price it paid for the option? Doesn’t the airline therefore lower its costs by these trades, gaining a leg up on its rivals?
The answer is No. These hedges have no impact whatsoever on Southwest’s cost of being an airline operator. They constitute an independent, speculative financial side business, a business that is exactly as good for Southwest shareholders as the CFO’s team is at outguessing the fuel market. Even when Southwest guesses right, it is not improving the airline business’s competitiveness.
To see why this is true, think about the incremental fuel cost to Southwest of running a flight with or without the hedge. If the spot price of fuel is $x/gallon at the time of the flight and it consumes y gallons, then the fuel cost is xy. If Southwest has successfully hedged the oil price, then it will make a bunch of money after closing out its position, but it would still independently save $xy by not running the flight. If Southwest has guessed wrong and lost money on the hedge, it would also save $xy by not running the flight. So the cost of operation–the increment in expenditure caused by producing another unit–is unaltered by the hedging strategy.
This situation should be easy to visualize because the hedges are on oil rather than jet fuel and because they are settled for cash rather than physical delivery. But even if the hedges were denominated in physically delivered jet fuel, successful or unsuccessful hedging would have no impact on airline operating costs. If Southwest just bought fuel early for $(x-a)/gallon and stored it until the spot price was $x/gallon, the opportunity cost of the flight would still be $xy, since the airline could cancel the flight and sell y gallons for that amount. The incremental expenditure difference between flying and not flying is exactly the same. (If opportunity cost confuses you, visualize that Southwest has some fuel on hand purchased at the lower hedged price and some at the spot price, and note that it doesn’t matter which barrel of gas goes into which plane–all the fuel is fungible, and it is all worth $x/gallon if that’s what it could be sold for.)
Now, risk-averse behavior by managers may be in their own interest, depending on the form of their compensation, the structure of the labor market, and their perceived ability differential over their peers. But it is of little help to the owners of public firms that are far from bankruptcy. That’s a point that should not be hedged.
For a PDW, I was asked to develop a short list of paradoxes linked to the strategic human capital (spoiler alert for those of you planning to be at the session at 8am on Friday). I’m sure some of them would not surprise you in the least. Others might spur some discussion though. Here is the short list:
- Rent from human capital may not show up in profitability
- “Who” is a firm?
- Firm-specificity isn’t as important as we might think
- HR Departments may not matter much
- High performance work systems don’t tell us much about such advantages
Rent. The first point is what you would expect from me so let me dismiss it quickly. Obviously, if rent is linked to human capital, some portion of it is likely to be captured by people. Nuff said.
Who is a firm? A sharp distinction is made between hiring on the spot market and an internal labor market. Rightly so. However, one might think that once labor is “internal” such people are part of the firm. Read the rest of this entry »
The “dynamic capabilities” literature, I think, is a bit of a mess: lots of jargon, conflicting arguments (and levels of analysis) and little agreement even on a basic definition. I don’t really like to get involved in definitional debates, though I think the idea of a capability, the ability to do/accomplish something (whether individual or collective), is fundamental for strategy scholars.
Last weekend I was involved in a “microfoundations of strategy” panel (with Jay Barney and Kathy Eisenhardt). One of the questions that I raised, and find quite intriguing, is the question of how we might “grow” a capability. The intuition for “growing” something, as a form of explanation, comes from simulation and agent-based modeling. For example, Epstein has argued, “if you didn’t grow it, you didn’t explain it” (here’s the reference). I like that intuition. As I work with colleagues in engineering and computer science, this “growth” mentality seems to implicitly be there. Things are not taken for granted, but explained by “growing” them. Capabilities aren’t just the result of “history” or “experience” (a common explanation in strategy), but rather that history and experience needs to be unpacked and understood more specifically. What were the choices that led to this history? Who are the central actors? What are the incentives and forms of governance? Etc.
So, if we were to “grow” a capability, I think there are some very basic ingredients. First, I think understanding the nature, capability and choices of the individuals involved is important. Second, the nature of the interactions and aggregation matters. The interaction of individuals and actors can lead to emergent, non-linear and collective outcomes. Third, I think the structural and design-related choices (e.g., markets versus hierarchy) and factors are important in the emergence (or not) of capabilities. Those are a few of the “ingredients.”
I’m not sure that the “how do you grow a capability”-intuition is helpful in all situations. However, I do find that there is a tendency to use short-hand code words (routines, history, experience), and the growth notion requires us to open up these black boxes and to more carefully investigate the constituent parts, mechanisms and interactions that lead to the development or “growth” of capability.
Last week I had the great good fortune to attend the Max Planck Institute at Leipzig’s first conference on Rigorous Theories of Business Strategies in a World of Evolving Knowledge. The conference spanned and intense four days of presentations, exploration, and discussion on formal approaches to business strategy. Participants were terrific and covered the scholarly spectrum: philosophers, psychologists, game theorists, mathematicians, and physicists. Topics included cooperative game theory, unawareness games, psychological micro-foundations of decision making, and information theory. It was heartening to see growth in the community of formal theorists interested in strategy and my guess is that the event will spawn interesting new research projects and productive coauthoring partnerships. (Thanks to our hosts, Jurgen Jost and Timo Ehrig for organizing and sponsoring the conference!)
If one had to pick a single, overarching theme, it would have to be the exploration of formal approaches to modeling agents with bounded rationality. For example, I presented on subjective equilibrium in repeated games and its application to strategy. Others discussed heuristic-based decision making, unawareness, ambiguity, NK-complexity, memory capacity constraints, the interaction of language and cognition, and dynamic information transmission.
Over the course of the conference, it struck me just how offensive so many of my colleagues find the rationality assumptions so commonly used in economic theory. Of course, rational expectations models are the most demanding of their agents and, as such, seem to generate the greatest outrage. What I mean to convey is the sense that displeasure with these kinds of modeling choices go beyond dispassionate, objective criticism and into indignation and even anger. If you are a management scholar, you know what I mean.
Thus, at a conference such as this, we spend a lot of time reminding ourselves of all the research that points to all the limitations of human cognition. We detail how humans suffer from decision processes that are emotional, memory constrained, short-sighted, logically inconsistent, biased, bad at even rudimentary probability assessment, and so on. Then, we explore ways to build formal models in which our agents are endowed with “more realistic” cognitive abilities.
Perhaps contrary to your intuition, this is heady stuff from a modeler’s point-of-view: formalizing stylized facts about real cognition is seen as a worthy challenge … and discovering where the new assumptions lead is always amusing. From the perspective of many management scholars, such theories are more realistic, better able to explain observations of shockingly stupid decisions by business practitioners and, hence, superior to the silly, overly simplistic models that employ a false level rationality.
I am not mocking the sentiment. In fact, I agree with it. Indeed, none of the economists I know dispute the fact that human cognition is quite limited or that perfect rationality is an extreme and unrealistic assumption. (This isn’t to say there aren’t those who believe otherwise but, if there are, they are not acquaintances of mine.) On the contrary, careers have been made in game theory by finding clever ways to model some observed form of irrationality and using it to explain some observed form of decision failure. If this is the research agenda then, surely, we have hardly scratched the surface.
Yet, as I thought about it during the MPI conference last week, it dawned on me that our great preoccupation with irrational agents is misdirected. That animals as cognitively limited as us often, if not typically, fail to achieve rational consistency in our endeavors is no puzzle. What else would you expect? Rather, the deep mystery is how agents so limited in rational thought invent democracy, create the internet, land on the moon, and run purposeful organizations that succeed in a free market. Casual empiricism suggests that the pattern of objective-oriented progress in the history of mankind is too pervasive to ascribe to dumb luck. Even at the individual level, in spite of their many cognitive failings, the majority of people lead purposeful, productive lives.
This leads me to remind readers that economists invented the rational expectations model precisely because it was the only option that came anywhere close to explaining observed patterns in economy-level reactions to changes in government policies. This, even though the perfect rationality assumption is axiomatically false. There you have it.
Which leaves open the challenge of identifying which features of human cognition lead to persistent patterns of success in highly unstable environments. I conjecture that our refined pattern recognition abilities play a role in this apparent miracle. Other candidates include our determination to see causality everywhere we look as well as our incredible mental flexibility. Social factors and institutions must be involved — and, somewhere in there, a modicum of rationality and logic. After all, we did invent math.
Via Karim’s twitter feed: Ronald Coase turned 101 years old today. Congratulations!
(My new goal is to be publishing at 101. That’s got to be a record of some sort.)
I’m working on a theory of the firm-related paper over the holiday break. One of the pieces I enjoy revisiting is Herbert Simon’s (1991) article “Organizations and Markets,” Journal of Economic Perspectives. What I like is the intriguing thought experiment in that paper (frankly, I think thought experiments are a VERY under-utilized tool in strategy and organization theory). To illustrate the “ubiquity of organizations” Simon asks us to imagine seeing the globe from above and envisioning market exchanges as red lines and firm-related exchanges as green lines. Clearly, the green dominates. Thus Simon never developed a comparative theory of governance (markets versus hierarchy) and focused on organizations themselves (the basis of the behavioral theory of the firm). I tend to think that the comparative aspects are fundamental, though naturally The Behavioral Theory also has a place in the canon.
For anyone interesting, here’s the first couple paragraphs of the thought experiment:
A mythical visitor from Mars, not having been apprised of the centrality of
markets and contracts, might find the new institutional economics rather
astonishing. Suppose that it (the visitor I’ll avoid the question of its sex)
approaches the Earth from space, equipped with a telescope that reveals social
structures. The firms reveal themselves, say, as solid green areas with faint
interior contours marking out divisions and departments. Market transactions
show as red lines connecting firms, forming a network in the spaces between
them. Within firms (and perhaps even between them) the approaching visitor
also sees pale blue lines, the lines of authority connecting bosses with various
levels of workers. As our visitor looked more carefully at the scene beneath, it
might see one of the green masses divide, as a firm divested itself of one of its
divisions. Or it might see one green object gobble up another. At this distance,
the departing golden parachutes would probably not be visible.
No matter whether our visitor approached the United States or the Soviet
Union, urban China or the European Community, the greater part of the space
below it would be within the green areas, for almost all of the inhabitants would
be employees, hence inside the firm boundaries. Organizations would be the
dominant feature of the landscape. A message sent back home, describing the
scene, would speak of “large green areas interconnected by red lines.” It would
not likely speak of “a network of red lines connecting green spots.”
O&M’s Peter Klein on production and the firm.
O&M’s Nicolai Foss and Peter Klein are publishing a book (forthcoming in early 2012) Organizing Entrepreneurial Judgment: A New Approach to the Firm, Cambridge University Press. Their book starts with the premise that “the theory of entrepreneurship and the theory of the firm should be treated together.” I agree.
So, if you want to read up on the latest and greatest at the nexus of entrepreneurship, organizations and markets – then this is definitely the book for you.
Here is the table of contents.
1. The need for an entrepreneurial theory of the firm
2. What is entrepreneurship?
3. Entrepreneurship: from opportunity discovery to judgment
4. What is judgment?
5. From shmoo to heterogeneous capital
6. Entrepreneurship and the economic theory of the firm
7. Entrepreneurship and the nature and boundaries of the firm
8. Internal organization: original and derived judgment
9. Concluding discussion
I haven’t quite read the whole book, yet, but am working through it. So more posts to come.
Glenn Hoetker recently gave me the opportunity to consider what new contributions the field of psychology could offer to the strategy literature (see the description here). The video illustrates how behavior often depends more on perception than on reality — does it matter if the steering wheel is attached or not if the other driver acts as if it is? Often, researchers are interested in organizational outcomes and theorize that the underlying behaviors are driven by objective reality. What research opportunities are highlighted as we take seriously the subjective nature of our most central constructs?
In this installment, we explore the question, “what is a firm?” This is so taken for granted in the field that most of you will probably stop reading here. Read the rest of this entry »
Last week there was a very useful WSJ article reporting on an analysis of the supplier relationships at the core of the new iPhone 4S (here … while it lasts). This seems like a nice mini-case analysis to see how our theories seem to explain actual outcomes.
They note that Qualcomm “is the big winner” because it is supplying a suite of chips that adds up to $15 per phone. Intel is a loser because it acquired Infineon and then those chips were dropped from the product.
Samsung lost out on the memory chips to its Korean rival Hynix — a surprise since Samsung is known to have a more reliable product. However, interestingly, Samsung did retain its role as the manufacturer of Apple’s proprietary A5 processor which provides the iPhone 4S and the iPad 2 with the bulk of its computing power.
The below is part 1 of an Oliver Hart lecture (from earlier this year) on reference points and the theory of the firm (here’s the associated Economica piece, and the QJE article). After Coase saw Hart present the first time, sometime in the 90s, he told Hart “If I had known as much mathematics as you, I would have become a chemist.” It wasn’t a compliment. Coase does not think much of formal approaches in economics.