Why are Founder CEO's the Best? Arrow and the Behaviour of Firms

The maxim in Silicon Valley is that founders make the most effective CEOs. Assuming that's true, can we understand a deeper reason for it? I think we can. To do so, let's talk about how groups make decisions.

  • Famously, Arrow's impossibility theorem shows that no voting system will be rational in the human sense.
  • A rational voting system means that:
    • If every individual prefers option A over option B, then A should win over B. (Pareto Condition)
    • If A wins out of the choice of {A,B}, then B should not win out of the choice of {A,B,C}. Either A wins or C wins. (Independence of Irrelevant Alternatives)
    • No single voter can choose the election outcome. (No Dictator)
  • Arrow's theorem says that it is impossible to have a voting system that satisfies all three of these conditions.
    • Note: The voting system is abstracted away. Arrow's theorem applies to any voting system. The only assumption is that individuals vote based on their ordinal (and not cardinal) preference.
  • Another way of describing Arrow’s theorem is: Groups of people cannot rationally make decisions.
    • Or: Groups of rational agents are irrational.
  • An important consequence of Arrow's theorem is that, for a group to behave rationally, its voters must be irrational or it must be run by a dictator.
    • That is: Either the voters are irrational or the voting system is irrational.
  • Why does this relate to firms? Because a firm is just a collection of individuals whose daily actions (i.e. votes) determine the direction of the firm.
  • Thus, Arrow’s theorem also applies to firms: A firm will only behave rationally when it is run by a dictator.
  • More loosely: Firms will behave more rationally when the power of the CEO is more concentrated.
  • This is why large bureaucratic organizations, where power is dispersed throughout the organization, will often seemingly behave irrationally, lacking clear direction and regularly making illogical decisions.
  • And hence the preference for founder CEOs who have the moral authority to wield concentrated power within the organization.

So, yes, there is a theoretical case to be made for founder CEOs.

The Nature of the Firm: Why do firms exist?

  • In his seminal paper The Nature of the Firm, Ronald Coase attempted to answer the question: Why are there firms?
  • This question of "Why are there firms?" could instead be phrased as "Why do people have jobs?"
  • Or invert the question: "Why isn't everyone self-employed?"
  • To approach this question, let's take a step back and think of a production system comprising of many individuals represented as nodes.
  • Each individual contributes to a different part of the production process, but also requires inputs from other individuals throughout the system.
  • The coordination between these individuals occurs through price signals in the free market — i.e. market transactions.
  • Through price signals in the free market, the individuals collectively reach an equilibrium of what they produce, how much they produce, and their rewards for producing. For econ wonks, this is called the Walrasian Equilibrium.
  • But in the real world, that's not the whole story. It turns out that groups of individuals often join to work together — that is, as a firm.
  • And what is most interesting is that the firm organizes within itself without price signals. Instead, the firm is centrally planned by the entrepreneur.
  • As Coase says, "the distinguishing mark of the firm is the super-session of the price mechanism."
  • But why do these firms emerge? Why don't those individuals continue to act independently and coordinate through price signals in the free market?
  • Coase says the reason that firms emerge is because of transaction costs. These are costs that naturally emerge from using the free market.
  • Transaction costs are things like: information asymmetry, escrow fees, contract writing and negotiation, regulation compliance, the lack of an established market, brokerage fees, sales taxes, the risk of trade secrets being leaked, etc.
  • Transaction costs act as friction to market transactions, making it costly and difficult to use the price mechanism of the free market.
  • Coase says that the creation of the firm can reduce these friction by bringing people "under one tent" and removing the need for individuals to trade with each other in the free market.
  • Instead, individuals provide their services to other individuals inside the firm according to the firm's organizational structure. This removes transaction costs that would have otherwise been encountered in the free market.
  • Examples:
    • Instead of contracting a lawyer every time a legal question arises, a firm will hire the lawyer as an employee and form a legal department.
    • Instead of contracting a designer every time a new prototype is required, a firm will hire the designer and form a design team.
    • Instead of contracting an engineer, a firm will....
  • That is why firms exist: To reduce transaction costs associated with using the free market.
    • And in what world would firms not exist at all? In a world with zero transaction costs.
    • Without transaction costs, the free market equilibrium (Walrasian Equilibrium) would prevail.
  • In this sense, the firm is the anti-thesis of the market. Unlike the market, the firm is centrally planned, removing the need for price signals between individuals.
    • Firms can then trade with other firms and individuals using price signals in the free market.
    • Firms are thus blobs of centrally planned economies operating within a free market ecosystem.
    • Firms essentially take groups of individuals and make them resemble individuals in the marketplace. (Note that an individual is also centrally planned, in a sense.)
  • The firm centralizes what was once decentralized when the cost of decentralization is too high.
  • The creation of firms helps the ecosystem resemble the idealized free market equilibrium (Walrasian Equilibrium) that would arise if there were no transaction costs.
    • Outside the firm, production is directed by price signals through market transactions.
    • Within the firm, production is directed by a central planner (the entrepreneur), removing the need for market transactions.
  • Coase predicts that ecosystems with larger transaction costs will tend to create larger firms. On the other hand, smaller transaction costs tend to create smaller firms.
  • Coase also predicts that more individuals will tend to create more firms and larger firms. On the other hand, fewer individuals tend to create fewer, smaller firms.
  • In the limit where transaction costs go to zero, the firm will go extinct and everyone will be self-employed.
  • In reality, an ecosystem will have many firms of many sizes and structures, producing many kinds of goods, and include many self-employed individuals navigating the free market.

Bank-runs are simply the collapse of the network effects surrounding credit

The bank runs in Greece have been on my mind the past few days and in order to properly think about what is happening, I have been gathering my thoughts on the nature of bank runs in general.

  • Network effects are powerful because they have momentum.
  • This momentum works in both directions: both when the network is growing as well as when the network is collapsing.
  • Since network effects can collapse on themselves just as easily as they can grow upon themselves, people often label the collapse of any network effect as a “bubble.”
  • But bubbles are actually the collapse of unsustainable network effects. Not all collapsed networks are bubbles.
  • Money and, more broadly, credit are subject to network effects.
    • (Indeed, modern money derives all its value from the network effect.)
  • Banks are systemically dependent on the network effects of money and, in particular, credit.
    • All money is credit, and credit is just another word for trust.
    • In other words: The more people trust a bank, the more trustworthy that bank becomes.
  • Bank runs are simply the collapse of the network effects surrounding credit, as people lose trust that their deposits can be withdrawn.
  • This is why, like all other network effects, bank runs are self-fulfilling, contagious, and very difficult to stop once they have started.
    • Because if everyone does withdraw their cash, there will not be enough cash to go around.
  • And this is why the role of the central bank (which can create as much cash as it wants) as the lender-of-last-resort is so crucial to financial stability.

The European Central Bank has said that it will not act as the lender-of-last-resort to halt the Greek bank run. The interesting question now is whether the bank run will spread into Italy and Spain. And what the European Central Bank will do about it.


What is 21 Inc. trying to do?

Ben Thompson today published an article on Bitcoin and the start-up company 21 Inc. I then somehow found myself in a twitter debate about Bitcoin and 21 Inc.'s business model with the notorious Walt French.

It turns out that it's very hard to express your ideas on Twitter. So below I've outlined my thesis:

  • Bitcoin is valuable for internet-of-things devices, allowing devices to algorithmically exchange property rights.
  • Ideally, IOT devices should be convenient to use with a "plug and go" design, just as normal devices exist today.
  • One solution to achieve this "plug and go" is for IOT devices to have access to bitcoins somehow embedded into its design, without the need for the user to "set it up" and link it to their own Bitcoin address. But how?
  • 21 Inc. aims to solve this issue by embedding IOT devices with its bitcoin-mining chips.
  • 21 Inc. will provide bitcoins on demand to the IOT devices that use its chips and in return, 21 Inc. will keep all bitcoins mined from those devices.
  • This works because the amount of bitcoins each IOT device needs is small and with high frequency. On the other hand, the amount of bitcoins each IOT device earns is large but with very low frequency.
  • Similar to a bank that borrows short-term and lends long-term, 21 Inc. will profit from the difference in bitcoins mined and consumed over the life of all the devices in its portfolio. This is also analogous to how insurance works by pooling risk.
  • In the end, 21 Inc. will be providing users a way to "pre-pay" for bitcoins that their IOT device will use over its lifetime without the hassle of set-up.

I think that's pretty much 21 Inc.'s plan at the moment.

Bitcoin has value from being a platform, not money

Like other fiat currencies, Bitcoin is a network-backed currency: It derives all its value from the network effect — also known as Metcalfe's Law. (Monetary economists call this the hot potato effect.)

Many people think that Bitcoin is flawed as a currency because it is not backed by something beyond itself. They are wrong. Bitcoin is flawed as a currency, but it is flawed because of its fixed supply, inherent in the protocol. Contrary to what many Bitcoin proponents argue, fixed supply is not a desirable characteristic of money because it would make monetary policy impossible. And remember, monetary policy is very important because it solves the problem of price stickiness and money illusion. In particular, bad monetary policy causes recessions (and disastrous monetary policy causes depressions).

Thus any currency that does not allow for monetary policy is inferior to the current model and is not likely to be mass adopted in the long-run — unless, of course, it finds some other solution to money illusion. But so far, I have not heard of any solution to money illusion other than monetary policy. To become widespread, Bitcoin needs a central bank that can adjust the money supply to prevent recessions. (Actually, a central bank is not needed if money supply adjustments are built right into the protocol, which would be very interesting, but I digress.)

Now, this does not prevent Bitcoin from being a platform for currencies. I have discussed before that it is likely that central banks will create their own crypto-currencies, and the easiest way for them to do so is to simply fork the existing Bitcoin protocol. Central banks would then be able to change the supply of money by leveraging the network effect (read the post to get a full description of how).

And if Bitcoin is forked to create official central bank money, bitcoins mined today will still have value in the future. But that value will be determined by central banks in the future, and means that today's value comes from Bitcoin being a platform, not Bitcoin being money.