Markets versus firms
The whole point of free market capitalism is that actions are directed by market prices and that this in turn ensures an efficient economy. But consider this: when a business firm instructs an employee to transfer from one department to another the employee is not obeying market prices, he transfers because he is told to. This is not free market capitalism. So why does it happen?
This question was asked by the British economist Ronald Coase who won the Nobel prize in economics in 1991 based on his research on the matter. I first read about this fascinating idea in last week's The Economist magazine. I found it fascinating, not least because it gave me some insights into the perennial question of whether large state owned enterprises (SOEs) and government related entities (GREs) should exist, at least at their current sizes, in an efficient economy. Here I am talking simply about the economics and efficiency of the market and not about any other policy matters. These ideas are based on Mr Coase's work but do not necessarily reflect his thinking.
The idea of an efficient market was introduced by Adam Smith, the Scottish philosopher considered to be the father of modern economics. Smith used the phrase “invisible hand” to describe the theory that if each consumer is allowed to buy whatever they want and each producer is allowed to sell whatever they want then this would result in an optimal allocation of resources and setting of prices that would benefit the economy as a whole. This optimality is what is now known as Pareto optimal, ie any reallocation of resources that makes one market participant better off would necessarily make at least one other participant worse off.
From this definition we see that for each consumer to buy what they want and each producer to sell what they want it would imply that each person works as an individual contractor and that they would contract with other market participants whenever they needed a good or service. This leads to Mr Coase’s question: why, then, do firms exist?
His answer is that firms exist when there are high costs to using the market. For example, in many countries it is legal and common for taxi drivers to be self-employed. The quality of the service is clear before a client gets in the car, indeed most markets require standardised cars. The fares are standardised and clear, visible on a meter. Client acquisition is simple, drive around until someone hails you. There might be benefits from collective bargaining, say on insurance, but there is no reason to believe that if there are enough self-employed taxi drivers then there won’t be competition amongst insurers to provide for this client segment. The costs of using this market are therefore low.
But what happens if we remove standardisation? At its most basic level, what happens if instead of employing people full time we employ them for specific jobs? If you’ve ever had to hire a consultant, individual or firm, you will understand the concept of the scope of work which outlines in detail what is required from the contractor. This has to be developed and negotiated on a case by case basis. There is also a listing of legal rights and responsibilities, with remedies and indemnification if anyone’s rights are breached. This also has to be negotiated on a case by case basis.
These costs would simply take up all of a person’s time. They would not be able to actually do productive work. This is why employment contracts do not specify in full detail all of these points, it would be exhausting to renegotiate every time an employee’s job changes. This is where markets fail, when there is no standardisation or there is uncertainty. An employment contract has to therefore be relatively vague if it is to be efficient and both employee and employer have to trust the contract. This is why a firm exists, to regulate non market compliant but nevertheless efficient transactions.
Consider a large endowment, fictional for this exercise. This endowment is managed by a sophisticated investment office (IO) and overseen by a board of trustees (BoT). The IO has previously submitted a plan to the BoT which was to develop a multi-strategy multi-asset class portfolio via allocations to investment managers (IMs) globally. Over the years the portfolio has done well, but the IO realises that they are paying away large amounts of fees, often 2 per cent of assets and 20 per cent of profits. These are high transaction costs. So why not expand the firm to internalise the investment managers and therefore reduce these high transaction costs?
The IO submits a plan to the BoT, who approve, and the IO starts to hire in IM teams to directly invest in the global markets. As the years pass, the performance of the portfolio starts to deteriorate. There are more and more internal portfolio blowups. What is happening?
Well, although the firm can reduce transaction costs, remember that it is the market that imposes efficiency. When an IM is external, they have to compete with other IMs for allocation. This incentivises them to keep innovating and to remain efficient. Once the IMs are internalised then they no longer have an incentive to innovate, the money is locked in. So the portfolio performance deteriorates. Perhaps one way to motivate the internal IMs is to pay them 2/20 again. It invariably always happens.
The more frightening issue is why are there portfolio blowups in which large amounts of money are lost in a short amount of time. An internal audit and review highlights something that was completely missed by the IO’s plan: governance. When the IMs where external then the IO acted in a governance capacity, performing regular due diligence on the IMs and holding them accountable. In addition, other investors are performing due diligence on the external IMs so there is an even higher probability of negative issues being highlighted.
When the IMs are internalised the IO becomes the IM. The IO attempted to create a risk function, but you know how it is. The IMs kept complaining that the risk function is holding them back. You see, the chief executive does not control the investment portfolio, the chief investment officer (CIO) does. I should know, I’ve been CIO three times in my life.
The BoT, who are supposed to only be responsible for the corporate governance of the IO, are now also responsible for the investment governance since the IO forgot that its responsibility was to protect the portfolio and not enrich themselves.
Thankfully this is an account of a completely fictional endowment.
The lesson here is that as the size of a firm increases, its transaction costs increase but its innovation and efficiency decrease. There is a happy equilibrium at some point. For an economy of our size, I’d be guessing wildly if I said that this equilibrium is probably well south of US$10 billion for a directly managed balance sheet, although the amounts managed externally can be unlimited.
Importantly, a firm should either be a manager of managers or a single, direct operator. The corporate governance and risk management can otherwise be weakened, severely.
The specs
Engine: 6.2-litre V8
Transmission: ten-speed
Power: 420bhp
Torque: 624Nm
Price: Dh325,125
On sale: Now
Our Time Has Come
Alyssa Ayres, Oxford University Press
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if you go
The flights
Etihad and Emirates fly direct to Kolkata from Dh1,504 and Dh1,450 return including taxes, respectively. The flight takes four hours 30 minutes outbound and 5 hours 30 minute returning.
The trains
Numerous trains link Kolkata and Murshidabad but the daily early morning Hazarduari Express (3’ 52”) is the fastest and most convenient; this service also stops in Plassey. The return train departs Murshidabad late afternoon. Though just about feasible as a day trip, staying overnight is recommended.
The hotels
Mursidabad’s hotels are less than modest but Berhampore, 11km south, offers more accommodation and facilities (and the Hazarduari Express also pauses here). Try Hotel The Fame, with an array of rooms from doubles at Rs1,596/Dh90 to a ‘grand presidential suite’ at Rs7,854/Dh443.
The National's picks
4.35pm: Tilal Al Khalediah
5.10pm: Continous
5.45pm: Raging Torrent
6.20pm: West Acre
7pm: Flood Zone
7.40pm: Straight No Chaser
8.15pm: Romantic Warrior
8.50pm: Calandogan
9.30pm: Forever Young
In numbers: PKK’s money network in Europe
Germany: PKK collectors typically bring in $18 million in cash a year – amount has trebled since 2010
Revolutionary tax: Investigators say about $2 million a year raised from ‘tax collection’ around Marseille
Extortion: Gunman convicted in 2023 of demanding $10,000 from Kurdish businessman in Stockholm
Drug trade: PKK income claimed by Turkish anti-drugs force in 2024 to be as high as $500 million a year
Denmark: PKK one of two terrorist groups along with Iranian separatists ASMLA to raise “two-digit million amounts”
Contributions: Hundreds of euros expected from typical Kurdish families and thousands from business owners
TV channel: Kurdish Roj TV accounts frozen and went bankrupt after Denmark fined it more than $1 million over PKK links in 2013
TERMINAL HIGH ALTITUDE AREA DEFENCE (THAAD)
What is THAAD?
It is considered to be the US's most superior missile defence system.
Production:
It was created in 2008.
Speed:
THAAD missiles can travel at over Mach 8, so fast that it is hypersonic.
Abilities:
THAAD is designed to take out ballistic missiles as they are on their downward trajectory towards their target, otherwise known as the "terminal phase".
Purpose:
To protect high-value strategic sites, such as airfields or population centres.
Range:
THAAD can target projectiles inside and outside the Earth's atmosphere, at an altitude of 150 kilometres above the Earth's surface.
Creators:
Lockheed Martin was originally granted the contract to develop the system in 1992. Defence company Raytheon sub-contracts to develop other major parts of the system, such as ground-based radar.
UAE and THAAD:
In 2011, the UAE became the first country outside of the US to buy two THAAD missile defence systems. It then stationed them in 2016, becoming the first Gulf country to do so.
Mercer, the investment consulting arm of US services company Marsh & McLennan, expects its wealth division to at least double its assets under management (AUM) in the Middle East as wealth in the region continues to grow despite economic headwinds, a company official said.
Mercer Wealth, which globally has $160 billion in AUM, plans to boost its AUM in the region to $2-$3bn in the next 2-3 years from the present $1bn, said Yasir AbuShaban, a Dubai-based principal with Mercer Wealth.
“Within the next two to three years, we are looking at reaching $2 to $3 billion as a conservative estimate and we do see an opportunity to do so,” said Mr AbuShaban.
Mercer does not directly make investments, but allocates clients’ money they have discretion to, to professional asset managers. They also provide advice to clients.
“We have buying power. We can negotiate on their (client’s) behalf with asset managers to provide them lower fees than they otherwise would have to get on their own,” he added.
Mercer Wealth’s clients include sovereign wealth funds, family offices, and insurance companies among others.
From its office in Dubai, Mercer also looks after Africa, India and Turkey, where they also see opportunity for growth.
Wealth creation in Middle East and Africa (MEA) grew 8.5 per cent to $8.1 trillion last year from $7.5tn in 2015, higher than last year’s global average of 6 per cent and the second-highest growth in a region after Asia-Pacific which grew 9.9 per cent, according to consultancy Boston Consulting Group (BCG). In the region, where wealth grew just 1.9 per cent in 2015 compared with 2014, a pickup in oil prices has helped in wealth generation.
BCG is forecasting MEA wealth will rise to $12tn by 2021, growing at an annual average of 8 per cent.
Drivers of wealth generation in the region will be split evenly between new wealth creation and growth of performance of existing assets, according to BCG.
Another general trend in the region is clients’ looking for a comprehensive approach to investing, according to Mr AbuShaban.
“Institutional investors or some of the families are seeing a slowdown in the available capital they have to invest and in that sense they are looking at optimizing the way they manage their portfolios and making sure they are not investing haphazardly and different parts of their investment are working together,” said Mr AbuShaban.
Some clients also have a higher appetite for risk, given the low interest-rate environment that does not provide enough yield for some institutional investors. These clients are keen to invest in illiquid assets, such as private equity and infrastructure.
“What we have seen is a desire for higher returns in what has been a low-return environment specifically in various fixed income or bonds,” he said.
“In this environment, we have seen a de facto increase in the risk that clients are taking in things like illiquid investments, private equity investments, infrastructure and private debt, those kind of investments were higher illiquidity results in incrementally higher returns.”
The Abu Dhabi Investment Authority, one of the largest sovereign wealth funds, said in its 2016 report that has gradually increased its exposure in direct private equity and private credit transactions, mainly in Asian markets and especially in China and India. The authority’s private equity department focused on structured equities owing to “their defensive characteristics.”
The specs
Engine: 6.2-litre supercharged V8
Power: 712hp at 6,100rpm
Torque: 881Nm at 4,800rpm
Transmission: 8-speed auto
Fuel consumption: 19.6 l/100km
Price: Dh380,000
On sale: now
Company profile
Company name: Suraasa
Started: 2018
Founders: Rishabh Khanna, Ankit Khanna and Sahil Makker
Based: India, UAE and the UK
Industry: EdTech
Initial investment: More than $200,000 in seed funding
Living in...
This article is part of a guide on where to live in the UAE. Our reporters will profile some of the country’s most desirable districts, provide an estimate of rental prices and introduce you to some of the residents who call each area home.
2025 Fifa Club World Cup groups
Group A: Palmeiras, Porto, Al Ahly, Inter Miami.
Group B: Paris Saint-Germain, Atletico Madrid, Botafogo, Seattle.
Group C: Bayern Munich, Auckland City, Boca Juniors, Benfica.
Group D: Flamengo, ES Tunis, Chelsea, (Leon banned).
Group E: River Plate, Urawa, Monterrey, Inter Milan.
Group F: Fluminense, Borussia Dortmund, Ulsan, Mamelodi Sundowns.
Group G: Manchester City, Wydad, Al Ain, Juventus.
Group H: Real Madrid, Al Hilal, Pachuca, Salzburg.
Who is Allegra Stratton?
- Previously worked at The Guardian, BBC’s Newsnight programme and ITV News
- Took up a public relations role for Chancellor Rishi Sunak in April 2020
- In October 2020 she was hired to lead No 10’s planned daily televised press briefings
- The idea was later scrapped and she was appointed spokeswoman for Cop26
- Ms Stratton, 41, is married to James Forsyth, the political editor of The Spectator
- She has strong connections to the Conservative establishment
- Mr Sunak served as best man at her 2011 wedding to Mr Forsyth
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UPI facts
More than 2.2 million Indian tourists arrived in UAE in 2023
More than 3.5 million Indians reside in UAE
Indian tourists can make purchases in UAE using rupee accounts in India through QR-code-based UPI real-time payment systems
Indian residents in UAE can use their non-resident NRO and NRE accounts held in Indian banks linked to a UAE mobile number for UPI transactions
more from Janine di Giovanni
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A MINECRAFT MOVIE
Director: Jared Hess
Starring: Jack Black, Jennifer Coolidge, Jason Momoa
Rating: 3/5
Yemen's Bahais and the charges they often face
The Baha'i faith was made known in Yemen in the 19th century, first introduced by an Iranian man named Ali Muhammad Al Shirazi, considered the Herald of the Baha'i faith in 1844.
The Baha'i faith has had a growing number of followers in recent years despite persecution in Yemen and Iran.
Today, some 2,000 Baha'is reside in Yemen, according to Insaf.
"The 24 defendants represented by the House of Justice, which has intelligence outfits from the uS and the UK working to carry out an espionage scheme in Yemen under the guise of religion.. aimed to impant and found the Bahai sect on Yemeni soil by bringing foreign Bahais from abroad and homing them in Yemen," the charge sheet said.
Baha'Ullah, the founder of the Bahai faith, was exiled by the Ottoman Empire in 1868 from Iran to what is now Israel. Now, the Bahai faith's highest governing body, known as the Universal House of Justice, is based in the Israeli city of Haifa, which the Bahais turn towards during prayer.
The Houthis cite this as collective "evidence" of Bahai "links" to Israel - which the Houthis consider their enemy.
