ProfessorBainbridge.com

Out of town to damn SOX

I'm off to San Francisco to give a speech on Sarbanes-Oxley to a Hoover Institution function. Back Tuesday. A long version of my remarks will be posted to SS RN soon and an abbreviated version will be published in the Hoover Digest eventually. In the meanwhile, here's Bainbridge's greatest SOX hits:

• Peekaboo, the Constitution Doesn't See You
• Shedding Light on SOX
• SOXing It to Small Businesses
• Incentives and Business Ethics
• SOX Pox

Duck Cassoulet

• 1 ½ cup haricots blancs (substitute any dried white bean)
  
• 1 package D'Artagnan duck fat
  
• ¼ pound pancetta
  
• 4 cloves garlic, peeled and minced
  
• 1 cup dry white wine
  
• 1 medium yellow onion, peeled but left whole
  
• 5 whole cloves
  
• 2 medium carrots, cut into chunky dice
  
• 1 bouquet garni made by tying up 1 rosemary spring, 4 parsley sprigs, 2 thyme sprigs, 2 bay leaves, and 1 tablespoon whole black peppercorns in a cheesecloth bundle
  
• 7-10 cups organic chicken stock
  
• 1 14.5-ounce can of diced tomatoes
  
• 4 D?Artagnan duck legs confit
  
• 3 links D'Artagnan duck and armagnac sausage, cut into ½-inch rounds on a slight bias
  
• 1 shallot, diced
  
• 1 package D'Artagnan duck and veal demi-glace
  
• 1 cup panko bread crumbs
  
• 1 teaspoon dried Italian herbs
  
• salt and freshly ground black pepper

Pick over the beans to remove any debris then put into a colander or sieve to rinse under cold running water. Soak overnight in at least 2 quarts cold water. Drain and transfer to a large pot.

Melt one teaspoon duck fat over medium in a non-stick skillet. Saute pancetta until its fat renders and the bacon crisps. Add the garlic and saute 1 minute, not allowing the garlic to brown. Transfer to large pot.

Deglaze skillet with white wine. Bring wine to the boil for 1 minute. Transfer to large pot.

Stud the onion with the cloves. Add onion, carrots, and bouquet garni to large pot.

Add enough chicken stock to pot to cover ingredients. Bring to a boil, reduce to a low simmer. Cook 1 to 1-½ hours or until beans are tender but still intact. Skim any scum that forms. Add tomatoes (with their juices) and a pinch or two of salt and freshly ground black pepper about 30 minutes before cooking ends.

Put a colander or large sieve over a large bowl. Drain bean mixture, reserving cooking liquid. Remove and discard bouquet garni and onion. Taste beans and adjust seasoning with salt and pepper as needed.

Put 2/3 bean mixture into a large casserole dish.

Remove skin from duck legs, reserving. Remove meat from bones, discarding bones. Shred leg meat. Add to casserole dish.

Melt 1 teaspoon duck fat over medium-high heat. Saute sausage rounds until lightly browned. Add to casserole dish. Mix well.

Sweat shallot in fat left in skillet after cooking the sausage until translucent and tender. Mix with remaining beans. Add resulting mixture to the casserole dish. Pour duck demi-glace over casserole. Pour in enough of reserved cooking liquid so that the bean mixture is just covered. If you want a leaner and tastier version, make ahead to this point, then cool, cover, and refrigerate overnight. Most of the fat will collect on the top and harden for easy removal the next day.

Preheat oven to 350 degrees.

Mix bread crumbs and Italian herbs. Melt 1 tablespoon duck fat and drizzle over bread crumbs. Mix well. Use the mixture to top the casserole.

Cover casserole dish with aluminum foil and bake at 350 for 1 hour. Remove foil and bake an additional 30 minutes or until bread crumbs are a deep golden brown but not burnt.

Make duck cracklings by cutting reserved skin into small pieces and rendering them in in a non-stick skillet over medium-high heat until crispy.

Serve in deep bowls. Top with cracklings and finely chopped fresh Italian parsley just before serving. Offer a Syrah-based red wine. I chose Torbreck The Steading (Barossa Valley) 1999, whose sweet and jammy fruits complemented the rich flavors of the cassoulet, while retaining enough bright acidity to slice through the unctuous cassoulet.

Seared Ahi Tuna in Cilantro-Lime-Soy Sauce

The sauce:

• 1 cup fresh cilantro leaves
• 1/2 jalapeno chile, seeded
• 1 tablespoon grated fresh ginger
• 2 garlic cloves crushed
• Juice of 1 lime
• 3 tablespoons soy sauce
• 1 tablespoon extra virgin olive oil
• 1 teaspoon sesame oil
• 1 tablespoon rice wine vinegar
• dash hot sauce or chili oil
• 1/8 teaspoon sugar
• Salt and freshly ground black pepper

Combine all ingredients in a mini-food processor and puree on high until the solid ingredients are finely diced

2 8 ounce blocks (preferably 1 inch wide and high) sushi-quality ahi tuna

1 ripe avocado, halved, pitted, peeled and sliced

Heat a tablespoon of peanut oil over high heat in a 10 inch non- stick saute pan until almost smoking. Meanwhile, lightly season the tuna with salt and pepper. When the oil is hot, saute the tuna blocks 1 minute on each of the four sides. Remove to a cutting board and let rest briefly. Slice thinly crosswise. Plate the sauce, arranging the tuna and avocado slices on top.

I like to serve this with pre-made shrimp tempura.

Whatever happened to being the party of limited government?

CNN reports:

Every American taxpayer would get a $100 rebate check to offset the pain of higher pump prices for gasoline, under an amendment Senate Republicans hope to bring to a vote Thursday.

While they're at it why don't they just vote themselves free campaign ads? As the K Street Gang's popularity sags to perilously low levels, a transparent attempt at vote buying is the best the Senate GOP can come up with?

In the first place, this sort of pandering really is unnecessary. Yes, people are annoyed by gas prices, but as Nick Schulz points out, their annoyance isn't changing behavior - and for good reason:

Energy prices may be rising, but energy itself is much less important to consumers and to the overall economy than it once was.

According to the Bureau of Economic Affairs ( see chart here), American consumer spending on energy as a fraction of total personal consumption has declined considerably since 1980. Whereas 25 years ago, one in every ten consumer dollars was spent on energy, today it's one in every 16. In other words, what it takes to heat and cool our homes and drive to and from our jobs and vacation destinations is relatively less costly than it was then.  ...

Of course, no one likes to pay more at the pump. And with some analysts predicting oil per barrel going up to $75 or higher in the near future, we might see retail prices go up further still. But unlike a generation or two ago, these increases won't prompt the broader economic pain they once did.

In the second, whatever happened to being the party of limited government and economic sense? Instead, as John Hinderaker reports:

The Republican Senators' proposal does nothing, other than ANWR drilling, that acknowledges the rules of supply and demand that govern prices. The "Gas Price Relief and Rebate Act" is mostly crude pandering of the kind we used to expect from Democrats, not Republicans.

One is tempted to agree with Bill Quick's summation:

We have to wake up the Stupid Party, before it completely merges itself into the Republicrat Statist Party.

Corporations in Politics

It is inevitable that corporations will play politics. Critics contend that corporate political activity, most especially campaign contributions, corrupts the political process and enables corporations to obtain legislation granting them rents at societal expense. In response, defenders of corporate political involvement argue that the ever-increasing burden of regulation requires corporations to include lobbying regulators and legislators as part of their overall business strategy. hence, it is to be expected that corporations will seek to manage politics in much the same way as they manage other business ventures. Jill Fisch makes an important contribution to this literature with a case study "examining the political involvement of one company, FedEx, in a series of regulatory reforms over a forty year period."

Drawing upon the business context, the legislative record, campaign finance materials and interest group analysis, the Article demonstrates that political activity has been an integral component of FedEx's business growth and operations. FedEx has successfully used its political influence to shape legislation, and FedEx's political success has, in turn, shaped its overall business strategy. Moreover, in identifying the specific components of FedEx's political activity, the Article highlights the range of mechanisms that corporations use to engage in politics, revealing that the exercise of political influence is far more complex than the purchase of political favors in a spot market.

Regulation is becoming an increasingly important factor for United States businesses. As a result, corporations must integrate political activity into their overall business strategy and must develop and manage their political capital in the same way that they manage other business assets. The FedEx story demonstrates the importance of politics to business and explains the growing investment by corporations in political capital. It further explains how the business world has responded, and will continue to respond, to regulatory restrictions by developing alternative mechanisms for exerting political influence.

Criminalizing Agency Costs

My TCS column this week is Are We Criminalizing Agency Costs? Should You Care?

Few mainstream pundits have provided better insights on the Enron and other corporate governance prosecutions of recent years than have bloggers Tom Kirkendall (a Houston lawyer) and Larry Ribstein (a University of Illinois law professor). In particular, they've repeatedly drawn attention to the problem Ribstein calls "criminalizing agency costs."

They've been so successful at popularizing this concept within the admittedly narrow confines of the corporate governance blogosphere that WSJ law blogger Peter Lattman recently felt comfortable using the phrase to describe one Enron defendant Jeffrey "Skilling's main defenses"; i.e., "that the government has criminalized corporate agency costs."

Lattman explains: "Criminalizing corporate agency costs? That's just a fancy way of saying that the government has misused criminal laws in this case to punish questionable business transactions and bad business decisions." This is true, but some additional elaboration perhaps would be helpful.

"Agency costs" are a central concept of modern corporate governance and finance. These costs arise because public corporations are characterized by a separation of ownership and control: The firm's nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically own only a small portion of the firm's shares.

As Professors Berle and Means observed in their landmark book The Modern Corporation and Private Property: "The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge . . . ."

Economists Michael Jensen and William Meckling coined the term "agency costs" to refer to the consequences of Berle and Means' divergences. Jensen and Meckling defined these costs as the sum of the monitoring and bonding costs, plus any residual loss, incurred to prevent shirking by agents. In turn, shirking is conventionally defined to include as any action by a member of a production team that diverges from the interests of the team as a whole. As such, shirking includes not only culpable cheating, but also negligence, oversight, incapacity, and even honest mistakes.

A sole proprietorship with no agents will internalize all costs of shirking, because the proprietor's optimal trade-off between labor and leisure is, by definition, the same as the firm's optimal trade-off. Agents of a firm, however, will not internalize all of the costs of shirking: the principal reaps part of the value of hard work by the agent, but the agent receives all of the value of shirking.

Economists Armen Alchian and Harold Demsetz offered the useful example of two workers who jointly lift heavy boxes into a truck. The marginal productivity of each worker is difficult to measure and their joint output cannot be separated easily into individual components. In such situations, obtaining information about a team member's productivity and appropriately rewarding each team member are very difficult and costly. In the absence of such information, however, the disutility of labor gives each team member an incentive to shirk because the individual's reward is unlikely to be closely related to conscientiousness.

Accordingly, an essential economic function of management is monitoring the various inputs into the team effort: management meters the marginal productivity of each team member and then takes steps to reduce shirking.

The process just described, of course, raises a new question: who will monitor the monitors? In any organization, one must have some ultimate monitor who has sufficient incentives to ensure firm productivity without himself having to be monitored. Otherwise, one ends up with a never ending series of monitors monitoring lower level monitors. Alchian and Demsetz solved this dilemma by consolidating the roles of ultimate monitor and residual claimant. According to Alchian and Demsetz, if the constituent entitled to the firm's residual income is given final monitoring authority, he is encouraged to detect and punish shirking by the firm's other inputs because his reward will vary exactly with his success as a monitor.

Unfortunately, this elegant theory breaks down precisely where it would be most useful. Because of the separation of ownership and control, it simply does not describe the modern publicly held corporation. As the corporation's residual claimants, the shareholders should act as the firm's ultimate monitors. But while the law provides shareholders with some enforcement and electoral rights, these are reserved for fairly extraordinary situations. In general, shareholders of public corporation have neither the legal right, the practical ability, nor the desire to exercise the kind of control necessary for meaningful monitoring of the corporation's agents.

How then do we deter agents of a public corporation from shirking? Economic theory tells us that actors are deterred when the expected punishment exceeds the expected benefits of committing the crime. In turn, the expected punishment is determined by multiplying the nominal sanction (the penalty imposed if convicted) times the probability of being caught.

An example might be helpful. I know from painful personal experience that the nominal penalty for speeding on Sunset Boulevard in West Hollywood is a $271 fine, plus the cost and opportunity costs associated with going to traffic school to keep the citation off my record. Because the odds of getting caught are very low, however, the expected sanction probably is just a few pennies. Being a rational actor, I therefore speed.

As I explained in an earlier TCS column, "Crime? And Punishment?", however, the criminalization of bad corporate governance has increased the expected sanctions faced by corporate executives. The probability of conviction has gone up because ambitious prosecutors can bring to bear the full panoply of coercive measures available only in criminal litigation, while the nominal sanction has gone up dramatically. All of which raises the question of whether we have cranked up the expected sanction to the point of over-deterrence.

The problem is that business decisions rarely involve black-and-white issues; instead, they typically involve prudential judgments among a number of plausible alternatives. Given the vagaries of business, moreover, even carefully made choices among such alternatives may turn out badly.

If prosecutors, judges, and juries are unable to distinguish between competent risk taking and criminal mismanagement, however, the threat of criminal sanctions may discourage managers from taking risks.

Yet, risk-taking is precisely what shareholders want managers to do. As the corporation's residual claimants, shareholders don't get paid until all other claims on the corporation are satisfied. Because risk and return are positively correlated, the high returns on corporate investment necessary to leave something for the shareholders require high risks.

The problem of criminalizing agency costs should now be apparent. Obviously, shareholders want managers who steal from the company or defraud investors to be punished. Yet, they also want managers to take risks. If prosecutors and juries can't tell the difference between the two, however, criminal sanctions may leave shareholders worse off by making managers more risk averse.

Stephen Bainbridge is a TCS columnist and teaches law at UCLA. Find more of his writing here.

Confirming Judges

From Hugh Hewitt:

These are votes which the Republican base will watch closely, and will demand fairness on and conformance to the "Gang of 14" agreement. If Senator Graham, for example, helps kill the Haynes nomination in the Judiciary Committee, that will be laid at Senator McCain's feet and rightly so.

And if any of these three are filibustered, the Constitutional Option will have to be dusted off and deployed, exactly a year after it ought to have been used in the first place.

I agree with Hugh that the 60-odd nominations in the pipeline need to be moved forward. I also agree that the Gang of 14 agreement needs to be enforced. For those of us on the right who have basically given up on Bush and the K Street Gang, solidly conservative judges are about the only thing left on offer by the Republicans. But why is Hugh still pushing to abolish the judicial filibuster. Abolition of the filibuster has always been a bad idea and, as the confirmation of Alito proved, was unnecessary. Just in PR terms, it'd be the GOP equivalent of FDR's court packing plan (or, if you prefer, Gingrich's government shut down). It might play well to a segment of the base, but the center-right majority in this country probably would be turned off by it.

The K Street Gang

The mail brings Matthew Continetti's new book The K Street Gang: The Rise and Fall of the Republican Machine. As a conservative critique of the GOP in Congress, it makes a nice match to Bruce Bartlett's critique of the Bush White House - Impostor. Continetti is a staff writer at the Weekly Standard, who has also been published in the New York Times, the Washington Post, and the Los Angeles Times. His conservative credentials are impeccable. And, like a lot of us, he has seen the conservative revolution of 1994 turn into a mess that serves only to demonstrate Lord Acton's aphorism about power corrupting. The K Street Gang blows the lid off the whole sordid history.

Response to Increasing Shareholder Power

My essay Director Primacy and Shareholder Disempowerment can now be downloaded in its "as published" form from the Harvard Law Review's website. From the introduction:

In his 2004 article, Lucian Bebchuk advances proposals designed to allow “shareholders to initiate and vote to adopt changes in the company’s basic corporate governance arrangements.” As Bebchuk explains, the housekeeping rules of corporation law effectively preclude shareholders from initiating corporate decisions. Indeed, the extent to which corporate law is stacked against shareholder “intervention power” goes beyond just the housekeeping rules; much of business law acts to limit shareholder involvement in corporate governance. Taken together, these rules form a regime I call “director primacy.”

Hence, I do not quibble with Bebchuk’s exposition of shareholder weakness; to the contrary, I welcome it as further evidence that my director primacy model accurately describes how corporations work. Instead, I intend to take issue with Bebchuk’s proposal to replace the existing, mostly permissive rules disempowering shareholders with a new set of mostly mandatory rules empowering them.

Part I of this Response argues that Bebchuk’s proposed default rules would be inefficient, asking: if shareholder empowerment is as value-enhancing as Bebchuk claims, why do we not already see it in the marketplace? After all, free markets typically produce only those goods people actually wish to purchase, and corporate governance terms are no exception. Part II invokes first principles to offer an alternative to Bebchuk’s account of the proper role of shareholder voting in corporate governance. It argues that the present regime of limited shareholder voting rights is the majoritarian default and therefore should be preserved as the statutory off-the-rack rule. Finally, Part III questions whether shareholders would make effective use of Bebchuk’s proposed regime.

Joe Jamail

I finally got around to watching the now infamous video of Texas trial lawyer Joe Jamail taking an expert witness deposition, which made the rounds a couple of weeks ago.

It has to be seen to be believed. Nobody comes off looking very good and the legal profession gets a black eye - almost literally - but Jamail definitely takes first prize for incivility. Nor is Jamail a first time offender, as illustrated by this appendix to the Delaware Supreme Court's decision in Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34 (Del. 1994):

On November 10, 1993, an expedited deposition of Paramount, through one of its directors, J. Hugh Liedtke, was taken in the state of Texas. The deposition was taken by Delaware counsel for QVC. Mr. Liedtke was individually represented at this deposition by Joseph D. Jamail, Esquire, of the Texas Bar. Peter C. Thomas, Esquire, of the New York Bar appeared and defended on behalf of the Paramount defendants. … During the Liedtke deposition, Mr. Jamail abused the privilege of representing a witness in a Delaware proceeding, in that he: (a) improperly directed the witness not to answer certain questions; (b) was extraordinarily rude, uncivil, and vulgar; and (c) obstructed the ability of the questioner to elicit testimony to assist the Court in this matter.

To illustrate, a few excerpts from the latter stages of the Liedtke deposition follow:

A. [Mr. Liedtke] I vaguely recall [Mr. Oresman's letter]•••• I think I did read it, probably. ••••

Q. (By Mr. Johnston [Delaware counsel for QVC] ) Okay. Do you have any idea why Mr. Oresman was calling that material to your attention?

MR. JAMAIL: Don't answer that. How would he know what was going on in Mr. Oresman's mind? Don't answer it. Go on to your next question.

MR. JOHNSTON: No, Joe-

MR. JAMAIL: He's not going to answer that. Certify it. I'm going to shut it down if you don't go to your next question.

MR. JOHNSTON: No. Joe, Joe-

MR. JAMAIL: Don't “Joe” me, asshole. You can ask some questions, but get off of that. I'm tired of you. You could gag a maggot off a meat wagon. Now, we've helped you every way we can. ...

MR. JAMAIL: Come on. Quit talking. Ask the question. Nobody wants to socialize with you.

MR. JOHNSTON: I'm not trying to socialize. We'll go on to another question. We're continuing the deposition.

MR. JAMAIL: Well, go on and shut up. ... You don't know what you're doing. Obviously someone wrote out a long outline of stuff for you to ask. You have no concept of what you're doing. Now, I've tolerated you for three hours. If you've got another question, get on with it. This is going to stop one hour from now, period. Go.

MR. JOHNSTON: ... I don't need this kind of abuse.

MR. THOMAS: Then just ask the next question. ...

Staunch advocacy on behalf of a client is proper and fully consistent with the finest effectuation of skill and professionalism. Indeed, it is a mark of professionalism, not weakness, for a lawyer zealously and firmly to protect and pursue a client's legitimate interests by a professional, courteous, and civil attitude toward all persons involved in the litigation process.

A lawyer who engages in the type of behavior exemplified by Mr. Jamail on the record of the Liedtke deposition is not properly representing his client, and the client's cause is not advanced by a lawyer who engages in unprofessional conduct of this nature. …

... the Court finds this unprofessional behavior to be outrageous and unacceptable. If a Delaware lawyer had engaged in the kind of misconduct committed by Mr. Jamail on this record, that lawyer would have been subject to censure or more serious sanctions.

The Delaware Supreme Court invited Jamail to make a voluntary appearance to explain his conduct. As far as I know, he never did so.

Is Jamail sufficiently self-aware to realize what a jerk he is? Apparently not, as illustrated by these tidbits from his publications:

• 47 S. Tex. L. Rev. 357: "Advocacy is not going in and being some macho-crazed idiot, but very professional and courteous--as long as you have to be--but show outrage, if it is called for; show excitement, if it is called for. ... When we say "the law," we are talking about an organized, reasonably accepted way for people to live together and settle their disputes without regard to force. Everywhere we look in the world today we see violence."
• 47 Baylor L. Rev. 1157: "Lawyer- bashing has become a popular indoor and outdoor sport, and lawyer jokes can be confidently relied upon to evoke loud guffaws and applause. How did all this happen? How did we get to the point where to acknowledge that you are a lawyer is to invite scoffing and derision?" {ProfB: Try looking in the mirror for the answer to that one}

The Minimum Wage

My latest TCS column

California is considering raising its state minimum wage. Bills under consideration would raise the wage by as much as a dollar and call for subsequent indexing of the wage, so that it will increase automatically along with inflation. According to press reports, Governor Schwarzenegger will not oppose a hike in the minimum wage, but is resisting indexing.

Assuming California ought to have a statutory minimum wage, which admittedly is a contested proposition, Schwarzenegger has it exactly backwards -- at least as far as an important segment of the relevant population is concerned.

The standard arguments over increasing the minimum wage are all focused on the effect of such a hike on the supply of jobs by employers. Basic price theory from Econ 101 tells us that employers faced with higher wage bills will hire fewer workers. Proponents of higher minimum wages counter with various empirical studies purporting to find no loss of jobs and various theoretical explanations for why standard price theory might not apply to this market. Opponents of wage hikes counter with their own studies and theories. And so the weary day wears on.

To be sure, the argument over job supply is an important one. Yet, in focusing on that issue, we overlook an equally important question; namely, what effect does a minimum wage hike have on the demand for jobs by potential employees?

At the outset, it is critical to recognize that the minimum wage debate is mainly a debate about how much working teenagers and twenty-somethings in their first job ought to make. The federal Bureau of Labor Statistics reports that (in 2002):

"Minimum wage workers tend to be young. About half of workers earning $5.15 or less were under age 25, and slightly more than one-fourth were age 16-19."

Let's focus specifically on the latter group. Imagine you're a 17 year-old junior in high school with a part-time job paying the minimum wage. You're eager to get started with life. You want to get a car, a place of your own, and maybe even get married. You're bored with high school and don't expect to go to college.

If you stay in school, you sacrifice current wages for higher future income. If you drop out, you likely will have a lower lifetime income, but start making money immediately.

Although you likely wouldn't articulate the problem in these terms, you're faced with a capital budgeting problem. Should you invest in your human capital by staying in school or should you drop out and go to work full time?

Although there are several ways for a business to make capital budgeting decisions, the simplest and most relevant to our hypothetical teenager is net present value. You therefore should discount to present value the net stream of income that would be generated by each of your choices.

The problem is that research in behavioral economics suggests that young people tend systematically to err in assigning discount rates; specifically, because they tend to be systematically biased in favor of current consumption, they tend to use too high a discount rate in making such calculations. As a result, the prospect of an immediate income will be given too much weight in their calculus and the prospect of higher lifetime earnings in the future too little weight and, when deciding between work and a present paycheck versus staying in school and deferral of income, they will tend to err towards the former.

Although relatively little empirical research has been done on the effect of a minimum wage hike on the demand for work by teenagers, one study does find results consistent with the foregoing analysis:

"Minimum wages increase the probability that teenagers leave school to become employed or work more hours, and increase the probability that they leave school and become non-enrolled and non-employed. Minimum wages also increase the probability that lower-wage employed teenagers become non-enrolled and non-employed." (Link)

Increasing the minimum wage is thus problematic because it makes the choice of work over school marginally more attractive.

For America to be competitive in a global marketplace, it needs an educated workforce. Minimum wage policy therefore must take into account the impact of changes in the minimum wage on the choice the youngest workers make between school and work.

The foregoing analysis has two specific implications for minimum wage policy. First, a differential lower minimum wage for those who have not completed a high school degree should result in a lower dropout rate.

Second, and here is where I think Schwarzenegger is wrong, the minimum wage ought to be indexed. Under current law, we get episodic large hikes in the minimum wage. In the interim between hikes, inflation tends to erode the value of the minimum wage, which will encourage teenagers to stay in school. In the year that a large hike occurs, however, the growth in the minimum wage far outstrips inflation, which tips the balance in favor of work. An indexed minimum wage, which grew steadily and no faster than inflation, would avoid the potential for biasing the choice between work and school.

Some thoughts on improving the minimum wage

My TCS column Minimum Behavior:

California is considering raising its state minimum wage. Bills under consideration would raise the wage by as much as a dollar and call for subsequent indexing of the wage, so that it will increase automatically along with inflation. According to press reports, Governor Schwarzenegger will not oppose a hike in the minimum wage, but is resisting indexing.

Assuming California ought to have a statutory minimum wage, which admittedly is a contested proposition, Schwarzenegger has it exactly backwards -- at least as far as an important segment of the relevant population is concerned.

The standard arguments over increasing the minimum wage are all focused on the effect of such a hike on the supply of jobs by employers. Basic price theory from Econ 101 tells us that employers faced with higher wage bills will hire fewer workers. Proponents of higher minimum wages counter with various empirical studies purporting to find no loss of jobs and various theoretical explanations for why standard price theory might not apply to this market. Opponents of wage hikes counter with their own studies and theories. And so the weary day wears on.

To be sure, the argument over job supply is an important one. Yet, in focusing on that issue, we overlook an equally important question; namely, what effect does a minimum wage hike have on the demand for jobs by potential employees?

At the outset, it is critical to recognize that the minimum wage debate is mainly a debate about how much working teenagers and twenty-somethings in their first job ought to make. The federal Bureau of Labor Statistics reports that (in 2002):

"Minimum wage workers tend to be young. About half of workers earning $5.15 or less were under age 25, and slightly more than one-fourth were age 16-19."

Let's focus specifically on the latter group. Imagine you're a 17 year-old junior in high school with a part-time job paying the minimum wage. You're eager to get started with life. You want to get a car, a place of your own, and maybe even get married. You're bored with high school and don't expect to go to college.

If you stay in school, you sacrifice current wages for higher future income. If you drop out, you likely will have a lower lifetime income, but start making money immediately.

Although you likely wouldn't articulate the problem in these terms, you're faced with a capital budgeting problem. Should you invest in your human capital by staying in school or should you drop out and go to work full time?

Although there are several ways for a business to make capital budgeting decisions, the simplest and most relevant to our hypothetical teenager is net present value. You therefore should discount to present value the net stream of income that would be generated by each of your choices.

The problem is that research in behavioral economics suggests that young people tend systematically to err in assigning discount rates; specifically, because they tend to be systematically biased in favor of current consumption, they tend to use too high a discount rate in making such calculations. As a result, the prospect of an immediate income will be given too much weight in their calculus and the prospect of higher lifetime earnings in the future too little weight and, when deciding between work and a present paycheck versus staying in school and deferral of income, they will tend to err towards the former.

Although relatively little empirical research has been done on the effect of a minimum wage hike on the demand for work by teenagers, one study does find results consistent with the foregoing analysis:

"Minimum wages increase the probability that teenagers leave school to become employed or work more hours, and increase the probability that they leave school and become non-enrolled and non-employed. Minimum wages also increase the probability that lower-wage employed teenagers become non-enrolled and non-employed." (Link)

Increasing the minimum wage is thus problematic because it makes the choice of work over school marginally more attractive.

For America to be competitive in a global marketplace, it needs an educated workforce. Minimum wage policy therefore must take into account the impact of changes in the minimum wage on the choice the youngest workers make between school and work.

The foregoing analysis has two specific implications for minimum wage policy. First, a differential lower minimum wage for those who have not completed a high school degree should result in a lower dropout rate.

Second, and here is where I think Schwarzenegger is wrong, the minimum wage ought to be indexed. Under current law, we get episodic large hikes in the minimum wage. In the interim between hikes, inflation tends to erode the value of the minimum wage, which will encourage teenagers to stay in school. In the year that a large hike occurs, however, the growth in the minimum wage far outstrips inflation, which tips the balance in favor of work. An indexed minimum wage, which grew steadily and no faster than inflation, would avoid the potential for biasing the choice between work and school.

Do Corporations Opt Out?

A core tenet of the contractarian theory of the corporation is that corporate law ought to consist mainly of default rules. As I explain in my Corporation Law and Economics text:

In the nexus of contracts model, corporations statutes and judicial opinions can be thought of as a standard form contract voluntarily adopted—perhaps with modifications—by the parties. The point of a standard form contract, of course, is to reduce bargaining costs. Parties for whom the default rules are a good fit can take the default rules off the rack, without having to bargain over them. Parties for whom the default rules are inappropriate, in contrast, are free to bargain out of the default rules.

If transaction costs are zero, the default rules—whether contained in a statute or a private standard form contract—do not matter very much. In the face of positive transaction costs, however, the default rule begins to matter very much. Indeed, if transaction costs are very high, bargaining around the rule becomes wholly impractical, forcing the parties to live with an inefficient rule. In such settings, we cannot depend on private contracting to achieve efficient outcomes. Instead, statutes must function as a substitute for private bargaining. The public corporation—with its thousands of shareholders, managers, employees, and creditors, each with different interests and asymmetrical information—is a very high transaction cost environment indeed. Identifying the party for whom getting its way has the highest value thus becomes the critical question.

In effect, we must perform a thought experiment: “If the parties could costlessly bargain over the question, which rule would they adopt?” In other words, we mentally play out the following scenario: Sit all interested parties down around a conference table before organizing the corporation. Ask the prospective shareholders, employees, contract creditors, tort victims, and the like to bargain over what rules they would want to govern their relationships. Adopt that bargain as the corporate law default rule. Doing so reduces transaction costs and therefore makes it more efficient to run a business. Of course, you cannot really do this; but you can draw on your experience and economic analysis to predict what the parties would do in such a situation.

Yale law professor Henry Hansmann, however, has just posted a paper that takes a new spin on the problem:

Publicly traded corporations rarely use the nearly absolute freedom afforded them to draft charters that deviate from the default terms of state corporation law. Conventional explanations for this phenomenon are unconvincing. A more plausible reason lies in the lack of any feasible amendment mechanism that will assure efficient adaptation of charter terms as changing circumstances dictate during the long expected lifetime of a public corporation. In effect, by adopting state law default terms, corporate shareholders and managers delegate to a third party - the state - the process of amending charter provisions over time. This theory provides much stronger reason for deferring to the law's default rules than do the other theories that have been offered. It implies that default rules may often be nearly as influential as mandatory rules, and that scholars are not wasting their time debating whether one rule of corporate law is more desirable than another even if, as is typical, the rule chosen will be formulated only as a default. This theory also suggests that it might be beneficial if leading corporate law jurisdictions were to provide greater choice among default terms than they currently do.

I'm not sure I buy the empirical premise that public corporations rarely opt out of the default statutory terms. Here's how Hansmann supports the claim:

I base this qualitative observation, in part, on examination of a sample of corporate charters generously shared with me by Michael Klausner, collected in the course of his work with Robert Daines.

Is there better evidence on this question out there?

The Costs of Being Public After Sarbanes-Oxley: The Irony of

In an article of that title, my friend Emory law professor Bill Carney writes:

The Sarbanes-Oxley Act of 2002 added numerous costs to the burden of being a public company. The most onerous of these, requiring inside and outside assessment of internal controls, is only now affecting the costs of remaining a public company. After reviewing the reports of increased compliance costs for larger companies, this paper reports on the increasing numbers of companies choosing to terminate reporting under the securities laws, and focuses on the costs reported for those (generally smaller) companies that disclose their actual compliance costs.

The Case Against Judicial Review

Jeremy Waldron's Yale Law Journal essay advances two arguments against judicial review:

First, it argues that there is no reason to suppose that rights are better protected by this practice than they would be by democratic legislatures. Second, it argues that, quite apart from the outcomes it generates, judicial review is democratically illegitimate.