Shareholders vs. Customers: Who’s Winning?

The foundation of free enterprise is Adam Smith’s invisible hand, which asserts that competition drives prices down and quality up as profit-seeking behavior results in minimal profits for the profit-seekers and maximal benefits for society as a whole. This world of free enterprise where “greed is good” is said to benefit us all because the greedy don’t end up with that much because the money is diverted into making great products that sell at low prices. This tug-of-war between shareholders and consumers in the end is a zero-sum game once the workers in the aggregate are also recognized as the consumers. In a truly competitive free market system, the consumers win and the company just gets the standard run-of-the mill profits in spite of their enormous efforts to bring about a more profitable outcome. The workers are the consumers who must earn at least enough to buy back the value of the goods and services that they are creating (as explained by the money flow paradigm). Henry Ford recognized this in the early 1900s when he doubled his workers’ pay to retain his skilled workforce and to enable his workers to buy cars that they were making. This also motivated his workers to focus on producing high-quality cars. Ford defied the common property resource problem and free rider problem where employers would like other employers to pay workers more to generate more customers for their products, but not pay their own workers more. Nevertheless, some employers complained about the “bad” example Ford was making in raising his workers’ pay.

The absence of competition leads to the opposite result. Monopoly power results in maximum profits, high prices, reduced quantity and minimal quality. Barriers to entry can result from economies of scale, network effects, first-mover advantage, economies from experience, and natural monopolies. Even industries with many firms may maintain a follow-the-leader discipline as a large dominant firm sets prices for all to follow. Adam Smith’s first invisible hand of competition is often defeated by Adam Smith’s implicit second invisible hand of market power and collusion as Smith noted when he said: “People of the same trade seldom meet together, either for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Ultimately, this translates into a conflict between the short-term interests of shareholders, who are focused on maximizing short-term profit margins and share price, and the long-term interests of the customers and the long-term viability of the company as a whole. This is especially true in modern times as technology constantly produces new products and services and improves economic efficiency and productivity. Money going into dividends and share buybacks is not going into product development and customer satisfaction. Cutting costs to improve profit margins often means cutting quality and restricting quantity. We have all seen inflation not only raise the price of our favorite treats but also shrink the quantity in the bag or box.

Asking whether the free enterprise system will correct these diversions and distortions is asking who is in charge and what are the effects of their decisions? In a true free enterprise economy where Adam Smith invisible hand of competition dominates, it is the customer who ultimately is in charge. But in the real world of imperfect competition, the CEOs and corporate boards call the shots. They can focus on the customer and constantly improve quality, quantity and productivity, while seeing prices fall in a truly competitive environment, or they can skip all that and focus on short-term share price with an expense minimization strategy that cuts costs often by sacrificing quality.

But what about Joseph Schumpeter’s creative destruction? Won’t the noncompetitive firms lose out in the long run and be replaced by truly competitive ones? As usual, we want the world to be simple and provide us with a story where we all live happily ever after. In reality, large companies can accumulate or draw upon large amounts of cash. When an economic slowdown comes about, the small, efficient, family-owned restaurant may go belly-up, while the somewhat inefficient, but well-financed, larger firm may have enough cash to ride it out and even buy up those competitors with less access to cash. Perhaps Schumpeter would have been more realistic by calling it competition destruction when firms go under in an economic downturn. Rather than strengthening Adam Smith’s first invisible hand of competition, recessions work to shift market power to Adam Smith’s second invisible hand of collusion.

But so far we have only been looking at industry level effects. What about the economy as a whole? Is money automatically flowing in a manner to maintain a well-balanced economy with maximum productivity and economic growth? Prices may be somewhat rigid when set by dominant firms, but don’t wages adjust automatically to move us back toward an economic equilibrium of full employment? This requires a great deal of mobility and substitutability. Perhaps you lost your job in New York, but your former college roommate tips you off to a great job fit for you in San Francisco. Oh, wait a minute. I forgot. Two-thirds of Americans don’t have a college degree. They don’t have a former college roommate or anyone else on the inside track elsewhere. Or what if you have a partner who has a job and needs to stay in the area? Perhaps you own a house or have relatives you want to keep close to. Labor mobility sounds nice in theory, but can be a lot harder to achieve in reality.

People want to get the best wage they can. But they have to compete with other people who may be willing to take the same job for a bit less pay. Competition among workers is alive and well in most venues. But what about jobs? In theory, jobs compete with one another for workers. If a worker gets a job offer, but finds a comparable job for a bit more, he or she is inclined to take the better paying job. The problem is that jobs often conspire with one another to form job blocks, just as workers can conspire with one another to form unions. Think of the coal mining town. There is only one major employer in town — the coal mine. The coal mining company forms job blocks where workers are all hired at a fixed wage. Take it or leave it. The resulting wage rate can be considerably less than the free market equilibrium wage. This can be corrected. Workers can form a union and demand the free market equilibrium wage. John Kenneth Galbraith in his 1952 book: “American Capitalism” refers to this as countervailing power. Economists understand this under their Theory of the Second Best, which says that when one factor is out of whack (e.g., monopsony) and cannot be fixed, the best solution is to have another out of whack factor (e.g., union) to counter it.

Workers often confront blocks of jobs that cheat the workers out of the free market wage. Almost every employer controls more than one job and fixes the compensation for the jobs under their control. In the decades after World War II, unions controlled as much as 35 percent of the workforce and this caused even nonunionized firms to pay the union wage to their workers. Today, unionization has dropped below 10 percent and, if you don’t count government employment, unionization has dropped to below 6 percent of the private workforce. Without a union, workers are unable to counter those ubiquitous blocks of jobs. For the economy as a whole, this means that significantly less money is flowing to workers than would be the case under a truly free market economy.

The fundamental problem is that the people on Main Street can no longer afford to buy back the value of the goods and services that they are producing. Oligopolies ( just a few sellers ) and oligopsonies ( job blocks ) dominate many of our major industries. Moreover, about 60 percent of Americans are living paycheck to paycheck. Private debt has skyrocketed. But even that is not enough to maintain full employment. Politicians love to complain about the national debt and how they intend to get rid of it or at least balance the budget. But Republicans pass unpaid for tax cuts and Democrats pass unpaid for expenditures increasing public debt in order to avoid having the economy slip into a recession and end up losing votes at election time.

Why wasn’t this problem fixed after the 2007-2009 Great Recession? Yes, the Federal Reserve did pour huge amounts of money into the New York financial markets. But very little of that money tricked down to the average Joe or Jane on Main Street. With 84 percent of the stock market owned by the 10 percent richest people, quantitative easing (QE) just drove up stock prices to make the wealthy people wealthier and drove down interest rates to facilitate the private debt of most everyday Americans while the government increased its public debt. This distorted money flow was a result of too much money flowing to passive investors (shareholders) and too little money going to workers (the consumers) and to creative entrepreneurs who produce new and better products and improve productivity.

To solve these problems we need to focus on the money flow paradigm which reveals the need for a more balanced money flow that does not require huge amounts of private and public debt and does not divert enormous amounts of money to passive investors (shareholders). We need to direct more money flow to creative entrepreneurs to create new and better products and services and to all our workers who are the consumers of those goods and services. Correcting our money flow involves a variety of fundamental governmental and corporate changes, but we must first more fully appreciate our money flow problem as revealed by the money flow paradigm.