Journalist Chris McDougall wondered why he was getting hurt when humans have been running for two million years. His best-selling book, Born to Run, is a well-told tale of people who run barefoot without getting hurt and of researchers who discover a paradox: support can make you weaker, not stronger. The more support a running shoe gives you, the more it weakens your foot, ankle, and calf muscles and the more prone you become to injury.

McDougall presents the stories that led to the science and the science that has led to a resurgence of barefoot or minimal shoe running. He visits the Tarahumara, an impoverished clan of long distance runners living in the very remote Copper Canyons of Mexico. McDougall romanticizes their lives, describing men and women of all ages routinely running for dozens of miles in sandals over hot, steep mountains.

Scientists have studied the Tarahumara for years because their isolation makes them good subjects. As roads arrive, the Tarahumara embrace modernity: their diet goes from corn meal and long runs to pickup trucks and Hohos. Epidemiologists have documented the diabetes, cancer, and heart disease that result. McDougall looks past this, focusing instead on the propensity of the canyon-dwelling Tarahumara and some of their more crazed gringo brethren to race ridiculous distances wearing heuraches cut from old tires.

Back home, McDougall consults a Stanford track coach who refuses to let his athletes wear expensive running shoes and discovers data suggesting that both the extent and severity of injuries go up with the price of shoes. He interviews Daniel Lieberman, a Harvard biomechanics professor, who explains precisely how the support a of a running shoe makes most runners over stride and heel strike, which delivers a much sharper blow than a barefoot runner who lands mid foot. A good video of Lieberman explaining his research is below. The peer reviewed work is here in Nature.

Lots of testing and learning is still being done both by individuals and by researchers, but nobody these days takes for granted that running shoes are always helpful. Shoe companies are trying to shift their designs and their message to promote “minimalist” shoes, some of which are now best-sellers.

Is this just a fad? Of course any shoe can become a fad if well marketed. On the other hand, humans have run barefoot for two million years but have worn running shoes for only about 30. I would not bet against barefoot running, given the injury rates that shod runners experience.

Protection turns out to be deceptive. It seems completely normal to me that as a runner, I would prefer a protective shoe. I want lots of cushioning. I want to avoid pronation, which must be awful because it sounds so bad. It would be simple to sell me orthotics — hey, my knees hurt sometimes. Although some people surely do fine in running shoes, for many people, highly protective shoes are like a cast. They reduce your mobility and your foot gets continually weaker as a result.

Economists, of course, know that protection often makes competitors weaker. They believe instinctively that competition strengthens counterparties, be they muscles, individuals, teams, companies, or regions. I have even argued that those who want stronger labor unions need to force unions to compete. Economists left and right can show that trade protection weakens both parties, although this knowledge never stops companies, communities, or workers who are hurt by trade from seeking it. Doubtless some similar principal applies to parenting: too much protection weakens your kids. Fine, now buckle your damned seat belt.

To evaluate social programs or parenting, we need the equivalent of the Tarahumara — a group isolated from extraneous influences that can test whether social protections produce more benefits than costs. Fortunately, an impressive young economist has shown that many of our protective programs are testable. Esther Duflo is an MIT professor, a MacArthur genius grant winner, and the winner of the  2010 John Bates Clark Medal for the best economist under the age of forty. Watch her fascinating TED talk on how she tests programs to fight malaria, educate kids, and immunize children. This is barefoot economics at its best.

Testing of this sort requires an appetite for failure. Politicians, business people, and scientists each approach tests differently, depending on how failure affects them.

• Politicians pay a huge price for failure. This forces them to simplify problems and promise sound bite solutions. If they do not do this, they won’t be elected and they won’t be politicians. Politicians cannot say “wow, this is a tough problem. Let’s try a bunch of things, fail at most of them, and learn what works.” Most politicians suffer from what Tim Hartford calls the “God Complex”. Hartford writes the Undercover Economist column for the Financial Times. He has published a terrific book called Adapt: Why Success Always Starts with Failure. You can get a flavor of his thinking at his fantastic TED talk. The God Complex is the equivalent of intelligent design: certainty that complex systems can best be managed centrally and that complex questions can be answered without the painful process of trial and error. Parents, CEOs, physicians, gods, and anyone else who pays a high price for failure are especially vulnerable.

• Business people embrace trial and error mainly because markets force them to. Hartford notes that ten percent of all businesses fail every year.  A market economy can be looked at as a huge, ongoing experiment that evolves, like every complex system, because of variation and selection. The best leaders of complex systems acknowledge that leading edge problems don’t have obvious solutions and encourage a structured process of trial and error. Hartford’s book discusses the value of lots of small, low cost trials that are decoupled so that they don’t spill over and of carefully documenting and interpreting results. An important and highly recommended read.

• Scientists love failure. It’s how they learn. They understand that humans have evolved as complex systems through millions of years of variation and selection. They reason either deductively from data or inductively to ask have we evolved to run? Evolutionary biologists have long noted that the unique way we sweat for thermoregulation, our hairlessness, our odd bipedal design (more energy efficient than any quadruped), our unusual ability to breath multiple times per step, and our highly engineered feet, ankles, and hips all suggest anatomy designed to run.

But until the 1980s, researchers were stymied by one big problem: we are slow. Why on earth would running matter, when every mammal worth eating can outrun us? 

It fell to David Carrier, a graduate student at the University of Utah, to notice something that had escaped other scientists: we are built for endurance, not for speed. The case for humans designed for endurance running is now widely accepted. This is partly because we have discovered a story that backs the data. Hunter-gatherers in the central Kalahari Desert in Southern Africa still practice persistence hunting: they run their prey to death (there is one other group that practices persistence hunting — or at least remembers it. Our pals the Tarahumara). Running down a large mammal takes as little as an hour or as long as 8 hours, but if a human can keep a mammal galloping so that it cannot catch its breath, cool down, or rejoin its herd, it will collapse of exhaustion before the human does. It appears that before we invented spears, humans survived by high-endurance, persistence hunting. Barefoot.

The BBC managed to film a group of men in the Kalahari hunting a kudu this way. Despite the drums and the breathless narration, it is a stunning film. Notice that the runners are shod in cheap shoes that do not let them heel strike. They look a lot like the sneakers we all wore as kids.

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On September 7, Amazon relented and made a deal to pay sales taxes on shipments to California (no doubt the trenchant analysis that follows persuaded them to do the right thing). For details of the deal see http://goo.gl/kNwjQ.

Now every other state in America needs to make a deal with Amazon — even if they have fewer than California’s 10% of the population. This reinforces the need for Congress to enact a cross-border VAT and to rebate 100% of the funds to the state to which the product ships.

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Amazon’s refusal to collect sales taxes is bad for the company’s reputation, bad for honest retailers, and bad for state governments. Six states have taken modest steps to level the tax playing field, causing Amazon to respond with a business, political, and legal offensive to protect its tax-avoidance strategy. The first battleground will be California, where Amazon and national retailers will fight a very expensive ballot initiative. Longer term however, Congress should close the unintended sales tax loophole created by Article I of the US Constitution.

One-click Tax Evasion?

Unlike almost every modern country, the US has never had a national sales tax. Most states tax sales within their state but are rightly prevented by the Constitution from taxing out of state transactions. Amazon has turned this important limit on state tax authority into a major piece of its business model. Unfortunately, a smart tactic is becoming a stupid strategy. Congress needs to level its head — and then level the playing field.

From its first day of business, Amazon.com has taken extraordinary measures to avoid collecting sales taxes. It locates distribution centers in low population states to minimize the number of customers for whom it must collect sales taxes. It builds complex software to ensure that every possible product ships across state lines so that customers have no tax obligation. It puts engineers and logisticians to work in shell corporations even if they work on Amazon’s retail website just to avoid creating “taxable nexus” — which obligate Amazon to collect sales taxes. It hires legions of attorneys to minimize and manage the inevitable tax claims. When states like Texas attempt to collect taxes, Amazon retaliates by closing facilities and filing f-you lawsuits. When states declare that Amazon’s hundreds of thousands of third party sellers and affiliates amount to a physical presence in the state, Amazon simply closes the programs — as it did last week in California. Today Amazon went even further: they filed a state ballot initiative in California that will let Californians vote on whether or not to pay sales taxes on third party purchases. National retailers are gearing up for a mammoth fight.

California Turns Green

Amazon is now America’s Number One Tax Evader. The company says that if you buy Hot Freddy’s Thai Salsa from a Los Angeles seller on Amazon, the sales taxes on the transaction are for you and Fred and the state to sort out. Unlike the corner grocery store, they won’t collect these taxes. Nobody disputes that Fred owes taxes on his sales to Californians, but Amazon says that collecting them is Fred’s job, not theirs. Since, as a practical matter, it costs California more to chase Fred than it is worth, Amazon’s policy needlessly costs California tax revenues and denies Californians badly needed public services.

So California sensibly joined five other states that require Amazon to collect sales taxes on the intrastate sales of third party sellers. The law goes further, and declares that third party sellers or affiliates (sites that earn commissions on traffic they send Amazon) constitute taxable nexus — as do subsidiaries. Jerry Brown signed the measure into law on June 30, whereupon Amazon immediately notified all California third party sellers and affiliates that they were discontinuing their program.

Amazon has built its business model around a court decision. In 1992, the Supreme Court ruled  in Quill Corporation v. North Dakota that a state can compel a company to collect taxes only if they have a physical presence, or a nexus, in the state. Absent nexus, the court held that online retailers and mail-order companies can sell products across state lines without collecting the tax. This decision reflects the current law and our national architecture as a republic formed in an era when very few goods were traded across state lines. It also reflects an odd twist in the way the US collects sales taxes: by taxing transactions based on where the seller does business not based on where the buyer lives, we effectively tax selling, not buying. In old fashioned Main Street America it doesn’t matter: every sale is local. But the rise of mail order and online retail meant that our peculiar approach created a giant loophole. I am aware of no other country that makes this mistake.

Your sales taxes have arrived...

The cost of this loophole is huge. According to the New York Times, “The state Board of Equalization, California’s tax collector, estimates the unpaid taxes at $1.15 billion in the last fiscal year, and estimates it will grow to almost $1.2 billion this year and $1.27 billion in 2012.”. For California, this is roughly the size of the state’s cuts to higher education. Not all of these taxes would have been collected by Amazon, but as the largest retail site in the world and the most aggressive defender of the interstate shipping loophole, they symbolize the problem.

Six states, including California, Texas, and Illinois, have now demanded that Amazon collect taxes based on the existence of third party sellers in their state. In each case, Amazon has killed third party and affiliate sales rather than comply. More states are likely to follow. Jeff Bezos has become an outspoken opponent of any move by states to cooperate on taxing cross-border sales and opposes any effort by Congress to resolve the issue. Amazon collects sales tax in only five states — Kansas, Kentucky, New York, North Dakota and Washington — where it has offices or another physical presence (and it suing New York). To avoid collecting taxes in several other states, it simply operates warehouses as subsidiaries which do not sell anything and are not subject to sales taxes. In California, Amazon hires engineers under the name of A9, its search subsidiary, and Lab 129, which digitizes books for the Kindle. In fact, these engineers all contribute directly to Amazon.com retail sales. Amazon does not even operate a search business in California or anywhere else and 100% of Kindle sales take place on Amazon — but Amazon is fighting for its right to use state resources without helping pay for them. A9 hires Silicon Valley engineers but argues that it creates no taxable nexus because it is a separate company and not itself a retailer. The new law makes this impossible. Amazon, of course, is suing.

Once upon a time, policymakers justified online sales tax exemptions on the grounds that e-commerce was an “infant industry” entitled to a break. The infant is now grown: online sales are now almost $200 billion. Soon, a majority of all media (books, movies, music, games) will be purchased online and the online share of many other retail categories will exceed 20%.

Amazon’s policy is narrow and short-sighted. Instead of building a finely tuned sales tax evasion machine, they should help shape a level playing field. Instead of crippling the tax base of states, they should lobby Congress for a national tax on interstate sales. This tax would only apply to goods shipped across state lines — something the commerce clause clearly lets Congress legislate. The taxes would be collected federally but rebated to states according to the ship to address. This would be the first step in rationalizing consumption taxes to actually tax buyers instead of sellers. Amazon could ask for two tax exemptions: for downloaded digital media because it is essentially a service — you cannot resell digital goods as property. Second hand items would be exempt, as they are in many states already, on the grounds that they were taxed once already.

Amazon is not going to do this, so citizens should. We could design the interstate tax as an education tax to build political support. Of course, any such measure would require Congressional tax leadership, a complete oxymoron at the moment. Amazon has effectively made a large business bet that Congress will be unwilling to enact a national consumption tax. But if national retailers and states combine to lobby Congress for a national sales tax on goods shipped across state lines, they have a powerful argument leveling the playing field and closing the loopholes that Amazon has invested far too much IQ figuring out how to exploit.

Besides, Amazon does not need a tax advantage in order to succeed. The company has a built a powerful brand by offering customers a great selection, a fine shopping experience, convenience, and low prices. The low prices are not simply the result of not charging taxes — they are the result of a much more efficient delivery system. Amazon has overhead that is radically lower than retailers like Home Depot, Barnes & Noble, or Sears. Amazon customers are not going to stop shopping online because they have to pay the same sales tax they would pay at the local store. With public pressure for Congressional leadership, Amazon will quickly figure out that the cost of collecting sales taxes is trivial relative to the cost of being branded the nation’s number one tax evader. If ever there were a time for retailers to organize a campaign to boycott Amazon, it is now. Independent booksellers should be especially easy to mobilize, since most are terminally ill and have nothing to lose.

Amazon is is rightly admired by consumers, investors, and business partners. It is suicidal for them to risk this reputation by becoming a poster child for tax evasion. With states struggling to finance basic health and education services and tens of billions of revenue dollars now at stake, Amazon should send a message that it is a public-spirited brand.  It owes us, and itself, a much higher standard of corporate citizenship.

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During the past two months, I have helped three technology startups raise early stage growth capital and casually advised several others. Each business is in a completely different market: mobile, pharma, cloud computing, crowdsourcing, global communications, etc. Each has unique strengths and weaknesses. The entrepreneurs have wildly different backgrounds and personal qualities.

Not all have completed their funding, but in the process each team has learned similar lessons in how best to approach outside investors (investments from friends, family, and fools doesn’t count. They apply different criteria.) Although I managed to raise tens of millions of dollars for early stage businesses, mainly Alibris, I have personally made most of the mistakes listed here and I have made some of them more than once. Nor is this list particularly unique: investors and experienced entrepreneurs write about them all the time.

So here is my list of the top ten mistakes that entrepreneurs make when they try to raise money from outside investors:

1. No story.  Entrepreneurs try to convince investors that they have a winning business – but investors have no idea which businesses will really work. It’s just too complicated. So investors do what human brains are wired to do when confronted with bewildering complexity: they listen for a coherent story. They listen for a particular kind of story that nearly always has three parts: a strong team that achieves impressive traction solving a big problem. These may be called Team has Traction on Trouble or Management has Momentum in a big Market, but to sell your company, you need to tell your version of this story.

2. No pain. Gill Cogan is a savvy financier, a friend, and a former investor of mine. I once pitched a business to him and after ten minutes, he smiled and said, “that’s what we call a vitamin business.” He explained that people often skip their vitamins – but they never skip their painkillers. Investors prefer a painkiller business. Or as another VC put it “what I really like is a tourniquet business”. A solution to a problem that is acutely felt can grow rapidly. A solution to a minor problem may not be a market at all, even if the problem is widespread. VCs do not fund vitamin businesses.

The flip side of no pain is, of course, no gain. More than anything else, investors want to back companies in huge or potentially huge markets. This leads to herd investing: everyone piles into mobile, cloud computing, or gaming. This is why venture investing has always been a fashion business. This looks irrational, but it makes perfect sense even if it kills the Phoenix. To start with, the cost and risk of investing in any startup is high and approximately constant, so why not focus on companies with huge upside? Moreover, fast growing markets put a lot of wind at a startup’s back, which makes errors much less costly. Investors understand what Google’s Eric Schmidt means when he says “rising revenues solves all problems” — so they back companies where explosive revenue growth is most likely. These are markets that solve big problems or capture huge opportunities.

3. No hub. You live in the wrong place. Capital is highly mobile, but capitalists and startup infrastructure are not. They live in Silicon Valley, Boston, and New York and more importantly, so do the entrepreneurs, technologists, researchers, startup attorneys, talented marketing types, engineers, specialized commercial banks, vendors, mentors, and much else. You can raise venture money in Austin, Charlotte, Seattle, LA, Portland, Chicago and a few other places – although investor quality drops precipitously outside of the major hubs. (If you care why and how this occurs and where is it all going, Google AnnaLee Saxenian – a leading scholar on this topic and a fantastic wife to boot). You may be able to raise money if you are not in a place with active venture or angel investors (several companies have, of course) but it’s tougher. If you live outside a funding hub and are serious about building a technology company, it often helps to relocate.

4. No traction. Your company has an idea but no product or service. Or it has a product but no customers. As Babak Nivi and Naval Ravikant, two well known investors behind the indispensable site VentureHacks, like to say, “traction speaks louder than words”.

You believe that you have invented a revolutionary new dog food that will quickly disrupt the market. Investors cannot possibly figure out if it is really better, so they look for a metric that is rising rapidly up and to the right – often by 20%/month. Any metric that shows rapidly growing engagement will do. Profit is ideal (if profits are growing fast, you can always raise money — although you may not need to). Revenue growth is next best, even if it is from a tiny base. Next best after that is growth in accounts, beta customers, users, or page views. Worst case, show videos of dogs wagging their tails and survey data from dog owners excited about your products. If you don’t have any signs of traction, you don’t have something that people appear to want. You don’t yet have a business.

As important as traction, is an understanding of why you achieved it and why it will continue. Are users engaging other users? What are your viral metrics? Are large companies buying? Why are they trusting a startup? Are customers buying? What are you offering that others cannot and how do you know? Real data about traffic, conversion, average transaction size, repeat rates, defections, costs, margins, etc. begin to paint a clear picture to investors. Ideas about what you hope will happen are simply no substitute.

5. No team. You love your team, but it may not be financable. Most investors back teams with a combination of proven business and technical experience. Why? A VC who was ex Air Force used to say, “backing entrepreneurs is like picking a pilot for an F-15. I favor the guy who has already crashed one, because he or she really doesn’t want to see that happen again”.  Or more commonly: “we know that good judgment comes from experience – and that experience comes from bad judgment”.

This may seem like a Catch-22, but it is rational. Recent research concluded that a venture-capital-backed entrepreneur who succeeds in a venture has a 30% chance of succeeding in his next venture. By contrast, first-time entrepreneurs have only an 18% chance of succeeding and entrepreneurs who previously failed have a 20% chance of succeeding.” The solution? Recruit a co-founder with the skills your team lacks. It does not substitute for product/market traction – but many investors will recognize that your ability to attract talented people is a form of traction.

By the way, there is one glaring sign of a weak team and I see it a lot: relatives in the company, especially on the founding team. Husbands and wives, fathers and sons, brothers and sisters, and couples of all sorts. It is rare that the weaker of these individuals would have been hired in a dispassionate search. Having your relatives in the company, especially a spouse, is a great way to signal investors that you are not determined to hire the very best.

6. Lousy communications. A lot has been written about this. Usually what gets called a communication problem is really a business problem. Bad communication is frequently a sign of bad thinking. But there is one communication problem that is chronic to entrepreneurs: over-communicating. You know too much about your business and in early stage conversations, your knowledge is a liability.

The solution is to prepare three sharply focused business summaries: a 15 word “big idea”, a 15 second elevator pitch, and a 15 slide funding pitch. The big idea is the subject line of the email that your trusted intermediary sends the VC. If they were helping you pitch YouTube in 2005, it might have said “Flickr for videos”. If you were pitching Alibris in 1997, it might have said “find millions of out of print books in one online store”. It is not a consumer-facing tag line, it is the cocktail party handle that people will use to describe your business.

The elevator pitch is the most important and most overlooked. Intermediaries who introduce you to investors will use this in the body of their email. You will use it to describe in a few sentences what problem you solve and what traction you are achieving. Bonus points if you can also fluff the team. Marc Andreesen, were he someone who needed money, might have pitched Ning in 2007 by asserting, “Social networks are an amazing, powerful medium. Ning lets any group build it’s own private social network. We recruited a first rate team, we are hosting more than 100,000 user-created networks, and we are growing at 10% per week.” Boom. Hold the elevator – I want to hear more.

Attached to the introductory email is either the 15 page pitch or a one page summary. Either can work. Do not prepare the pitch from scratch — follow a proven recipe like the excellent ones outlined here, here, here, or here. 15 pages, 15 minutes, 30-point type. It  is hard to over communicate in 30-point type.

There are three things that you should not communicate to an investor. Do not show them secrets. Investors share ideas — that’s often how good ideas germinate. They will share yours. Don’t show them an NDA — they won’t sign it. And don’t show them a business plan. You may want a business plan to force yourself to think through your operations and to have something to use to build a founding team, to brief a board member, or to attract talented leaders. But a business plan will not help you raise money because investors won’t read it and they shouldn’t.

7.  High burn. You have ten employees working for cash, nice offices, no product, and no customers. There are PR and law firms on retainer. You are burning faster than you are learning. Remember this: investors are not looking for companies that need money. They look for companies that will succeed whether the investor commits or not. Raising equity is like borrowing: quite often, the more desperately you need money, the less likely you are to get it. If this is you, take heart: you are unlikely, no matter how hard you try, to violate this rule more than I have.

To state the obvious: any business without revenue has to run very lean, even if they start with a million dollars of 3F seed money. You are still trying to fit your product to the market. You are testing, tweaking, selling, and learning. For most web-based businesses, you don’t need titles; you need one or two people who can sell and small team that can build. Pay is low – everyone works long hours for a bunch of stock. As one investor memorably put it, “an early stage business runs like a one story whorehouse: no fucking overhead”.

8.  No cred. Experienced investors listen for a team that shares the details about what it has built. They listen for specific milestones that reflect customer needs met. Weak teams spend more time talking about future plans – their unproven ideas about where to go next. Talk about traction, engagement, measurable progress both in your current business and in past ones. If you worked at a brand name company or went to a brand name school, mention it – but focus on what members of your team have built. You are trying to build a business, so your record of what you have built gives your team credibility.

9.  No insight into sales or distribution. Early stage companies often don’t know what they don’t know about sales or distribution. This is understandable because early stage companies are obsessed with building a product or a service to fit a market. Achieving product/market fit, or traction, or engagement is hard, critically important work. When it finally happens, it is like a deep sea fish striking your baited line – customers start pulling the product from your hands. You know it instantly (recall the crazy moment in the Social Network where Facebook suddenly goes viral at Harvard).  Getting to this point is the obsession of every startup team. As a result, most are not yet obsessing about sales and distribution.

But they will. Sales and distribution challenges vary all over the map, but most in most companies there are large learning curves and scale effects. Your customer acquisition costs drop as you get bigger and smarter. But in the beginning, you don’t really know how much it costs to acquire customers. The number is likely to be much bigger than you imagined. Which means you can burn through a lot more cash in year one than you expected to.

Put another way, traction can be a trap because it leads entrepreneurs to try to get as much capital as possible out of their growth. This is completely backwards. The point of starting a company is to get as much growth as possible out of your capital.

10. No lawyers. Entrepreneurs, with rare exception, did not go to law school or if they did, they did not pass the bar and become lawyers. New entrepreneurs often dislike lawyers – but they quickly learn that good lawyers matter. A lot.

Once investors are shareholders, their interests are substantially aligned with yours. Until they are shareholders however, the economic interest of an entrepreneur and an investor are opposed. Investors want to buy low; entrepreneurs want to sell high. And the terms, which can be bewildering to a new entrepreneur, matter a lot (as many a VC has said, “you can set the price, if I can set the terms”. They mean it.) In this situation, an entrepreneur needs legal counsel at least as competent as that enjoyed by investors. Day to day, a low cost lawyer is fine. For a major financing however, get a good lawyer who does startup financings for a living.

That’s my list of ten common errors. It is not comprehensive: you could no doubt put together a list of ten others. Nor is it universally right: every generalization has exceptions, including this one. And avoiding these mistakes is no guarantee that you will attract an investor. In raising money, most entrepreneurs kiss a lot of frogs before they find a prince. Then again, so do investors.

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Of course, along with a heart of oak, the town also has a brain of well mashed potatoes. We celebrate diversity beyond parody and indulge in thousand clown politics “somewhere to the left of whoopee!”. Our schools work with immigrant kids that show up speaking more than two dozen languages (actually, nobody speaks two dozen languages. That’s the problem. Each kid speaks one. A different one). Like our libraries, these schools are collapsing under the weight of dodgy managers, paleolithic unions, and ineffective parents (not necessarily indifferent, just collectively ineffective outside of Crocker Highlands).

My part of town, near Lake Merritt, has been brought together by a weekend farmer’s market and by the perpetual comedy of the Grand Lake Theater billboard (typical offering: “Prosecute Dick Cheney for torture” followed by “Kick Ass II”).

We have a terrific neighborhood association which, like most neighborhood associations, is where liberals go to be conservative. Ours is earnestly opposed to rich corporations. And to poor corporations. But perhaps not to Trader Joe’s, because they are German and cool. Also not to Peets, because he was Dutch, their coffee is cool, and they come from Berkeley. (Starbucks: you are clearly suspect). We like “small local businesses” because they are so small and local. The Gap is a dilemma. It is local, but not small — so like Starbucks, we tolerate but do not embrace. What matters here is not whether you create stable, well-paying jobs with health care benefits or even whether you deliver useful goods or services. What matters most in Oakland is that you are small, local, and (ideally) ethnic. Our motto: we love you. Unless you succeed.

Which pretty much rules out McDonalds. In 2004, the Golden Arches wanted to take over Kwik Way, a burger joint that had been abandoned for years. In 1980, Commander Cody and his Lost Planet Airmen memorialized Kwik Way in “Two Triple Cheese” on their Lose it Tonight album. The lyrics suggest that the Commander lived in this part of town, even if he takes liberties with the street names. His ode to saturated fat, salt, and cholesterol now enjoys a place of honor in the permanent collection of the Museum of Modern Art in NYC. Watch it below: it’s pretty good.

Post Cody, the Kwik Way became an abandoned dump and a favorite haunt of sketchy crackheads who sold stuff in plastic tubes and left them lying all over the massive drive-in parking lot. McDonalds offered to renovate the place, hire local kids to run it, and keep it swept up. The arches might have framed the Grand Lake Theater quite nicely, but no way. The ‘hood mobilized against the would be corporate trespassers. Conveniently ignoring the KFC next door, we stopped Big Mac by asserting that the traffic would snarl up the place (we argued, in short, that “we gotta stop this restaurant because it might be so popular”).

Gleeful idiocy of this sort mixed with strong coffee is what keeps Oakland running. Truly if you polled my neighbors, 65% would nod solemnly at the assertion that McDonalds was responsible for Dick Cheney and his Guantanamo torture. (The sordid truth, of course, is that McDonalds has killed more people than Dick Cheney ever dreamed of and quite likely contributed to the Veep’s own lousy ticker. But the Oaklandish among us objected to the crowds that McDonalds would attract, not to the celebrated American tradition of serving cardiotoxins to teenagers.)

Kwik Way crumbled until it was finally sold to a local developer with an appreciation of mauve, ecru, and other soothing colors. He relaunched it as a higher priced burger joint a couple of weeks ago. The place sells food that is arguably more salty, fatty, and sugared than McDonalds, but hey, it is small and local. Here is a video of the opening (a prime specimen of neighborhood values appears at the 1 minute mark).

Comparing the two videos, who wants to argue that we have made real progress?

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Predictably, given the crisis in state and local budgets, rants against public sector unions are now kicking into gear. A recent editorial in the pro-labor New York Times is typical:  

“Last April, in the midst of one of the worst financial crises that New York and the nation have ever faced, the state’s unionized workers got a 4 percent pay raise that cost $400 million. It came on top of 3 percent raises in each of the previous three years. These raises were negotiated long before the recession began, by a Legislature that routinely gave in to unions that remain among the biggest political contributors in Albany.

“During the same period, many private-sector workers had their pay or hours cut. Private-sector wages in New York dropped nearly 9 percent in 2008. In 2009, Gov. David Paterson pleaded with the unions to give up the raises to help the state out of its crisis. Union leaders attacked him in corrosive television ads, and Mr. Paterson eventually caved, settling for an agreement that reduced pension payments to new employees.

“The deal wasn’t enough to address New York’s serious fiscal problems. The average salary for New York’s full-time state employees in 2009 (even before the last round of raises) was $63,382, well above the state’s average personal income that year of $46,957.

What is going on? Have unions driven up public worker pay? Not exactly.

To start with, nonunion as well as unionized government employees have enjoyed larger pay increases than the private sector increases, so it is hard to blame unions alone. 

Second, it turns out that even if you look at take home pay, not benefits or job security, that what public unions have done is to compress wage differentials. The lowest third of public employees earn higher pay and benefits than their private sector counterparts but the highest third (including managers not covered by union agreements) are paid less. This means we overpay secretaries and underpay managers. The former is not a huge problem, but the latter surely is, since what is most profoundly wrong with public services is largely a management responsibility. (Contrast this approach with Singapore, which runs one of the most efficient civil service systems on the planet. They recruit top management talent and pay some of them $2 million/year. My bet is that taxpayers are well served.)

Are public employees actually overpaid? The Economist equivocates, and not for the first time:

Economists still debate exactly what impact public-sector unions have on pay. Evidence from the American Bureau of Labour Statistics support the conservative argument that they have used their power to extract a wage premium: public-sector workers earn, on average, a third more than their private-sector counterparts. Left-leaning economists reply that public-sector workers are, on average, better educated. 

How can we tell whether public employee pay is high if benefits and job security are better but cash compensation varies? One way is to look at how often employees voluntarily quit. Don’t count people who are fired or who retire or transfer – just count folks who quit. After all, if people are underpaid, they’ll find a better job and leave. If they are not finding a better job and leaving, then considering the whole group and the different forms of compensation, they are overpaid.  

Fortunately the good folks at the BLS keep score. What do they tell us? Private sector workers quite three times more often than public sector workers do. You might think that this is fine, since turnover is expensive. (The Daily Kos makes this argument, but it is beside the point if you are trying to determine whether public employees are overpaid).

Of course, it would make sense to pay public employees more than private sector workers doing the same job if they were more productive. But it is not so simple to figure out whether they are or not. You can think about productivity as having two parts: hours worked and output per hour. We know that private sector employees on average work more hours. The BLS National Compensation Survey, private-sector employees worked an average of 2,050 hours in 2008, 12 percent more than the 1,825 hours worked by the average public-sector employee. 12 percent is a significant difference, even if these averages always conceal a bit of mischief. 

Comparing workers hour for hour, the best evidence that improving public sector productivity is a real opportunity comes from two sources. The first is McKinsey, the consulting firm whose research arm has done a great deal of research on labor productivity in sectors and countries around the world. McKinsey’s research suggests that: 

The private sector becomes more productive each year. Long term productivity increases in the private sector average 1.64 percent in the United States, 1.54 percent in the European Union, and up to 7.53 percent in developing economies such as China and India. Although figures for public sector productivity are notoriously difficult to come by because of the problem of quantifying outputs, research suggests that public sector productivity in large economies such as the United Kingdom and the United States is flat or even down and certainly below levels seen in the private sector.

The second source of information is the government itself. Peter Orsag, the talented technocrat who until recently ran Obama’s Office of Management and Budget, was rightly very focused on the gap in labor productivity with the private sector. 

Some of this increasing gap has to do with advances in management techniques in the private sector. Some, undoubtedly, has to do with the challenges the federal government has in attracting and hiring top talent…The average time it takes to hire a new federal employee is 140 days – and by that time, many of the best candidates, understandably, have gone elsewhere. But I believe that the biggest driver of this productivity divide is the information technology gap

Orszag offered some telling examples: IBM reduced the number of data centers it uses from 235 to 12, while Hewlett-Packard has consolidated 14 data centers into one, but since 1998, the number of federal government-operated data centers climbed from 432 to more than 1,100. Orszag also noted that “high-performing” private sector firms kill about one of three IT projects within their first six months. Uncle Sam, he asserted, rarely ends a single one.

Managing public sector productivity takes real effort and leadership to overcome the lack of competitive forces in government. Private sector businesses face constant pressure to improve productivity by reducing costs or improving output. Government agencies usually don’t. We need public services because private markets cannot provide public goods, including street cleaning, police, and a judicial system because of the free rider problem — but increasing pay without increasing productivity is economically and politically disastrous. 

Thinking about public sector pay as partly a productivity problem is helpful because it puts the challenge of public sector unions in perspective. Public employee pay and productivity are management responsibilities. What, exactly, do we pay public managers to do, if not to produce services cost effectively?

From this perspective, labor unions are like vendors. If you sell chain link fencing to the City Parks Department and the city pays you the price you propose, nobody would blame you. From this perspective, a city official who overpays for labor is no different from one who overpays for park fences. An overpaid union member, like an overpaid vendor, represents a management failure and the rare public employee who gots hired away because they found a better job who represents a union failure. That this rarely happens, tells you that public unions are better at their jobs than are public managers. 

The analogy is obviously fraught. Vendors do not enjoy a legally protected monopoly on their fences. A vendor, unlike a union, will not have a three year contract that accounts for 80% or more of all spending. Unlike unions, vendors cannot usually contribute enough money to local politicians to affect a purchasing decision (not unheard of, but not typical). Vendors cannot shut down city services if they don’t like the price. These are real issues, about which more next time.

But the larger point stands: every union agreement has two signatures on it and it is the job of public sector managers to produce effective services with limited budgets. Public sector managers frequently shrug, palms skyward, and blame union restrictions for inaction. 90% of the time, they are shirking their responsibilities. Blaming unions for high union pay lets city and state managers off the hook much too easily.  The compensation data say that we underpay for managers — it appears that taxpayers are getting what we pay for. Nowhere is this clearer than management reluctance to fire marginal public employees — our next topic.

Next The Price of Job Security

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Towards the end of last year’s hit movie, The Kids are All Right, Nic and Jules (Annette Benning and Julianne Moore) drop off their daughter Joni (Mia Wasikowska) to begin her freshmen year at an attractive, unnamed college. The campus was gorgeous — its stately buildings and lawns captured the promise of a nourishing and provocative undergraduate experience.

Although it received no mention in the film’s dialog or credits, the scene was shot on the campus of Mills College in Oakland. I recognized the location only because I had visited the campus just a few hours before seeing the movie. The campus is five minutes from my house and I married a professor, but this was only my second visit to Mills in three decades of living in the Bay Area.

Mills College is a hidden treasure that gets little recognition on screen or off. The school is a stranger to Silicon Valley and unknown to residents of Northern California outside of its passionate alumnae. This group includes several accomplished Bay Area women (and Dave Brubeck, since the graduate fine arts program admits men).

The college recently named a new President, Alecia DeCoudreaux, a Wellesley grad who brings a first-rate business, legal, and nonprofit background to her work. She may prove to be an inspired choice because she is better equipped than most academics to help Mills find three important things that it currently lacks: 

• A renewed raison d’etre. Women’s colleges survived secularization, discrimination, and patronization. But what is the role of an all-women’s college when the average US campus is 60% female? 
• Money. Mills subsidizes the cost of its degrees, but is dangerously under-endowed compared with peer institutions.
• Partners. Nearly every other national women’s college participates deeply in academic consortia with adjacent colleges, allowing women access to a full range of courses and to men as an elective in social and academic settings.

The Landscape

Because most US colleges and universities were all male, women’s colleges arose more out of necessity than preference. Once all-male universities began to admit women, most women’s colleges began to admit men. As a result, women’s colleges today are strongest in countries whose major universities exclude women. Japan has more than seventy women’s colleges. India has more than sixty. Canada, in contrast, has one all women’s college left, Australia has two, the UK has ten and continental Europe appears to have no remaining secular women’s colleges.

During the past two centuries, more than 140 women’s colleges have closed their doors, more than 90 have gone co-ed (and at least a half dozen have done both, occasionally more than once). Only ten women’s colleges in the US went co-ed prior to World War II – but at least 34 took this decision in the sixties and seventies as women entered higher education in force. 

My own family illustrates the trend towards co-ed schools. My grandparents met at Pomona College in the 1920s at a time when most colleges were still all male. Pomona had been founded as a co-ed college 1887, but while my grandparents dated and married in the campus chapel, Claremont established Scripps, an all-women’s college. By the time my mother attended Pomona in the late 40s, the Claremont Colleges had started an all-men’s school thanks to the surge of GI Bill funding. My mom’s college roommate was Panzy Pitzer, whose family endowed another Claremont College that was, for many years, a second all-women’s school. Pitzer became co-ed the year I applied to Pomona in 1970. CMC renamed Claremont-McKenna, followed suit in 1976. Likewise, my in-laws attended segregated colleges (Harvard and Radcliffe) that are now merged and co-ed and my wife was in the first class of women at Williams College in the 1970s.

My daughters, had I managed to produce any, would not recognize the campus of their ancestors. Women in the US today make up 60% of college students. Women earn higher grades than men and graduate in higher numbers. Among older students, low-income students, and black and Hispanic students, the student body is even more predominantly female. Indeed, Mills or any other university that wishes to advance black and Latino education needs to focus on the poorly understood and rarely articulated needs of men. 

Now that men’s colleges have all but vanished in the US (we are down to one, by most counts), only sixty US  women’s colleges remain. More than a third of these are Catholic schools. Another 20+ are regional schools (many vestiges of “finishing schools” that were common in rural America, especially the antebellum South).

Success as a 21st Century Women’s College

Nine secular women’s schools in the US can credibly claim national reach: the five surviving “seven sisters” (Barnard, Bryn Mawr, Mount Holyoke, Smith, and Wellesley), all founded in New England between 1837 and 1889, plus Scripps, Simmons, Spelman, and Mills. Seven of these nine schools have substantial endowments. Eight of the nine participate in meaningful academic consortia. Only Mills does neither.

The chart on the left shows the respective endowment of leading women’s colleges, normalized for undergraduate enrollment (unlike most sisters, Mills has graduate programs, so the comparison is even worse for Mills using total enrollment). For a college the size of Mills, a smaller endowment translates directly into higher pressure on annual fundraising campaigns, since Mills provides more than 90% of its students with financial aid, which totals about $15m annually.

The second disadvantage facing Mills is its relative academic isolation. As the table below illustrates, most national secular women’s colleges participate closely with adjacent colleges. This involves much more than cross-registration for classes. Consortia schools share libraries, divide specialized departments, train faculty, engage the local community, and provide a range of common services. As important, women in consortia schools are able to interact with male students academically and socially at whatever level they judge optimal.  Mills serves women for whom the, optimal level of contact with men is fairly low — and I imagine that many women at Mills learn more and learn better as a result. The challenge for Mills is that the battle for female educational equality is won and then some. It must now bet its future on women who need more than 60% of their classmates to be female. 

Future

What should Mills do? Here are three interesting scenarios.

1. Straighten up and go co-ed. Bad idea and in any case  off the table after a passionate strike successfully reversed a decision by the trustees to do this in 1990. But Mill has a gorgeous campus, a proven ability to attract a capable teaching faculty, and to build a very engaged and passionate alumnae network. Can this group raise money for Mills? Yes, with continued focus and renewed leadership, it can. Stronger ties to Silicon Valley would not hurt, but the school might need to muzzle its proud anti-corporate ethic to achieve this. Appointing a President who is a former drug company executive is a solid start.
2. Stay the course. Mills can try to remain a proudly idiosyncratic gem that caters to women for whom 60% female is not female enough. It’s a tough group to bet on, since it is not a group that seems likely to grow as the years pass. On the other hand, it doesn’t need to grow, since nobody is going to start another women’s college. Mills may want to simply continue to provide women with an undergraduate experience that they are proud of and willing to support. This limits the scope of innovation available to the campus, but the kids are all right and hidden treasures are treasures nonetheless. 
3. Build the consortium. Can Mills overcome the lack of a meaningful consortium and rival Scripps as a premier west-coast women’s college? Yes, but only if it takes on the Claremont Colleges, not just Scripps. This implies two big changes: a focus on undergraduate education and a commitment to diversity that draws more from Oxford than from Oakland.

Mills should phase out its business and education programs. The business school is a comic disaster: architecturally and pedagogically barren and economically unnecessary. The education school is renowned, but pointless. Plenty of research demonstrates that if you want a better history teacher, you teach them history, not education. Ed schools simply do not produce better teachers. 

Instead of graduate programs, DeCoudreaux should build a three school version of the Claremont Colleges: convert the Lokey Business School to a high quality co-ed but heavily female science and technology school, where a focus on women makes a lot of sense. The school should rival Harvey Mudd. Endow it with Valley money from technologists who value this sort of training (Andreesen College, anyone?). Then turn the Ed School into a large, high quality, fully co-ed college to rival Pomona. The schools would share a range of services from libraries to placement, social events, and faculty development. Mills would be enhanced as a fully competitive, high quality all-women’s school. In twenty years, Mills would rival not only Claremont, but the surviving sisters. Hard to see that happening any other way. 

Mills has a choice, not between women’s vs co-education but between being a tiny university with underfunded graduate programs and group of a very high caliber colleges focused on outstanding undergraduate education. From here anyway, it’s clear which direction Mills should go.

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I have always loved printed books. I like discovering them and reading them. I like how they look, feel, and smell. I like rooms filled with books like the reading room of the British Museum or the New York Public Library or the rare book room at Shakespeare’s. I like the cluttered shelves of professor’s offices and books that become like old friends.  (Lawyers offices I like less. Identical leather bound volumes suggest a rigid mind. Doesn’t do it for me). 

If I visit your house, I will head for your public bookshelves. Scanning what you display and claim to read tells me about you. If you visit my house, you will find loaded bookshelves in the bathrooms, the bedrooms, and the basement. To say nothing of the offices.  

I love bookstores. I like discovering books but I also like seeing and smelling that many books. For many years when our kids were little, my wife and I had a babysitter show up every other Saturday night, just so we would get some time together. We were often too tired to plan real dates, so as I backed the car out of the driveway, I’d say “where to?”. We quite often ended up at a bookstore — our idea of a hot Saturday night. 

I started an online book company to support small bookstores and frequently preached the endurance of printed books. “Books have been around for five centuries. We believe in the form factor. If you don’t, you should not invest in this business”. I often joked that only eBook company CEOs actually read eBooks. Until recently, I not only bought more printed books than electronic ones, I also bought more books in stores than online. 

For me, it’s hard to imagine a life without printed books. But each year starting now, paper books will get scarcer, brick and mortar bookstores will become tougher to sustain, and the odds that I learn what you are reading from your shelves diminishes. For my grandkids, printed books will be like old maps: wonderous objects worthy of reverence — but nothing you’d actually use. 

In reporting earnings today, Amazon CEO Jeff Bezos noted that his company had achieved two milestones. Amazon enjoyed its first ten billion dollar quarter (when I entered the online book business in 1997, Amazon sales were about ten million dollars a month — 3 thousand times smaller than today).

More significantly however, was the reason for this growth.

“Kindle (electronic) books have now overtaken paperback books as the most popular format on Amazon.com. Last July we announced that Kindle books had passed hardcovers and predicted that Kindle would surpass paperbacks in the second quarter of this year, so this milestone has come even sooner than we expected.”

Amazon is not the entire economy, of course. Most books are still printed — but the shift to electronic books is accelerating, thanks to exploding sales of readers — especially iPads and Kindles.

As soon as 2013 and certainly by 2015, consumers will buy more electronic books than printed books. Outside of college towns and large cities, music stores disappeared five years ago — even though MP3 players integrated with online stores are only a decade old (the first iPod did not come out until two weeks after 9/11. Full iTunes integration and the acquisition of a lot of music took a bit longer).

As Mary Meeker’s chart from the recent Web 2.0 conference illustrates, iPad, iPod, and iPhone (all workable readers) adoption has been much faster than any technology in history. Faster than browsers and faster than DVDs. And her data exclude Kindles and Nooks.

Unlike music, supply is not a constraint on the growth of this market. Amazon has been patiently building its eBook inventory for years, long before sales could possibly justify it (I seriously doubt that Amazon has yet to see a dollar of profit on eBooks if you measure all eBook costs to date vs all eBook revenues). Whereas music was content constrained for years, books have arguably been device constrained until recently.

No longer: today, Amazon announced that 

“The U.S. Kindle Store now has more than 810,000 books including New Releases and 107 of 112 New York Times Bestsellers. Over 670,000 of these books are $9.99 or less, including 74 New York Times Bestsellers. Millions of free, out-of-copyright, pre-1923 books are also available to read on Kindle.

800,000 books is not every book, by a long shot. But it is almost every popular book and when you add Google books and the Open Content Alliance, the total number of scanned titles surely approaches ten million. Not all of these are available commercially, yet — but most will be within a few years. (Few people read more than a 2-3 thousand books in a lifetime anyway. The average is surely no more than a hundred).

The availability of very high quality reading software built for a variety of platforms is also not a constraint.

“Amazon added to its growing list of “Buy Once, Read Everywhere” Kindle apps, launching a Kindle app for Windows Phone 7. In addition, the Kindle for Android app was updated to enable users to buy, read and sync over 100 Kindle newspapers and magazines. All Kindle apps let customers “Buy Once, Read Everywhere”–on Kindle, Kindle 3G, Kindle DX, iPad, iPod touch, iPhone, Mac, PC, BlackBerry and Android-based devices. All Kindle apps are free and incorporate Amazon’s Whispersync technology, which allows readers to seamlessly switch between devices.

Finally, storage is not a contraint. 

“With Kindle Worry-Free Archive, books purchased from the Kindle Store are automatically backed up online in the Kindle library on Amazon where they can be re-downloaded wirelessly for free, anytime.

Digital reading is becoming so normal that it will soon be hard to find people who do not read digitally. Already, some magazines are not available in print. There will be the usual death throes: publishers will fight retailers over the cost of book returns (a big but not avoidable cost of brick and mortar retailing). These wars will brief and destructive to both sides.

Borders will close its doors this year. Barnes and Noble may remain open only because they will move out of book sales. They seem likely to take up clothing or electronics or gift cards or coffee. Or furniture or typewriters. Or something.

There are winners, of course. Device makers win (Amazon, Apple). Electronic retailers win (Amazon, Apple). Publishers who get out in front win (Smart: Wall St. Journal, Economist. Dumb: New Yorker, New York Times. Hopeless: magazines and book publishers who refuse to release electronic copies).

Books have had a good run. I am going to miss them.

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DeLong recently gave his students some well thought out advice: What Econ 1 Students Need to Remember Most from the Course” followed shortly by “What Econ 1 Students Need to Remember Second Most from the Course“. This is a brief, brilliant introduction to economic thinking (and the comments he received are worth a read as well). With the Jamkid home from Chicago and preparing to enroll in its fabled microeconomics course in the new year, it seems fitting to republish it (although the emphasis is mine). Savor the post like a fine glass of wine and perhaps with one.

“Economics”, writes DeLong, “deals with those things that we want but that are “scarce.” We economists care about commodities whenever there are not enough of them for all of us to be satisfied that we have all that we want. Under those circumstances societies then have to–we have to–figure out whether it is worth making more of these scarce commodities. And then, if we do make more of them, we then need to figure out who is going to get to use them.

Where things are not scarce (the air, for example), that is not economics. Where we do not care that is not economics either. Where things are both scarce and where we care, we have the economic problem.

How ought a society to go about dealing with the economic problem? How should we–collectively–decide whether it is worth our while to make more of any particular commodity? And if we do decide to make more of them, how ought we to decide who is going to get to use them?

At this point I need to pause and note two facts about the world. Most scarce things that we care about are “rival.” And most scarce things that we care about are “excludable.” By “rival” I mean the only one person can use it at a time. I am now using this iPad to read my lecture notes. Because I am now using it, you cannot be. By “excludable” I mean that it is relatively easy to keep someone from making use of a commodity. I can keep your cows from eating my grass by putting up a barbed-wire fence.

Because commodities are “rival,” somebody’s use of a particular good imposes an opportunity cost on the rest of society. Because I am using this iPad, there is one fewer iPad for the rest of you to use. My use restricts your opportunities. A good economic system would make me take account in my decision-making of any reduction in your opportunities and resources that might be caused by my actions.

This is where the market economy comes in.

Let us assign each newly-produced commodity a particular person. Call this person the “owner.” Let the owner decide who is going to get to use the commodity. Let the owner exclude all others who from using the commodity. And let the owner charge the designated user he or she has decided upon a “price” for the right to make use of this commodity.

This simple institutional arrangement has a huge number of advantages as societal mechanism for planning and coordinating the production and distribution of scarce, rival, excludable commodities.

It solves the problem of production–what commodities we should try to make more of. Individuals look forward into the future and recognize that others will be willing to pay them high prices for commodities they greatly desire. That gives individuals an incentive to figure out how to make more of those scarce, rival, excludable commodities that are scarcest.

It solves the problem of economizing--of how to get people to economize on their own consumption and not hog too great a share of society’s total resources for themselves. Because they have to pay the owners the prices the owners ask, their eyes may be bigger than their stomachs but their wallets generally will not be.

It solves the problem of distribution–of determining who is going to get to use newly-produced commodities. The owner has an incentive to choose the person willing to pay the highest price–and the person willing to pay the highest price is, in some sense, the person who values it the most, to whom it is scarcest.

Moreover, it solves the problem of coordination: As long as market prices are free to move to equalize quantities supplied and demanded, there does not need to be any huge centralized computer bureaucracy keeping track of everything and making sure that plans add up. The market will coordinate itself.

And it solves the problem of information: In a market economy with commodities with owners, decision-making is pushed out to the periphery of society where people already know what is going on. You don’t need any huge centralized computer bureaucracy collecting and processing information–and where people do discover that there are things that they don’t know but need to learn, why knowledge of something and that somebody else would like to learn it is also a commodity and those who know those two facts are its owners.

It is hard to imagine a simpler institutional framework–owners and prices–that could solve those five problems so very well.

At this point I need to pause and point out a lucky consonance between the requirements of a societal institution for producing and allocating rival, excludable, scarce commodities on the one hand and the psychological propensities of us East African Plains Apes on the other. That we believe that things are ours and that we own them is perhaps not so surprising–it appears deeply deeply engraved in mammalian psychology. Squirrels certainly act as though they believe that they “own” nut-foraging sites. Dogs believe that they “own” bones. We East African Plains Apes, however, not only believe that we own things–we like to give them away. We are animals that solidify our own societal bonds via relationships of gift-exchange. And it is this psychological propensity to engage in gift-exchange–what Adam Smith called our natural propensity to truck, barter, and exchange in such a way that both sides are happy because they feel that they have gained something from the deal–that serves as the underpinning of our market economy.

That is the first thing I want you to remember from this course: The market economy, based on deep human psychological propensities, is an extraordinarily effective societal instrumentality for planning and coordinating the production and distribution of scarce, rival, excludable commodities.

Remember this. Keep it as an active process running on your wetware always. Lay up this idea in your heart and in your soul. Bind it for a sign upon your hand, that they may be as frontlets between your eyes. Teach it to your children when thou sittest in thine house, when thou walkest by the way, when thou liest down, and when thou risest up. And write them upon the door posts of thine house, and upon thy gates: that thy days and the days of thy children–or at least the commodities they own–may be multiplied.

What is the second most important thing for an econ one student to remember? It is how stringent the requirements for any form of “market efficiency” are: how many ways a market economy can go wrong and go badly wrong. I count seven ways that market economies can and do go badly wrong:

First, the market will go wrong if the wealth distribution is wrong. The market judges value by willingness to pay, and the rich are much more willing to pay them the poor, and those without wealth or income have no willingness to pay at all. If your wealth and income are zero, then the market literally does not care whether you live or die–it is of no interest to it at all.

Second, the market will go wrong if commodities do not have the proper characteristics. Remember: rivalry, excludability, and also information–people have to know what they are buying. An absence of or imperfect rivalry–increasing returns to scale in production or consumption of any sort–and the market will go wrong. An absence of or imperfect excludability–free-rider problems of any sort, or any failure of property rights definition or enforcement–and the market will go wrong. An absence of good information about exactly what you are buying or selling–adverse selection or moral hazard problems of any sort–and the market will go wrong.

Third, the market will go wrong if market agents do not take the prices at which they buy and sell as given but rather have some control over the prices at which they transact. The belief that the market is efficient hinges on the absence of market power–as well as on the proper income distribution, and on the proper characteristics of commodities.

Fourth, the market will go wrong if prices do not equalize quantities supplied and quantities demanded at every moment. “Price stickiness” for any sociological or psychological reasons disrupts the market’s ability to function.

Fifth, the market will go wrong if Say’s Law breaks down (MM: I did not take the course, but Says Law says roughly that we will not have failures of either aggregate supply or demand. The market will always clear.) If there is substantial downward pressure on spending on currently-produced goods and services because of an excess demand for financial assets of a kind that the private sector cannot immediately and instantaneously generate on a large scale, then the market will go wrong and we will have a downturn and a depression. If there is substantial upward pressure on spending on currently-produced goods and services because of an excess supply of financial assets of a kind that the private sector cannot immediately and instantaneously shed, then the market will go wrong and we will have a burst of inflation that will disrupt the functioning of the price system.

Sixth, the market will go wrong whenever its prices function as forecasting mechanisms. A proper forecasting mechanism would weigh each individual’s opinion by the precision of his or her knowledge. A market tends on the contrary to weigh each individual’s opinion by his or her wealth. This means that whenever economic processes tend to revert to seem average level that the market is likely to get things wrong, for when prices rise above average those who are optimistic become richer and their opinions carry more weight and so prices tend to rise further above their likely long-run fundamental values. Bubbles and crashes, manias and panics, are thus built into the system.

Seventh, the market will go wrong whenever individuals are bad judges of their own long-term interests–note that I say when, not if. Humans are very bad at assessing and dealing with risk. Humans are not that great at appropriately weighting different conflicting pieces of information. And humans are absolutely horrible at dealing with substances or patterns of behavior that can be addictive.

Whenever the system falls into any one of these seven arenas of psychological, behavioral, or institutional myopia and market failure, the market will go wrong. A good government will put its thumb on the scale in order to offset all of these seven forms of market failure. A great government will have foresight and take care to structure political-economic institutions to make these seven arenas of myopia and market failure as small as possible.

Remember this too. Keep it as an active process running on your wetware always. Lay up this idea in your heart and in your soul. Bind it for a sign upon your hand, that they may be as frontlets between your eyes. Teach it to your children when thou sittest in thine house, when thou walkest by the way, when thou liest down, and when thou risest up. And write them upon the door posts of thine house, and upon thy gates: that thy days and the days of thy children–or at least the commodities they own–may be multiplied.

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