Economic theory, please disprove

I was thinking about this today after reading another tale of another relative being laid off from a large company, and this came to me. It’s something I don’t -want- to be right about.

Company gets investor money. A large company requires many investors. Investors’ money quickly becomes -very- important to said company. The only thing that tends to bring in more investor money is either the appearance of profit, or at the very least the appearance of doing something to cut loss. Cutting loss usually means firing people. Ergo, when the economy is bad, large companies have to let people go to please investors, thus, in a sense, making the economy worse (due to a rise in joblessness). Seems like the investors get along well at the expense of the actual productiveness of the company.

Or am I missing something glaringly obvious here?

Yes, the investors OWN the company, pleasing them is the A-#1 most important thing management can do. If you owned a small company, wouldn’t you demand that the managers take actions that please you?

You’re assuming that laying people off makes a company less productive, and therefore less profitable. Sometimes that’s true, because management (like anybody else) can be stupid. Often, however, layoffs are just what a company needs to become more competitive and survive difficult times. This is painful for the people being laid off (I’ve been there), but the alternative would be for the company to go bankrupt, causing investors to lose their money and all of the employees to lose their jobs.

No, you are right. Short-term interests ($$$) of the investors–esp. that sticky thing called “growth”–are always more important than anything else.

What this means is that firing employees is the fastest and most basic way to cut costs and show a better profit margin. Whether or not this ignores hidden costs associated with hiring new, less-experienced workers later depends on each company’s situation. If I have a direct-mail-envelope-stuffing company, and my business drops off so that I only have orders for 900,000 envelopes a day instead of 1,000,000, it makes sense for me to cut the relatively unskilled workers until the orders go up again. But if I have a pharmacueticals company, and profits are down, it’s a much weightier matter if I want to fire a bunch of highly trained PhDs–I might not be able to get them back, and up to speed, quickly enough when the market rebounds.

Unfortunately, in a larger sense, this duty to short-term investor profits means that almost no company (esp. publicly owned companies) can implement anything but short-term strategies. But that’s business for you.

Well, you’re missing one thing; bringing in more investor money involves issuing more stock, which dilutes the investment position of current shareholders. The current shareholders tend to resent this, and large stock issues usually require their approval, so it usually doesn’t happen. Instead, the push is to do anything to keep the stock price rising to make the current shareholders happy. Even though the management (and even the majority of voting shareholders) might prefer to avoid certain measures, it’s impossible to ask the whole stock market whether they’d like to forgo the profits involved in outsourcing overseas, for example. In this way, the stock market exercises a sort of mindless amoral control over corporate executives.

I am not an economist, but here is my take on your question. First the answer is sometimes yes, sometimes no.

The example of an envelope stuffer being fired for lack of work shows that sometimes firings are rational. Another example comes from the fact that lax management (or strong unions) sometimes leave a company with a lot of dead wood. In my daughter’s first job as an editor with an academic publisher whose annual journal subscriptions were often in the thosands, she felt that about half the people there were accomplishing nothing. There were even some whose accomplishments were negative, since they interfered with the productive employees. If a new management team can axe those, they are doing something that is good in the long term.

All too often in a recession you get the following. A company with a large skilled work force finds that slowing sales have left it with a large inventory. In an extreme case, they might have enough to go a year with no production. In that case, they can show giant short-term profits by laying off their work force and selling off their inventory. The management team that does this can now sell off their options at a jolly old profit and move on to the next company having mined this one. Now recession ends and the company finds itself in the position of no inventory and the highly skilled work force decimated. IMHO, good management would first have avoided the large buildup of inventory in the first place, partly by tracking production and sales more closely and second would strain a gut to preserve the work force, which really was its most valuable asset.

The economic world may be crudely divided into farmers and miners. The miners have no long-term future. Even farmers can be miners. It is said that US agribusiness is mining the topsoil.

The sad thing is that your example actually makes good, economic sense! Try to figure out this scenario.

A CEO gets a large share of stock as part of his salary.
The CEO plans to sell a large share of his stock on January 1.
The CEO lays off employees simply to cut expenses and to keep the stock price up until January 1.
The CEO sells his stock on January 1, and the stock price dives soon afterwards.
Share holders and employees with the stock in 401K accounts get crushed.
The CEO resigns with a multi-million dollar severance package.

CEO goes to jail for breach of fiduciary responsibility and failure to disclose material information. :rolleyes:

Stock price is not entirely based on current performance of the company. The ‘standard’ measure of a company’s current performance is (for most industries) the price/earnings ratio, usually shortened to ‘P/E ratio.’ Most companies are traded at some multiple of their P/E ratio, which is based upon analysts’ expectations of future performance. If ACME Corp announces that they will lose $0.08 a share this quarter, but expect to show a $1.25 per share profit next quarter, the stock is not going to plummet. And, if ACME Corp announces $1.25 per share next quarter but doesn’t make it, the executives had better have a damn good reason why the forecast was missed (and this is something that the securities authorities, such as the SEC in the United States, monitor).

If a money-losing public company presents a reasonable looking plan for how they intend to grow their business, analysts (and therefore investors) are likely to take a positive outlook on it. Certainly, executives have a fiduciary responsibility to make sure that the company’s money is being properly spent, including the payroll. If, in the course of looking into how the company can be made profitable, the executive decides that they have too many staff, they are obliged to make cuts.

I am an economist (or at least that’s how I earn a living). Your story is correct in some situations.

Investors don’t put money in companies to feel good about themselves, they put money in companies to make a return: profit. If they don’t make a return on their money in one investment they tend to move it elsewhere. If enough investors remove their money a company generally gooes out of business.

Some very basic (and overly simplified) economics (also basic accounting):

Profit = revenue - costs
Revenue = price * quantity of product sold
Costs = fixed costs + variable costs

Say we’re in an economic downturn and people stop buying as many of your company’s widgets as previously, on the basis of the very simplified equations above, there’s a few actions the company can take:

Accept lower profits: Investors can get pretty unhappy about that and may move their money elsewhere leading to a decrease in the value of your company. However, in a generalised recession, returns on most assets tend to decrease as well, so there may be nowhere for them to move their money to that earns more than what they are getting.
Increase prices: this can be pretty difficult to do (unless you’re a monopoly). Your costumers tend to move to your competitors or substitute other goods for what you sell (if you’re selling apples, they might start buying your competitor’s apples or even start buying pears if you push your price up). - I’m not going to get into a discussion of elasticities here.
Sell more: Sometimes companies react to sales drops by more aggressive marketing and sales. In some cases this can pick up lost revenue. However, despite what advertising companies may say, for the vast majority of products, advertising won’t do much if your product isn’t competitive or people aren’t buying.
Cut your fixed costs - Again, difficult to do. In the short term, by definition, fixed costs can’t be changed.
That pretty well leaves you with cutting variable costs. For most companies, labour is one of the largest variable costs. When a company starts going downhill, labour is therefore often one of the things it cuts back.

As I said, that’s a pretty simplified view. It can be complicated by a lot of things, including:
Financial markets tend to value companies on the present value of their future stream of profits (rather than their profit at any one point in time). Therefore, if the financial market believes that your company has a profitable future, they may downgrade its value more slowly.
Companies often have a few in-built buffers that allow them to ride out temporary bad patches -retained earnings etc. However, there’s only so much you can eat into these before investors see it as devaluing their investment.
As someone else mentioned above, hiring and firing is not a costless exercise. It costs money to lay people off and pay out their benefits. It also costs money to hire and train new people when an upturn arrives (economists tend to call these costs ‘transaction costs’). Companies will generally not fire people until the transactions costs are outweighed by the savings from averted wages.
Elasticities: Alright, I said I wasn’t going to mention it but I’ll try to do it in a non-jargonistic way: People react differently to changes in prices of different products. For some products, people underreact to changes in their price. For example, if the price of potatoes goes down by 50%, people don’t tend to hurry out and buy up big on potatoes (there’s only so many potatoes you can eat). For other products, people overreact to changes in their prices - if the price of Mercedes Benz cars went down by 50%, you’d probably see a greater than 50% increase in the sales of Mercedes Benz cars.
Ignoring competitors and costs for a second, this means that some companies (eg the sellers of Mercedes benz in the example above) can increase total revenue by dropping prices and selling more quantity, (remember revenue = price * quantity) similarly they could increase prices and sell a little bit less but still increase revenue. For other companies (eg potato sellers), these approaches would be disastrous.
Obviously this gets complicated when you start thinking about competitors as well. And I’m not even going to talk about Giffen Goods.

So, what does all this mean? In short: yes, some companies do tend to cut labour when sales are heading south. However, there are a few ameliorating factors and there are a few other strategies that they also follow.

Generally, cutting labour in a recession doesn’t mean that company managers are evil (economists don’t tend to think of companies in terms of morals) just that they are rational.

There are a lot of other things I could have added here but I wanted to keep it simple and I didn’t want to write a book. I’m sure others will be along to fill in the gaps.

I think the positive investor response to “downsizing” is simply because big investors know that companies are naturally overstaffed and many employees are inefficient. Therefore, correctly done, staff reductions will almost always increase productivity.

In an environment where employees are assumed to be interchangeable, there will be some kind of a bell shaped curve of employee capability, since people are not constant and HR departments do not hire perfectly. It’s always been accepted that, unless a company has already weeded out the poor performers, 5 to 10 percent of employees can be laid off with no loss of production at all. I’ve been through this and seen it happen.

Unfortunately, at many companies factors such as union restrictions and protection for executives prevent laying off the right 5 to 10%.

Things are rarely that simple. More likely, it goes like this:

Company builds workforce and factories to produce goods. Suddenly, demand falls off. But demand rises and falls all the time. So company continues making product at current rates, allowing inventory to grow. But demand doesn’t come back. Sometimes this is due to a recession. But other times the lack of demand is permanent - a competitior makes a better product, or shifts in demographics or other permanent shifts in the economy make the product less desirable. Or maybe it’s a recession. Or maybe a combination of both. But even after recessions end, demand patterns change. So there’s no guarantee that a product will sell at previous levels after it’s over. In the meantime, inventory builds.

Eventually, companies lay off people. But this is not a decision that’s made lightly, because hiring and firing is extremely expensive. Companies don’t do it on a whim for windfall profits. At least, the good ones don’t. But at some point, when your warehouses are full of product that aren’t selling, you have to make tough choices.

This is good for the economy, btw, and therefore in the long run good for workers. The ability of companies to scale up and down to meet changing market demands prevents recessions from becoming depressions. If companies didn’t scale back, they would lose money. The price of shares would drop. Investors would lose their money. Eventually, everyone would be out of work.

During recessions, the workforce is required to do more with less. Companies pare to the bone, and productivity per employee rises.

When a recession ends, sales pick up. Inventories begin to drop as sales outstrip production. A company becomes cash rich. At some point, when the company has decided that the recovery is real it will start to re-invest its new profit. Factories ramp up again, new projects are undertaken, and hiring starts again.

If you followed the economic news of the last recession cycle, you could see all of this playing out across the economy. As the recession started, inventory levels across the country started to rise, and productivity fell. This was followed by layoffs. Economists then started watching inventory levels, which are a ‘leading indicator’ of a recovery. Then inventory levels began to fall, and productivity began to increase (as the company gets busier, the period between increased activity and hiring new employees means the current employees have to work harder and be more productive. Plus, in hard times companies work hard at getting rid of waste and dead wood). Eventually, the increased productivity led to positive profit numbers. Finally, you start to see hiring activity as companies bring their workforces back online and/or use the profits made from the last few quarters of high productivity to invest in new product development or expand manufacturing of existing products.

This is why employment is a ‘trailing indicator’ of a recovery. It’s the last thing that really happens when the economy recovers.

At a macro level, all this is pretty straightforward. It’s part of the workings of a healthy economy.