Possible Insight

Production Function Space and Hiring

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Previously, I used my Production Function Space (PFS) hypothesis to illuminate the differences between startups, small businesses, and large companies. Now, I’d like to turn my attention to the implications of PFS on a firm’s demand for labor.

I don’t know about you, but a lot of hiring behavior baffles me. I see companies that appear clearly and consistently understaffed or overstaffed, relative to demand for their offerings.  Then the hiring process itself is strange.  I’ve consistently seen companies burn all kinds of energy and incur all sorts of angst just to come up with a job description. Shouldn’t it be obvious what isn’t getting done? Why do they delegate apparently core aspects of production to contractors? And despite decades of evidence, why do firms insist on using selection procedures like unstructured interviews that aren’t very effective.  Also, there’s the mystery of why incentive-based pay doesn’t work in general despite plenty of evidence that humans respond well to incentives in other circumstances.

Can the PFS hypothesis shed any light?  I think so.  But this hypothesis implies that a firm’s labor decisions are substantially more complicated than we thought, so don’t expect a nice “just-so” story.

I see three big implications if many employees benefit the firm primarily through searching PFS instead of producing goods and services:

  1. Uncertainty. The payoffs from searching PFS are uncertain.  In many cases, they’re really uncertain. You could end up with a curious but unmarketable adhesive or you could end up with the bestselling Post-it notes. You could end up with just another search engine or you could combine it with AdWords and end up with Google. A search over a given region is essentially a call option on implementing discovered production functions.
  2. Specificity. Economists refer to an asset as “specific” if its usefulness is limited primarily to a certain situation. The classic example is the railroad track leading up to the mouth of a coal mine. I think employees searching PFS are fairly specific. Each firm’s ability to exploit production functions is rather unique. Google and Microsoft can’t do exactly the same things. Moreover, each firm’s strategy for exploring PFS is different. So it takes time for an employee to “tune” himself to searching PFS for a particular firm. All other things being equal, an employee with 3 months on the job is not as effective at searching PFS as an employee with 3 years. And an employee that leaves firm A will not be as effective at searching PFS for firm B for a significant period of time. Think of specificity in searching PFS as a fancy way of justifying the concept of “corporate culture”.
  3. Network Effect. The number of people searching a given region seems to matter. I’m not at all sure if it’s a network effect, a threshold effect, or something else. But there seems to be a “critical mass” of people necessary to search a coherent region of PFS. You need a certain collection of skills to evaluate the economic feasibility of a production function. The larger a firm’s production footprint and the larger the search area, the greater the collective skill that is required.

Let’s start with hiring and firing decisions.  As you can see, firms face a really complex optimization problem when choosing how many people to employ and with what skills.  Suppose demand for a firm’s products suddenly declines.  What’s the optimal response?  Due to the the network effect, firing x% of the workforce reduces the ability to search PFS by more than x%.  Due to specificity, this reduction in capability will last much longer than the time it takes to rehire the same number of people.  Thus, waiting to see if the drop in demand is temporary or permanent provides substantial option value.  Of course, a small firm doesn’t have much cushion, so may have to lay off people anyway.

Thus I predict a sudden drop in demand will result in disproportionately low or significantly delayed layoffs, and the disproportion or delay will be positively correlated with firm size.  Moreover, firms will tend to concentrate layoffs among direct production workers to minimize the effect on searching PFS.  This tendency may explain why they delegate some apparently core functions.  Being able to flexibly adjust those direct costs preserves the ability to search PFS. This hypothesis implies that the more volatile the demand for a firms’ products, the more they will outsource direct production.

Conversely, what should a firm do if demand suddenly increases?  Based on the PFS hypothesis, I have three predictions: the firm will (1) delay hiring to see if the demand increase is sustained, (2) “over hire” relative to the size of the demand increase, and (3) hire a disproportionate number of people outside of core production.  The reason is simple, diversification.  Due to uncertainty, the best way for a firm to ensure its long-term survival is to have a large portfolio of ongoing PFS searches. Extra dollars should therefore be allocated to PFS searching labor rather than capital or direct production labor.  However, because a firm knows that it will be reluctant to fire in the future, it will initially be conservative in deciding to hire.

It seems like these predictions should be testable.  I wish I had a research assistant to go through the available data and crank through some econometric analysis.  I’m thinking the next step is to work through the implications of PFS searching on employee behavior.  Unless anyone has other thoughts.

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Written by Kevin

March 9, 2011 at 8:47 pm

Posted in Economics

One Response

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  1. […] my Production Function Space (PFS) hypothesis produced a few decent insights (see here, here, and here), it had some major flaws. First, it completely ignores the demand side of the equation, i.e., how […]


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