Thursday, September 04, 2008

Why Free Markets Don't Work: Measurement Dysfunction as Management Strategy

Reading Robert Austin's book Measuring and Managing Performance in Organizations (Dorset House, 1996), was such an eye-opening experience for me that it has merited mention in this blog several times before this, most prominently in In Defense of Misbehavior. Once you understand measurement dysfunction, in which the performance measurement of individuals almost inevitably drives dysfunction into an organization, you will never again see the world in quite the same way.

The gist of it is this: an old axiom of business is "You cannot manage what you do not measure." But in his Ph.D. thesis, Austin, formerly an executive with Ford Motor Company and now on the faculty of the Harvard Business School, applies agency theory, a form of game theory, to show that in all but the most trivial of situations, it is impossible to measure all metrics applicable to an individual's performance. There will always be aspects of performance that cannot be measured. When rewarded (or punished) based on the metrics you do measure, the person being measured will be highly incentivized to game the system by slacking off on the those unmeasurable metrics. A classic example are call center agents hanging up on customers in the middle of calls to meet their quotas.

Austin's work has been cited by Tom DeMarco ("Mad About Measurement") in Why Does Software Cost So Much? (Dorset House, 1995), and by Joel Spolsky ("Measurement") in Joel on Software (Apress, 2004). It compelled me to get a copy of his dissertation (Robert Daniel Austin, Theories of measurement and dysfunction in organizations, Carnegie Mellon University, University Microfilm, #9522945, 1995), and even put a talk together on the topic which I've given several times. Given the recent horrifying cover story in BusinessWeek, "Managing by the Numbers: How IBM improves quality by tracking employees' every move" (September 8, 2008) , this topic is bound to become popular blog fodder once again.

But that's not what I'm here to talk about. I'm here to talk about why free markets don't work.

A few years ago, a large telecommunications equipment manufacturer decided to save money by eliminating all desktop PC support and having their product developers support their own predominantly-Windows desktop computers. This was done, of course, as a money savings move.

Did they save money? On paper sure, because they eliminated a bunch of IT staff from the bottom line. In reality, who the hell knows? All they really did was move their desktop IT support from where its cost could be measured to where it could not be measured. Most of the product line of this manufacturer was Linux-based, so the developers, who were earning hefty salaries for their Linux and telecommunications expertise, were not Windows experts. Most of their Windows support experience came from buying a home PC from BestBuy.

I suspect those developers were the most expensive IT support staff on the planet. But its all good because those costs weren't measured. Nor was the loss in productivity, the reduction in efficiency and quality in the work environment, and the moral hit to both the developers and the IT staff that came with the assumption that those two skill sets were interchangeable. I mean, really, it's just all computers, right? How hard can it be?

Sure, you could see this as a form of measurement dysfunction: some VP got a bonus by gaming the system. This is how people most often think of measurement dysfunction, as a more general term for incentive distortion. But this can also be seen in another way, not inadvertent dysfunction caused by the measurement of performance of individuals, but in a deliberate application so as to move costs to where they could not be measured. It's measurement dysfunction as management strategy.

Pollution is another form of measurement dysfunction. Companies realize cost savings by not dealing with the environmental costs of manufacturing. That's because, without government regulation, environmental costs are not borne by the polluter. The costs are pushed off onto the downstream neighbors of the manufacturer, or into the surrounding community, even onto future generations. As long as you just think locally and take a short term view, there is a strong incentive to move environmental costs to where they cannot be measured. Offshoring is just another form of this: moving environmental, or even societal, costs to where they are not measured.

In his book, Best Business Crime Writing of the Year (Random House, 2002), James Surowiecki collects magazine and newspaper articles on the spate of corporate crime that lead to the demise of Enron, WorldCom, Tyco, and other best-in-class companies. The actions of the executives described in these articles illustrate another form measurement dysfunction. Federal, state and local laws are a form of measurement. There is a strong (given the huge dollar amounts involved, I'm tempted to say irresistible) incentive to game the system by testing the limits and loopholes of those laws in an effort to derive revenue from areas for which the results of actions are not measured. I suspect that many of these executives didn't even realize they had committed a crime until the men with badges, guns, and handcuffs showed up with warrants, subpoenas, and writs. The Sarbanes-Oxley Act is an attempt to fix this dysfunction by measuring a metric that had not been measured before.

Measurement dysfunction is much more broadly applicable than just as incentive distortion. That's why it's known by other names in other contexts: unintended consequences, perverse incentives, and moral hazard are some I know about. With all due respect to my libertarian friends (and I have a lot of them), I argue that measurement dysfunction is why free markets don't work.

There will always be an economic incentive for participants in a truly free market to dump costs into or derive revenue from any gray area in which there is no measurement. And in an information economy, there are a lot of gray areas. That's because the measurement of all dimensions of market costs is impossible. Adam Smith described an "invisible hand" that guides markets to the most efficient allocation of resources. But for many metrics of market cost, there is no hand at all, invisible or otherwise. I'm not arguing for controlled markets. But I am arguing for regulated markets: that a significant (and perhaps unfortunate) amount of government regulation is necessary to act as a visible hand, forcing market participants to bear the full costs of their transactions.

In the realm of performance measurement of individuals, Austin argues against extrinsic motivation, for example bonuses tied to specific goals, because of the measurement dysfunction this produces. Instead, intrinsic motivation, for example corporate culture, causes individuals to do the right thing independent of incentives. If intrinsic motivators worked at the corporate level, free markets could work as well. But it's been argued that corporations are psychopathic because, devoid of any other legal restraint, their sole purpose is to maximize shareholder value.

I'm not saying that corporations are evil. I'm the founder and CEO (and janitor) of a corporation myself. But I am saying that it would be foolish not to acknowledge the measurement dysfunction that occurs in a truly free market.


Paul Moorman said...

Since when have we had free markets? We have enough laws to fill a football stadium and more coming every day. Given more human behavior, the goal is to surround the free market with regulation, setting its bounds.

The next alternative is having government tell industry what to make, how much to produce, etc. Given the fact that government is also humans and driven not by profit, but power, there ability to guide things is horrible.

The best alternative is to have all us humans be better people, and I believe there simply exists a balance between our morals (or lack thereof) and laws. If we had a perfectly moral society, how many laws would we have? Probably ten (yes, those ten written on those stone tablets). If we had the other extreme, we would have lots of very restrictive laws and shoot people for relatively minor offensives. Sound like any countries you can name?

Chip Overclock said...

Recently my friend Jim from back east visiting Colorado remarked that those that self-identify as Republicans in the West were markedly different from the same in the East. Western Republicans tended to be more what the East think of as Libertarians: less Government is good. (He was mentioning this in the context of him being gay, Western Republicans pretty muching thinking it wasn't any of their -- or the Government's business -- which is a departure how most think about the Republican platform.)

I self-identify as a pro-gun Liberal: I'm a member of the ACLU and the NRA. This is actually not that unusual in the Denver/Boulder area, one of the reasons I like living here. That means I'm lucky enough to frequently find myself sharing a lunch table with folks from all over the political spectrum. My Republican friends -- meaning, here in the west, Libertarian -- are always promoting free markets. Both my conservative and liberal friends are probably tired of hearing me go on and on about measurement dysfunction, but I couldn't resist finding yet one more application of it.

You're right, it's definitely a balancing act. Austin's thesis implies that government regulation actually won't solve the problem either, because not all metrics can be measured. So ultimately, regulation isn't the completely answer either; it can only be a stopgap. It has to be something driven into the corporate culture.

I'm intrigued with the idea of corporations being psychopathic. Yet behind every corporation are human beings, and those humans have a moral responsibility to do the right thing. I wish I saw more of that. Corporations moving toward "greening" is a step in the right direction (albeit usually justified by the bottom line).

Always good to hear from you, Paul. Thanks for the comment!

Anonymous said...

Interesting to hear your statements about corporations.
Since many years ago you discussed the possibility of corporations being citizens, you have just made one of the clearest arguments about
why that can never be true.
It is also why corporations cannot be tried for criminal offenses, but
their officers can.


Chip Overclock said...

Hmmmmm... I may have been citing SF author Alexis Gilliland, who suggested (fictionally) that AIs might achieve legal rights by incorporating. But otherwise I agree with your point.

Anonymous said...

Hi. Im a grad student and taking economics for the first time ever. Ive always been a science gal, and am transitioning into the world of healthcare management. I came across your blog honestly because I googled "why free markets dont work" looking for an Idiot's Guide to Free markets definition.

Here's my question (if you're still reading this ..HA!) or ranting if you will...

So in a free market society...goods and services provided would be solely based on the public's preferences/demands and things that would make them happy. Companies would try and market/monopolize on those services and be willing to pimp themselves out for a profit. All without government intervention...meaning what? No taxes, no regulations, no rules?

So why is that such a bad thing? Because people ultimately dont know whats good for them? Because government wants their cut?

Free markets would not allow for market competition. It would encourage monopolies and an unhealthy society based on our own stupid choices.

It cant be as simple as a society wanting to smoke and oh look at the impact on the healthcare industry.

If we have moderate regulation or a modified "free" market... they would be more plausible right?

Chip Overclock said...

Disclaimer: economics is my hobby, not my profession. Plus: I'm not offering an opinion here that is either pro or con regarding free markets. I'm generally pro, but don't believe they work in an information economy.

What I'm describing in this article is what an economist would call an "externality", which is a cost incurred by a party who did not agree to it. That tells you almost nothing, so an example helps.

When a company sells a product for which the factory that manufactures it pollutes the environment, the social cost of that pollution is an externality because it is not borne by the company that makes the product nor by the consumers of the product, but instead is borne by the people that live around the factory and who did not agree to the transaction.

But generally you become aware of the pollution. What if the company is leveraging an externality that cannot be measured?

Robert Austin applied an offshoot of game theory (itself a math that was first applied to economics) called agency theory to describe how incentive programs can't work in an information economy. The short answer is people can always game the system in a way that cannot be practically measured.

I'm saying this is what externalities in an information economy are all about: people can game the market in a way such that the actual social cost cannot be practically measured. This becomes easier in an information economy in which it becomes very expensive, or impossible, to measure all costs in a transaction.

I'm interested in economics for the same reason I'm interested in physics: I think it describes the real world in which we live. Economics is this interesting and crazy mixture of very hard math (which I'm not qualified to understand) and psychology (ditto), the latter because it deals with irrational actors (us).

Thanks for the comment!