8.4 How Managers Can Harness Market Forces
Satellite images of North and South Korea illustrate the power of market forces.
When Japanese troops in Korea surrendered at the end of World War II, it set in motion a remarkable natural experiment. The Soviet Union accepted the surrender in the north of the country, and administered the region that came to be known as North Korea. The United States accepted the surrender in the south, and set up the region now known as South Korea. These terms of surrender would later have enormous economic implications. Soviet influence led North Korea to set up a centrally planned economy, in which government officials decided who made what, who got what, and how much was made. By contrast, the United States set up a market economy in South Korea, and instead of a centralized government bureaucracy directing economic activity, it was left to market forces.
This natural experiment in market forces yielded rather extraordinary results. Both Koreas were equally poor in the immediate aftermath of the war. Today, the average annual income in market-oriented South Korea is about $36,000 per year. That’s about twenty times greater than in the centrally planned North Korea, where average income is about $1,800 per person and people are often hungry. Market forces have allowed South Koreans to explore and exploit gains from trade, and this has made them enormously better off.
There’s no more striking way to see this difference than the photos that NASA takes from space. As satellite photos show, South Korea is brightly lit and pulsating with activity, while North Korea is dark, as if nothing is happening.
The lesson from the Korean peninsula seems to be that if you’re going to be the CEO of a country, it’s far better to operate like South Korea—using market forces to allocate your scarce resources—than North Korea, where all choices are made by centralized managers.
Internal Markets Allocate Resources
The extraordinary success of South Korea, harnessing the power of market forces, has lessons for the management of individual companies. Some companies have figured out how to use the lessons from market economies to develop new internal markets that help them.
That’s the idea behind internal markets, which are markets that managers set up within their organization so that different divisions can buy and sell scarce resources. Just as regular markets efficiently allocate scarce resources to better uses, internal markets can help your company, nonprofit, or government agency allocate scarce resources to better uses.
The internal operations of most large companies more closely resemble North Korea than South Korea. A typical CEO—much like the leader of North Korea—holds an enormous amount of centralized power, and uses that power to direct all activity within the company. A CEO—again, much like North Korea’s supreme leader—heads a vast bureaucracy, and together with his or her deputies formulates long-term plans that guide the broader enterprise and decide how best to deploy workers and machinery among their alternative uses.
The knowledge problem means that managers can’t get the information they need.
Feeding America is a nonprofit—the largest network of food banks in the United States. It solicits food donations from large companies like Kraft or Walmart, and then allocates that food to 210 regional food banks around the country. Their good work means that thousands of families will be able to eat tonight.
The logistics of getting this right are complicated. To see why, put yourself in the shoes of an executive at Feeding America’s Chicago headquarters. You’ve just been sent a truckload of fruit to distribute, and you want to send it to the region that’ll get the largest benefit from it. To figure out where this is, you’ll need to know the marginal benefit of a truckload of fruit for each of your 210 regional food banks. Calling all 210 regional food banks would take forever, and even then, you’ve got no guarantee they’ll provide accurate information.
This is an example of the knowledge problem, which is that the knowledge or information you need to make a good decision may be so broadly dispersed that it’s not available to any individual decision maker. Think of this knowledge as being like a treasure map. The problem is that many people have a few small shreds of the map—the food bank in Houston may know the marginal benefit it would get from another truckload of fruit, just as the food bank in Jacksonville knows its marginal benefit. But no one has access to the whole map—what each food bank’s marginal benefit is—making it impossible to navigate a path to the best outcome. Without access to this dispersed information, the executives at headquarters have no way to identify the best use for that truckload of fruit.
Markets solve the knowledge problem.
An internal market determines what food they’re serving at this food bank.
The top brass at Feeding America realized that they could harness market forces to help them. After all, if markets allocate stuff to its better uses, they figured that an internal market can help them allocate food to where it’ll be most useful. They set up an internal market for allocating donated food. Here’s how it works: When a new truckload of food arrives, all food banks can bid for it in an internal eBay-style auction. This means that the food banks that really need fruit can bid more for fruit. Because the highest bidder wins the auction, each truckload of donated food goes to a food bank that really needs it. To ensure that all food banks can compete for the food on a level playing field, they don’t bid using real money, but rather an artificial currency issued by Feeding America.
This internal market avoids the knowledge problem, because it doesn’t rely on a centralized decision maker knowing what’s best or rely on personal relationships that may lead some regional food banks to do better than others. Instead, it relies on each regional food bank knowing its own marginal benefit and bidding accordingly. To continue the treasure map analogy: You don’t need the whole map if there’s someone at each navigation point telling you where to go next. Feeding America has discovered that the forces of supply and demand can allocate the donated food more efficiently than their managers can. The result is that less food is wasted, more people get fed, and because donors know their food is finding needy families, they’re more willing to donate.
Use internal markets to allocate scarce resources.
Feeding America’s success points to a lesson that you should remember when you’re a manager: You might be able to harness the power of markets to help you do a better job.
For instance, at Google, when computer resources were scarce, the executive team didn’t ask managers to decide whether the Gmail team was more deserving than the YouTube or Chrome teams. Instead, managers allocated computer processing time, disk space, and memory by setting up an internal market so that the different product teams could compete to buy the space they needed. NASA has tried something similar. When NASA sent a spacecraft to Saturn, it had to figure out how to allocate the scarce resources of weight, electric power, data transmission, and budget across the different teams conducting scientific experiments. Rather than rely on the judgment of managers, it set up an internal market in which the scientists could trade the resources they needed.
EVERYDAY Economics
Getting into the classes you want
Many college students have experienced the frustration of wanting to take a particular class, only to discover that it is full. Can you think of a way to use internal markets to make sure that you get into the classes you value the most? Several leading business and law schools have a solution. They allocate scarce slots in popular classes with an internal market. Each student is given the same amount of Monopoly money to use to buy and sell spots in popular classes. The more you want to be in a particular class, the more you’ll bid, leading each spot to be allocated to the student who values it most.
Internal prediction markets can improve your forecasts.
Another type of internal market—an internal prediction market—can be helpful whenever you need an accurate forecast. For instance, managers at Ford need accurate forecasts of the number of each type of car they’ll sell each week. Traditionally they relied on forecasts put together by their internal analysts. But when Ford set up a prediction market and allowed its employees to bet on the outcome, the market yielded forecasts that were 25% more accurate.
Likewise Google’s managers need to forecast things like how many people will use Gmail, whether a project will be completed on time, and what its competitors will do. When Google set up its own prediction markets, the prices yielded remarkably accurate forecasts about these critically important business issues. Experiments at other companies such as HP, Intel, Nokia, and Siemens yielded similar findings.