insights volume 4 november 2008

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DisclaimerInsights is published by the University of Melbourne for the Faculty of Economics and Commerce. Opinions published are notnecessarily those of the publisher, printers or editors. The University of Melbourne does not accept responsibility for the accuracyof information contained in this journal. No part of this journal may be reproduced without the permission of the editors.

Mailing Address:The Faculty of Economics and CommerceThe University of MelbourneVictoria 3010 Australia

Telephone: +61 3 8344 2166Email: [email protected]: http://insights.unimelb.edu.au

Published by the Faculty of Economics and Commerce, November 2008© The University of Melbourne

Melbourne Economicsand Commerce

volume 4 november 2008

Big brother or a fair go By Graham Sewell

Market competitiveness By Bryan Lukas

Accounting induced performance anxiety

By Anne Lillis

Understanding global imbalances By Richard Cooper

An interview with Robert E. LucasBy Ian King

Closing the gap? By Paul Smyth

Forward with fairness By John Denton

Intelligent systems in accounting By Stewart Leech

New agenda for prosperity By Stephen Sedgwick

Real options analysis By Bruce Grundy

Inflation targeting By Guay Lim

New economic geography By Russel Hillberry

Paying doctors to improve health By Anthony Scott

Innovation: high value-added strategy By Danny Samson

Neuromarketing By Phil Harris

INSIGHTS

Insights v4 cover final:Layout 1 28/10/08 8:01 AM

Welcome

This volume appears in the middle of the mostserious international monetary crisis since 1929.In our last issue, we published a prophetic paperby Satyajit Das about the inevitable bursting of the liquidity bubble. This bubble has clearlyburst. Unfortunately, the deadline for this issueprevents us from publishing two forthcominglectures dealing more directly with the causes andconsequences of the credit crisis. These willappear in the next volume of the journal.

However, the recent large number of publiclectures has provided a rich harvest for inclusion inthis volume. Three professors expound theirparticular areas of interest in their InauguralLectures. These are followed by papers on anumber of contemporary issues – globalimbalances, industrial relations, a summary byProfessor Sedgwick of the proceedings of theEconomic and Social Outlook Conference,intelligent systems in accounting, and aninterview with Nobel Laureate Lucas on inequalityand incomes across societies. Finally, this issueincludes condensed versions of six refresherlectures given by leading Faculty members.

These lectures are aimed at updating Alumni onrecent developments and research in a number offields.

Insights is sent to a large number of Alumni andother interested people; and it is also accessibleon the Faculty’s webpage. We hope it is widelyread and finds a place in waiting rooms and oncoffee tables for others to read. So far this year,more than 8,000 people accessed the publicationonline from Australia, US, Netherlands, Japan,Germany, UK, India and Singapore.

Insights is a team effort. Caroline Stirling has donethe artistic illustrations, which are suggestive ofthe themes of some of the papers, in this issue.We congratulate her on depicting the substanceof the first article for the journal’s cover sotastefully. Finally, comments and suggestionsfrom readers – on all aspects of the journal – aremost welcome.

Joe IsaacEditor

[email protected]

Insights: Melbourne Economics and CommerceISSN:1834-6154

Editor: Emeritus Professor Joe Isaac, AOAssociate Editor: Ms Brooke YoungSub-editor: Ms Rebecca Gleeson

Advisory Board: Professor Robert DixonProfessor Bruce GrundyProfessor Bryan Lukas

Illustrator: Ms Caroline StirlingDesign: Ms Sophie Campbell

Insights publishes condensed and edited versions of important public lectures connected with theFaculty of Economics and Commerce. Its objective is to share with the wider public – especiallyAlumni – the issues presented and developed in these lectures. It also constitutes an archivalsource of an important element of Faculty life.

Insights v4 cover final:Layout 1 28/10/08 8:01 AM

03 Big brother or a fair go: is workplacesurveillance coercive or does itguarantee our rights at work?

By Graham Sewell

08 When a firm is market-oriented:product and brand managementimplications

By Bryan A. Lukas

11 Accounting induced performanceanxiety: consequences and cures

By Anne Lillis

19 Understanding global imbalances

By Richard Cooper

23 An interview with Robert E. LucasJnr.

By Ian King

26 Closing the gap? The role of wage,welfare and industry policy inpromoting social inclusion

By Paul Smyth

31 Forward with fairness: a businessperspective on Labor’s reformagenda

By John Denton

37 The use and misuse of intelligentsystems in accounting: the risk of technology dominance

By Stewart Leech

42 New agenda for prosperity

By Stephen Sedgwick

Alumni refresher lecture series:

47 Real options analysis andinvestment appraisal: theopportunities and challenges

By Bruce D. Grundy

51 Inflation targeting

By Guay C. Lim

57 New economic geography andmanufacturing

By Russel Hillberry

61 For love or money? Paying doctorsto improve the quality of health

By Anthony Scott

65 Innovation: a high value-addedstrategy

By Danny Samson

69 Neuromarketing – marketinginsights from neuroimaging research

By Phil Harris

insights vol 4Table of contents

Insights Melbourne Economics and Commerce 01

03Insights Melbourne Economics and Commerce

“My anxiety is that we are sleepwalking into asurveillance society where much more informationis collected about people, accessible to far morepeople shared across many more boundaries thanBritish society would feel comfortable with.”

Richard ThomasUK Information Commissioner(interviewed in The Times, 16 August 2004)

Is it time to reconsider Big Brother?

Sentiments like those expressed above byRichard Thomas have become a regular feature ofnews reports. In his novel Nineteen Eighty-Four,George Orwell famously predicted thatsurveillance would play a crucial role inmaintaining an oppressive social order under atotalitarian regime. The name he coined for sucha pervasive, centralised and oppressivesurveillance system was, of course, ‘Big Brother’.Through its attachment to the eponymoustelevision show, the term has become associatedwith trivial voyeurism and we now face theprospect of a constant diet of Facebook, YouTubeand reality television. It is creating a generationthat does not know the importance of privacy; a generation where the default state is one of total self-disclosure, even to completestrangers. This has led the outgoing ChiefJustice, Murray Gleeson, to comment that somepersonal information previously considered to beself-evidently private may no longer be so.

Yet one important lesson we can learn fromOrwell’s dystopian vision is that those who holdpersonal information on us are also able to exercise power over us.

Although a well-developed sense of privacy is oneway to counter this power, there are some thingsthat we have always been compelled to revealabout ourselves. This is particularly the case in theemployment relationship where employersconsider it legitimate to gather all kinds ofpersonal information about their employeesthrough workplace surveillance. One questionarises from this state of affairs: is workplacesurveillance and the power that accompanies itexercised in a benign and paternalistic way or in a malign and coercive way? In Orwell’s Oceania,surveillance is enrolled in an oppressive and brutalproject of control, but it is possible to imaginecircumstances where surveillance protects us andhelps to maintain our basic freedoms.

In this article I will present the workplace as afamiliar setting where these opposing views bothhold sway – that is, there are well-establishedintellectual traditions that see surveillance as eithera tool of management oppression or as a way ofenforcing basic notions of fairness in theworkplace. What we must be able to establish ishow these intellectual traditions affect our stancetoward the purpose and necessity of workplacesurveillance. This is important, as I shall argue thatneither provides a completely satisfactory accountof workplace surveillance if taken in isolation.

A condensed version of his Inaugural Lecture given at the University of Melbourne on 29 July 2008.

big brother or a fair go: is workplacesurveillance coercive or does itguarantee our rights at work?

by graham sewell

We are greatly in need of informed debate in Australia about the purpose and consequences of workplace monitoring

04 Big brother or a fair go

Consequently, in order to appreciate the personal andorganisational impacts of workplace surveillance,we need to develop a conceptual and empiricalapproach that takes into account these opposingviews. This is because the status of surveillance is invariably paradoxical and our experiences of it are often contradictory. For example, a commonreaction to the failure of surveillance to preventcrime or misconduct is to argue for more of it –rather than, say, pursue another course of actionthat could potentially be more successful.

Another paradox of surveillance is that it ispotentially a two-way street in that it can be usedto expose the activities of people who abusepositions of authority. This most famouslyoccurred in 1991, when amateur film footage wasused to identify members of the Los Angeles PoliceDepartment who beat Rodney King. Finally, butnot exhaustively, I offer another common paradoxof surveillance in that, despite the familiar adagethat ‘If you’ve got nothing to hide you’ve gotnothing to fear’, we can appreciate the protectivebenefits of surveillance when it is directed at othersyet cavil when it is directed at us. If we are all thetargets of surveillance then one of its effects,psychologically speaking, at least, is that we are allseen as potential criminals. The UK provides avivid example of this. Anyone who is detained bythe British police can be compelled to give a DNAsample which is retained indefinitely regardless ofwhether that person is charged or not, let aloneconvicted. One of my tasks in this article is to showhow these paradoxes of surveillance play out in theworkplace, so that we can begin to appreciate theneed for a reformulation of our ideas aboutsurveillance to take into account its ambiguousrole as a means of coercion or protection.

Measuring everything that moves: my managers cannot resist theseductions of surveillance

As countless scholars – most notably Max Weber– have observed, one of the defining features ofmodern organisations is the use of hierarchicalsystems of command and control. Weber saw this as a sine qua non for the achievement oforganisational ‘incorporation’ – that is, getting agroup of people from diverse backgrounds to work

toward a common purpose. In a modern capitalistorganisation there is no guarantee that commonpurpose will emerge spontaneously or by consent.Organisational goals are usually devised by anelite group of decision-makers who must thenensure that employees’ efforts are directed towardthem. In a bureaucratic organisation this isachieved by breaking a job into a series of specifiedduties. Determining whether an individual isperforming these duties becomes theresponsibility of an immediate superior, thusgiving rise to the familiar notion of thebureaucratic hierarchy. This is, quite literally, aform of ‘over-sight’ or ‘sur-veillance’; and itcaptures the operating principles of this form oforganisational control. Of course, it has becomefashionable to talk of ‘post-bureaucratic’ or ‘flat’organisations where such forms of hierarchicalcontrol are supposed to have been consigned to thedustbin of history. Even if such pronouncementsare true – and I for one doubt that they are – I haveargued extensively in my published work that ourtheoretical as well as our everyday understandingof organisational control is still dependent on thisconceptual notion of oversight or surveillance.

In drawing attention to the importance ofbureaucratic hierarchy as a form of oversight,Weber was formally capturing the familiarChristian belief that the omnipresent eye of Godwill see your every sinful transgression and punishyou accordingly – a principle famously depicted in Hieronymus Bosch’s painting, The Seven DeadlySins. In organisational literature, however, ourunderstanding of the disciplinary effect ofsurveillance has more recently drawn on MichelFoucault’s discussion of the Panopticon – a prisondesign proposed by Jeremy Bentham wherewarders watch prisoners held in a ring of cellsarrayed around a central tower. Importantly,overseers in the tower could not be seen by theinmates, leaving them with the impression thatthey could at any moment be under surveillance.This is the source of panoptic discipline: the effectof surveillance would appear to be continuouseven if inmates were not necessarily underconstant scrutiny.

It is tempting to take the Panopticon quiteliterally as a model of perfected surveillance.


Indeed, authors talk about the prospect of anelectronic or information Panopticon to such anextent that it runs the risk of becoming a cliché. I think that one way of avoiding this fate is to seethe Panopticon as a figurative expression of thedesire to know all there is to know about others inthe belief that this will render them self-disciplining subjects. Thus, Bentham’s Panopticonprovides us with a secular version of the prospect ofdivine retribution leading the God-fearing torefrain from sinful behaviour – that is, to fall intoline behind some culturally determined notion ofwhat constitutes appropriate behaviour or rightconduct. Importantly, the enduring nature of thisbelief is not dependent on the actual means ofsurveillance approximating to the operatingprinciples of the Panopticon. Thus, although someargue that technological developments mean thatthe panoptic model no longer holds in some socialsettings, the workplace is nevertheless still onesuch setting where managers claim the legal andmoral right to subject their subordinates to a formof scrutiny that involves the centralised storage and dissemination of personal information. This is particularly the case when it comes to themeasurement and evaluation of personal workperformance, meaning that we can still talk aboutthe cultural and normative force of the Panopticon– it stands as a powerful metaphor for managers’

desires to collect information that can be used tocompare the performance of individual employees.Indeed, it is a widely held belief that collectingsuch information is an essential part of running anefficient and effective organisation.

Coercion versus care: the purposeand necessity of workplacesurveillance

But why should individual performancemeasurement – part of a process of enhancedmanagerial control as I have presented here – be so important at a time when employee‘empowerment’ is now the mantra ofmanagement consultants? In the sociology oforganisations our general understanding of thepurpose and necessity of this form of workplacesurveillance falls into two ideologically opposedcamps. There are those who see it as beingessentially coercive – a case of the few watchingthe many to serve the interest of the few. In otherwords, managers are agents of a minority class ofcapitalists who use performance measurement to ensure that employees are working as hard asthey can all the time. In contrast, there are thosewho see workplace surveillance as beingessentially ‘caring’ – a case of the few watchingthe many to protect the interests of everyone.

06 Big brother or a fair go

In other words, managers are disinterestedtechnocrats who use performance measurementto ensure that employees and employers each doas promised in an employment contract, in theprocess protecting everyone from the effects ofself-interested or anti-social behaviour – forexample, free-riding, bullying or various forms ofharassment. In essence, this is the source of theargument: that surveillance can protect ourrights at work because it ensures that employeesdo not suffer injustices, be they perpetrated bytheir colleagues or by their employers.

As I indicated above, bureaucratic control isassociated with very detailed descriptions of rolesand responsibilities; but in today’s world, where job descriptions are open-ended and employeesexpect flexibility, there is – some might sayparadoxically – an even greater desire to subject the

performance of employees to scrutiny. A coerciveview would frame this as using surveillance tomaximise the opportunities created by employeediscretion and flexibility to intensify work. This is because performance monitoring is a wayof ensuring that employees are using theirdiscretion for the good of the organisation ratherthan themselves. Interestingly, exactly the sameargument can be advanced from a caringperspective except that, in this case, a belief in theessential fairness of the employment contractmeans that flexibility benefits all. Thus, only thesmall minority who wish to use their increaseddiscretion to indulge in free-riding or anti-socialbehaviour should have anything to fear from thisform of surveillance.

The problem for researchers and employees alike is that it is possible to simultaneously see the


merit of each of these perspectives on workplacesurveillance. Like a citizen who does not appreciatethe power of the state until they are arrested anddetained on the strength of a false accusation, wemay well be inclined to see surveillance as beingessentially benign and protective for most of thetime. To repeat the old adage: it is, after all, onlythose who have something to hide that havesomething to fear. Yet, when our performance doesnot measure up and our work efforts are called intoquestion, especially if we really have been workingto the best of our abilities, then we may well beinclined to think of performance measurement asbeing little more than an instrument of managerialoppression. It is at moments like this that neitherthe coercive nor the caring perspective on its own can provide an adequate account of theconsequences of workplace surveillance.

This gives us pause to think about how the otherparadoxes of surveillance are played out at work.For example, it is easy to use the failure toapprehend a single high-profile offender – perhapssomeone who abuses their position at work toobtain personal gain – as a reason to intensifysurveillance of everyone’s activities without everstopping to think about the consequences. Thismight include increasing compliance costs, say, by having employees do more and morepaperwork, eroding trust, or actually reducingemployee discretion. You cannot begin to measurea job unless you break it down to its standardcomponent parts which, in itself, goes against thespirit of discretion. Rather than putting it downto a failure of surveillance, it may well be better tothink about how such a person was appointed inthe first place. In other words, it is the selectionprocess that needs to be tightened up, not thework monitoring systems.

Finally, we may cavil as more and more of ourwork activities become subject to measurement,but there are times when it can work to ouradvantage insofar as we may be able todemonstrate that we have actually reached therequired standards to be promoted or to win abonus. Similarly, we can use things like mobilephone or internet usage records to demonstratethat we were actually doing what we were saidwe were doing, should our conduct ever be calledinto question. These are moments when the

products of surveillance can be used to theadvantage of employees; moments when we canuse performance information to get managers tokeep their side of the bargain.

Where do we draw the line?

As ever, the question is where do we draw the linewhich determines what is acceptable and what isunacceptable in terms of surveillance? In civilsociety, such matters are dealt with through legaland democratic processes, with varying levels of success. However, in the workplace fewequivalent avenues exist. For example, inAustralia, personal employee information – inpractice taken to include individual performanceinformation – is excluded from Federal privacylegislation. This was because it was intended tobe an industrial relations matter but, even underthe current government’s Forward with Fairnessproposals, workplace privacy is not explicitlyaddressed. As a result, the status and role ofworkplace surveillance is a matter of good faithbargaining between employers and employees,with little or no reference to minimum statutoryprotections or maximum permitted intrusions.This means that we are greatly in need ofinformed debate in Australia about the purposeand consequences of workplace monitoring; adebate that can only be improved by developinga subtle appreciation of the paradoxes ofsurveillance and the tensions these create whenwe are trying to understand whether it is coerciveor protects our rights at work.

Professor Graham Sewell is in theDepartment of Management and Marketingat the University of Melbourne.

08 When a firm is market-oriented

The meaning of being market-oriented

One of the important debates in the marketingliterature since the 1990s is the question of whatit means for a firm to be market-oriented. Thedebate stems from mounting evidence thatmarket-oriented firms deliver superior financialperformance to their owners.

Most firms that I have engaged with as aconsultant or researcher claim to be market-oriented. Their claim usually goes something likethis: ‘I believe in listening to the market carefully.I spend a fortune on market research. I integratemy market research findings in my decision-making process. I am, therefore, market-oriented.’The truth, however, is that market research doesnot make a firm market-oriented. Most firms thatI engage with are not market-oriented, at all.

So, what makes a firm market-oriented? In my experience, the main building blocks ofmarket orientation are to be customer-oriented,competitor-oriented and collaborator-oriented.Collaborator-oriented means that a firm will putitself in the position of its collaborators – forexample, in the position of a supplier or strategicalliance partner. Competitor-oriented means that afirm will put itself in the position of its directcompetitors. Customer-oriented means that a firmwill put itself in the position of its customers.Then, once a collaborator-competitor-customerperspective has been adopted, the firm has to

respond to the following question: ‘What would Ias a collaborator, competitor and customer reallyexpect to benefit from my own firm?’

In this short essay, I do not have the space toexplore all three orientations in detail. Therefore,let me concentrate on customer orientation –probably the most important and difficultorientation of the three for a firm aspiring to bemarket-oriented to execute.

Customer orientation as a componentof market orientation

To be sure, customer orientation means that a firmwill (a) look at itself by pretending to be acustomer and (b) answer the question stated above:‘What would I as my own customer really expectto benefit from my firm?’ The reason why marketresearch of customers does not make a firm market-oriented is that the firm does not become its own customer through market research – marketresearch consists usually of asking people outside ofthe firm what benefits are needed from the firm.Only by the firm becoming its own customer canit take into consideration the full scope and depthof customer benefits that are technically andotherwise possible. Why? Because only the firmknows what is really possible. Only the firm hasinsights into what can be really offered tocustomers. Let us look at some firms that havemanaged to be market-oriented and have listenedto their own answers to their question.

when a firm is market-oriented: productand brand management implications

by bryan a. lukas

A market-oriented firm is a business-model innovator, a product-market pioneer and a brand developer

This essay served as the basis for his Inaugural Lecture given at the University of Melbourneon 10 June, 2008.


The first example is Virgin Group’s domestic airlineventure in Australia. The firm asked itself what itwould want from a domestic airline in Australia.The firm admitted that meals on short flightsbetween capital cities were really not value-adding,paper tickets did not add anything either, and thata bit of in-flight fun would not go astray. So VirginBlue was launched as a no-frills, deep-discount andfun-loving airline in Australia.1 The next example isStarbucks. The firm asked itself what it would wantfrom drinking coffee in a coffee shop in the US. Theanswer was: to be part of a small community. SoStarbucks aimed to become the ‘third place’ inAmerica, in addition to work and home. The firmsaid to its customers: ‘Stay as long as you like in ourcoffee shops; bring your family, friends andcolleagues along; bring your work along; and youdo not have to order a new cup of coffee everytwenty minutes to earn your right to be here.’ Thenthere is the case of ING Group. The Dutch firmasked itself what it would want from a retail bank.The bank conceded that it would expect a decentreturn for its savings deposits, would not want topay fees for those deposits, and would want 24-houraccess to those deposits from any customer location.So ING Direct was launched as a virtual bank thatpaid above-average interest on savings deposits anddid not charge savings-account fees. The virtualbank was launched in Australia, Europe and NorthAmerica.

Let us look at these examples more closely. Not only do Virgin Blue, Starbucks and INGDirect exemplify what it means to be customer-oriented; in each instance, these firms have alsochanged the way business is conducted in theirline of work. Specifically, it appears that a trulymarket-oriented firm is an innovator – but ratherthan being a product2 innovator in an engineeringsense, a truly market-oriented firm is a business-model innovator. Virgin Blue revolutionisedAustralian domestic air travel. Starbucksrevolutionised the American way of ‘having acoffee’. ING Direct revolutionised savingsaccounts in Australia, Europe, and to some extenteven in North America.

Revolutions require a certain mindset – they aredisruptive, and they often require a firm toabandon its traditional product markets. Let usexplore this observation further.

Market orientation implications forproduct markets

Truly market-oriented firms are prepared to moveaway from their existing product market(s), and toignore both typical customer segments andcommonly accepted product lines.

Consider Virgin Blue again. The firm started upand established itself successfully with a focus ontourists and travellers who could not afford to flywith the incumbent airlines. Business people werenot part of Virgin Blue’s original target audience.As for Starbucks, this firm started off selling fresh-roasted, gourmet coffee beans and relatedequipment in a small retail store. Today, it makescoffee in thousands of coffee shops. Finally, look atING Direct. Its Dutch parent company, INGGroup, is a full-service bank that offers banking,insurance and asset management services. Incontrast, ING Direct focuses mainly on thesavings accounts business and does not offerinsurance and asset management products.

Abandoning traditional product markets has anumber of follow-on effects. Usually, one effect isthat existing product brands need to be adjusted,or new brands need to be built, in order toaccommodate the change in product markets. Letme explain this observation in more detail.

Market orientation implications forbrand management

A brand’s ability to affect a consumer’s productchoice is a function of what consumers knowabout a brand. What customers know about abrand is, in turn, a function of customersexperiencing the brand in its designated productmarket. If that product market is abandoned by afirm because its market orientation necessitatesthat move, then the existing brand is detachedfrom its designated context. Therefore, the brandneeds to be adjusted, or a new brand needs to beput in place, to fit the new product market(s) ofthe market-oriented firm.

Let us consider Virgin Blue once again. VirginGroup did not call its airline venture inAustralia ‘Virgin Group’. Nor did it use any of its existing airline sub-brands – for example, Virgin Express or Virgin Atlantic.

10 When a firm is market-oriented

Instead, it created a new sub-brand by using a newsuffix: ‘Blue’. With this move, new associationsdistinctive to the Australian context were addedto the well-established parent-brand associationsrelated to ‘Virgin’. ING Group did somethingsimilar to Virgin Group by replacing ‘Group’ with‘Direct’, thereby creating a new sub-brand for itsnew operations. Starbucks is an example ofadopting a new brand. The first Starbucks coffeeshop to make coffee the way we experienceStarbucks coffee today was actually called ‘IlGiornale’. Mr Schultz, the owner of Il Giornale,bought the small coffee bean roaster, Starbucks, togrow his business. He then dropped the IlGiornale business name and registered all of hisshops as ‘Starbucks’. I presume that the name ‘IlGiornale’ did not lend itself as well as ‘Starbucks’did, as a memorable name, to an aspiring coffeeshop empire aimed at being present in nearlyevery US city and town.

In summary, to be market-oriented is to be abusiness-model innovator, a product-marketpioneer and a brand developer. The concept ofmarket orientation is the philosophical cornerstone of the discipline of marketing.

1 In recent times, Virgin Blue has changed its strategic stancefrom a cost leader to a differentiator. It remains fun-loving,but no longer aims to be a no-frills price-breaker. For thepurpose of this essay, however, Virgin Blue’s originalstrategic stance as a cost leader – lasting from the firm’slaunch to approximately 2006 – is a good example.

2 By ‘product’, I mean both goods and services.

Professor Bryan A. Lukas is Professor ofMarketing and Head of the Department of Management and Marketing at theUniversity of Melbourne.


Introduction

In 1975, Stephen Kerr published a simple butimportant paper entitled ‘On the folly ofrewarding A while hoping for B’, which capturedthe intended and unintended consequences ofperformance measures. Kerr identified the ways inwhich commonly used performance metricsinduce behaviour that may enhance reportedperformance on the measures used, but do nothave any substantive performance impact – forexample, achieving ‘reject rate’ reduction bystopping quality inspections rather thanimproving attention to quality. The prominenceof accounting metrics in performance evaluationof organisations and their management brings onwhat I call accounting-induced performanceanxiety. The anxiety to perform favourably againstaccounting performance benchmarks has bothintended and unintended consequences.

This lecture examines the phenomenon ofaccounting-induced performance anxiety byreflecting on three collaborative research projects:

1. The way intense performance anxiety – forexample making losses – affects decisionmaking at the firm level;

2. The way conventional accounting performancemeasurement practices within firms can inhibiteffective strategy implementation; and

3. The potential for recent performance-measurement innovations, such as theBalanced Scorecard, to reduce the problem ofaccounting-induced performance anxiety.

Project 1 – Intense performanceanxiety: reporting accounting losses1

This project examines accounting-inducedperformance anxiety that derives from capitalmarket pressure to report profits. The accountingprofit/loss threshold represents a powerfuldecision heuristic (empirically derived) because:

– The reporting of a loss acts as a trigger foroutside intervention (e.g. by boards, regulatoryagencies, equity markets and lenders); and

– Investors asymmetrically ‘devalue’ a firm in asmall loss situation relative to a small profitsituation, while these firms are in fact verysimilar economically.

Although the likelihood of crossing the profit/loss – zero profit – threshold creates severeaccounting-induced performance anxiety, thisthreshold is not a particularly importantbenchmark in an economic sense. Small profit firms are not ‘profitable’ in an economic sense, as their earnings would not be generating sufficient return on capital.

accounting-induced performance anxiety:consequences and cures

by anne lillis*

The anxiety to perform favourably against accounting performancebenchmarks has both intended and unintended consequences

A condensed version of her Inaugural Lecture delivered at the University of Melbourne on16 September 2008.

* I acknowledge helpful comments and/or assistance with the preparation of this inaugural lecture from Margaret Abernethy, Albie Brooks, Marc Costabile, Jennifer Grafton, Richard Lee and Matthew Pinnuck.

So if the anxiety was really performance driven, itshould be evident somewhere in the small profitarea. However, it is the loss threshold which is arelatively arbitrary accounting threshold withlittle economic meaning.

Managers have a variety of mechanisms availableto them to avoid reporting losses. One is ‘earningsmanagement’ – the ability to use the discretionthat is available within the reporting ofaccounting numbers to show the firm in a profitposition. It is well documented in the literaturethat a disproportionately large number of firmsreport small profits, and a disproportionatelysmall number of firms report small losses. Thissuggests firms use available mechanisms to avoidthe reporting of losses, including the use ofaccounting discretion to stay on the right side ofthe threshold. The asymmetric distribution offirms around the zero profit/loss threshold isalmost certainly evidence of accounting-inducedperformance anxiety.

A different reflection of the same type of anxietyarises from the behaviour of firms that havecrossed the profit/loss threshold – into a lossposition – and want to get back to reporting aprofit as quickly as possible. Presumably, thesefirms have unsuccessfully exploited all availablepotential for accounting discretion in the bid toreport a small profit. More drastic action caninclude discarding less productive investments

that may have been ‘carried’ during moreprofitable times, or cost cutting in discretionaryareas like R&D. Investments in fixed assets arelumpy and irreversible. Reducing the level ofemployment, on the other hand, provides acontinuum (non-lumpy) of divestment potential.Cutting employees turns out to be a highlyvaluable ‘response’ lever in this situation.

An examination of changes in employee numbersfor a very broad cross-section of US firms,classified by their level of earnings deflated bytotal assets, shows the following patterns:

– The average percentage growth in number ofemployees is systematically lower for loss-making firms than for profit-making firms.There is a significant discontinuity at thethreshold and the difference is not explained bydifferences in economic fundamentals betweensmall loss and small profit firms (Figure 1).2

– Firms that cross the threshold from a profit toa loss reduce their investment in employeesdisproportionately in the year that they crossthe threshold.

– The effect is more significant in the yearfollowing the ‘threshold crossing’ – consistentwith firms taking some time to decrease theirinvestment in fixed labour.

– In comparing firms that crossed the thresholdwith firms with a similar earnings-drop that did

Accounting-induced performance anxiety12

Figure 1: Employmentchanges

Average annual percentagechange in no. of employeesby firms as a function ofdifferent levels of net profit(either side of zerothreshold) Source: Pinnuck, M. & Lillis,A.M. 2007, op.cit.

Large losses

Threshold

Averagepercentage

change

Small losses Small profits Large profits

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

-1.00%

-10 -9 -8 -7 -6 -5 -4 - 3 -2 -1 1 2 3 4 5 6 7 8 9 10

not cross the threshold, across all quartiles ofearnings decreases, the fall in employment isgreater for the firms that switched fromreporting a profit to reporting a small loss.

We conclude from this analysis that the profit/lossthreshold acts as an anxiety-inducing decisionheuristic which has significant economicconsequences. The fact that employees are so easilydivested – relative to other assets – may renderthem particularly susceptible to ‘management’ toachieve accounting performance benchmarks.

Accounting-induced performance anxietywithin firms

In order to describe the way accounting-inducedperformance anxiety plays out within firms,consider the following dilemma. A manager of alarge division of a local manufacturing companyconsiders recommending the acquisition of a smallniche manufacturing company with technologyand intellectual capital assets that offer strongpotential to enhance the division’s future earnings.This manager is faced with two sets of financialand non-financial information that may conveyquite different messages:

1. Decision-facilitating information – informationprovided to the manager about the financialand non-financial consequences of the decision.For example: an analysis of the strengths andcapabilities of the target company; anddiscounted cash flow analysis of potentialfinancial consequences of acquisition over afive-year horizon, compared with the ‘donothing’ option.

2. Decision-influencing information – informationcollected by higher level management toevaluate the performance (decision outcomes)of the subunit-managers. For example:divisional profit and return on assets (ROA),measured annually – the basis for managerialperformance measurement and bonuses.

The messages may conflict. The discounted cashflow analysis of the acquisition versus the ‘donothing’ option may support the acquisition, butthat decision might ‘depress’ both divisionalprofit and ROA for the next year or two as thecosts of the acquisition are taken up, the asset

base is expanded immediately, and the expectedpayoff is deferred. Which message is ‘right’?Routine annual performance measures will nevercompletely reflect the quality of managerialdecisions when measured over short timeintervals. Many managerial decisions generateshort-term costs and delayed benefits. It is themulti-period analysis that gives the morecomprehensive picture of events. Yet we knowaccounting is always locked into arbitraryreporting cycles.

Which signal will exert the strongest influence ondecision-making? Generally, the literature tells usthat the decision-influencing information –performance measurement, evaluation, incentives– will dominate. It is difficult to ignore rewardedbehaviour. Annual accounting performancemetrics within firms tend to induce myopicdecision-making and subunit-level optimisation.

Project 2: Customer-responsivemanufacturing3

These two related projects examine howperformance measurement practices can subvertgood strategic decision-making when firmspursue strategies focused on customerresponsiveness.

Conventional measures of manufacturingperformance focus on efficiency and productivity(e.g. cost variances, scrap, downtime).Conventional structures within manufacturingfirms also tend to support mass production at lowcost. Efficiency was historically encouraged inmanufacturing subunits through task-segregation,by ‘buffering’ manufacturing subunits from thevagaries of markets and customers. Sales subunitswere charged with responsibility for dealing with customers. Interdependencies betweenmanufacturing and sales were always high butthey were sequential in nature, with the sales and manufacturing interface managed throughscheduling. These measures and structures are wellsuited to manufacturing firms with high levels of product standardisation, stable productionprocesses and a focus on cost minimisation.However, these attributes no longer reflect current strategic priorities in manufacturing.


14 Accounting-induced performance anxiety

Figure 2 classifies 36 local manufacturing firms bystrategy, and demonstrates the prevalence ofmultiple strategies focused on quality, service,customer responsiveness and dependability ratherthan low cost.

The shift from low cost to responsive manufact -uring is captured in a quote from a local manu -facturer producing heavy-duty men’s work clothes.They “used to do long runs of ‘97 regulars’ orefficient combinations of ‘82 regulars’ and ‘112stouts’, put them in inventory and sell them.”Now, however, they face demand for a varied mixof products at short lead times. While the productrange in this example has remained relativelystable, the firm has significantly increased itsresponsiveness to customers by shortening leadtimes and meeting greater within-order variety.These market-initiated changes have increased therate of production changeovers, reduced batchsizes and increased disruption.

Accounting-induced performance anxiety ariseshere from the failure of performance measurementapproaches to keep pace with shifting strategicpriorities. Figure 3 reflects the manufacturingsubunit performance measures used by the same36 firms reflected in Figure 2.

The paradox here is that the same firms that havemoved away from a low cost strategy are using

efficiency and productivity measures extensively.Is this the folly of rewarding efficiency whilehoping for responsiveness? It raises a challenge formanagement: how to elicit responsiveness frommanufacturing subunits. How do you shift themindset of efficient lot sizes and maximumthroughput to allow for the costs of disruptionassociated with frequent changeovers, reducedbatch sizes and greater product variety? In order tobe flexible enough to meet variable customerdemands and associated short lead times,manufacturing and sales need to work much morecollaboratively than has historically been the case.Interdependencies are described as ‘reciprocal’rather than sequential, as manufacturing and salesmanagers negotiate ‘joint’ optimal solutions,rather than manufacturing determining optimalscheduling and efficient batch sizes.

We found that firms deal with this in a couple ofways:

– A structural response; or

– Reducing the intensity and accounting focus ofperformance measurement.

Structural response

The structural response involves investing inintegrative structural arrangements that facilitatecross-functional co-ordination and interaction –

Figure 3

Manufacturing performance measurement practices inthe 36 firms reflected in Figure 2.

Source: Lillis, A.M. 2002, op.cit.

Cost andefficiency/productivity

measures

Customerservice

measures

13

1

6

12

3

Qualitymeasures

Figure 2

Classified summary of strategic orientations.

Source: Lillis, A.M. 2002, op.cit.

Low cost

Service,responsiveness& dependability

3

4

1

1

2

6

19Quality


more organic, less mechanistic structures. Thesestructural mechanisms include cross-functionalteams, task forces and daily cross-functionalmeetings. The aim of these devices is to link the efficiency and productivity-focused mindsetof manufacturing with the customer-focusedmindset in sales, and to facilitate the jointdevelopment of optimal production solutions.

Reducing the intensity of the accountingfocus of performance measurement

In settings with a strong commitment tocustomer responsiveness, the absence ofstandardisation makes it increasingly difficult tospecify unambiguous performance standards.Performance standards in manufacturing subunitsare generally constructed in the form of standardproduct costs that specify standard expectations inrelation to material, labour and overhead input perunit of output. Such standards are set to reflect aspecific efficiency or productivity level (assumedlabour standard to assemble a certain number ofunits per hour). It is notoriously difficult to buildthe costs of disruption and unpredictable frequentchange overs onto standard costs. Firms strugglewith this – they are unable to rewrite efficiencystandards to incorporate the costs of disruption,but they want manufacturing subunits to beprepared to ‘wear’ the disruption in the interests ofcustomer responsiveness. The way they deal withit is to ‘play down’ the pressure around costbudgets and efficiency standards. In effect, theyrely less on accounting performance benchmarksas they would be ‘counter-strategic’.

So what happens when firms do not get this right– when structure and performance measurementimpede flexibility?

“We’re nowhere near as flexible as we would like.We always liken it to a battleship where it takesmiles to turn it around.”

“Production is so intent on meeting their weeklytargets, if a special order comes in they tend to say,‘Oh no, what a nuisance’, rather than looking atthe opportunity presented. And that’s fair enough,that’s where they’re valued at...That’s their wholereward system. Yes [the special order does getdone], but it takes a lot of management effort totell people that they are going to do it.”

“Setters and leading hands are imbued with thisview that the line must not stop, and try as wemay we cannot get that out of their thinking. Thetrouble is we have far too many long servingemployees and they know that they have to get25,000 products off that line this shift and theywill do it...They'll believe that they have done agood job and in fact some of the managementmechanisms may tell them they're doing a goodjob. But it might not match the customer serviceangle and that's what's wrong.”

What happens when they get it right?

“We have a fairly informal management structure.It’s run a bit like a big milk bar.”

Project 3: The Balanced Scorecard –a mechanism to reduce accounting-induced performance anxiety4

The Balanced Scorecard (BSC) is a performancemeasurement innovation designed to specificallycounter the adverse effects of managing directlyby accounting numbers. The BSC is a muchbroader performance measurement protocolembracing a wide-ranging set of financial andnon-financial metrics that should have a causallink with future profits. At a minimum, the effectshould be to dilute the influence of accounting inevaluation, and thus reduce accounting-inducedperformance anxiety.

BSC captures particularly well the dual role ofperformance measures, as it is fundamentallydesigned as a decision-facilitating tool. It providesa dashboard of measures that are basically designedto enhance the information available to managers indecision-making. By targeting leading indicators,managers who seek to make decisions that improveon the BSC metrics should theoretically beimplementing strategy effectively and drivingfuture financial performance improvements.

However, there are challenges associated withimplementation of a BSC. Some of thesechallenges relate to the potential for evaluationmechanisms to subvert the good intentions of the BSC. There is also the assumption that the BSC is a neutral management tool that will be used exactly as it is designed to be used: to enhance managerial effectiveness.

The literature has been either silent or equivocalon how this performance measurementinnovation interacts with the mechanisms usedto evaluate the performance of managers.

Thus, we are potentially back where we started.We have a good decision tool that might not beused if the decisions it signals are not consistentwith evaluation mechanisms. What if themanager is expected to use the BSC in decision-making, but her bonus depends on subunitprofit? Other researchers have documented thatfirms initially using a BSC try to reinforce the useof the score card by attaching incentives toperformance on the full range of metrics. Theproblem is that perceptions of validity andreliability of metrics for evaluation and bonusesare somewhat different from the way the samecriteria would be applied to informationconsidered relevant for decision-making. Thereare documented tendencies in practice to over-rely on conventional financial metrics when itcomes to evaluation.

This question was addressed in a study5 thatsurveyed 183 profit-centre managers and askedthem to identify two sets of performance measures – the measures they consider the most informative for running the business(typically a BSC set of measures) and the measuresthat are used by the next level of management upthe hierarchy to evaluate their performance. It ratedthe ‘commonality’ between the two sets of measures

and assessed the association between ‘commonality’decisions and profit-centre outcomes.

It found:

– Among the managers interviewed, there was amoderate degree of commonality between themeasures they considered ‘best’ for running thebusiness and those used to evaluate theirperformance (approx 62 per cent averagecommonality).

– The weighting on aggregate financialmeasures in evaluation is significantly greaterthan their usefulness in running the business(Figure 4). Managers consider disaggregatedfinancial information useful for running thebusiness, such as sales by subunit/productline, costs, cash flows, etc. They consideraggregate financial measures such as profitand ROA less useful. Yet there is adisproportionate reliance on aggregatefinancial measures in evaluation.

– Outcomes improve when firms broadenevaluation protocols to embrace more of themeasures that managers consider important.The greater the level of commonality betweenthe two sets of measures, the more the managersactually use the measures that are identified asimportant in running the business – and bydefinition, the lower the level of commonality,the less they use these measures. The use of thesemeasures improves the firm’s ability to exploit

Accounting-induced performance anxiety16

Figure 4

Extent of use of performancemeasures for ‘information’ and‘evaluation’Source: Grafton, J., Lillis, A.M. &Widener, S. (2008), op.cit

its capabilities – both existing and future – asmanagers are using the range of ‘high quality’measures available to them more effectively. Inturn, the cases with higher commonalityproduce better financial performance outcomes– a result which appears to be a function ofgreater use of the measures and more strategicresponsiveness, not just a direct result ofmeasuring accounting performance and drivingimprovement on that metric.

So, is this the cure? Do we just need to broadenthe performance measurement base to incorporatea comprehensive set of non-financial leadingindicators that will drive up future profits? TheBSC is a performance measurement innovationthat has gained significant traction in practice. Ithas led to a significant shift in performancemeasurement practice within organisations, in that managers rely less on broad accountingperformance measures than they did a decade ago.

However there are still challenges. The BSC isdesigned primarily to facilitate decisions.Whether or not it manages to do so depends verymuch on how it links with performance evaluationthroughout the firm. There are practicalimpediments to the complete adoption of the BSCin evaluation, and firms seem reluctant to do it.Many of the issues relate to undue complexitywith so many measures, the inescapable ‘softness’of some measures on a BSC and the fact that theyare inherently situation-specific and thus notcomparable across subunits. There are manyexamples of firms reverting to the use ofaccounting measures in evaluation. To the extentthat evaluation protocols remain accounting-focused and disconnected from the array ofdecision-facilitating measures that managers wantto use, performance anxiety will remain anddecisions are likely to be accounting-driven.

Concluding comments

This lecture has addressed the issue of accounting-induced performance anxiety from a range ofperspectives. Accounting-induced performanceanxiety arises from the prominence of accountingin performance measurement practice, and hasseveral consequences. In response to capitalmarket pressures, accounting benchmarks can beshown to have socio-economic consequences as

firms change employment patterns when theyreport accounting losses. There are many ways inwhich accounting benchmarks can induce short-term decisions that compromise long-term firmvalue in response to capital market pressures.

Within firms, accounting performance measurescreate silos, cultivate self-interest and ‘shortterm-ism’ among managers. It becomes difficultto achieve collaborative ‘firm-wide’ solutions andmanagers focus on driving up short-term evaluationmeasures rather than adding long-term value.

There is no apparent cure for capital-marketinduced performance pressure. Capital markets will always induce efforts to improve and ‘manage’accounting performance to convey particularmessages about the firm and its prospects. There ismuch more potential to reduce the adverse impactof accounting-induced decision making withinfirms, by making adjustments to organisationstructure, control systems and performancemeasurement practices. The BSC is a partial remedyto the dangers of accounting-focused evaluationwithin firms. However, there are many challengesassociated with the reconciliation of the decision-facilitating role of the BSC and the mechanismsused in evaluation. To date there is little evidence ofsustainable change in evaluation practice.


Professor Anne Lillis is Professor ofManagement Accounting and Deputy Head ofthe Department of Accounting and BusinessInformation Systems.

1 Pinnuck, M, & Lillis, A.M. (2007). Profit versus Losses: DoesReporting an Accounting Loss Act as a Heuristic Trigger toExercise the Abandonment Option and Divest Employees?,The Accounting Review, 82:4, pp. 1031-1053.

2 The threshold crossing effects described in the remainingdot points are not evident in Figure 1.

3 Abernethy, M.A. & Lillis, A.M., (1995). The impact ofmanufacturing flexibility on management control systemdesign, Accounting, Organizations and Society, 20:4, pp. 241-258; Lillis, A.M. (2002). Managing multiple dimensions of manufacturing performance – an exploratory study,Accounting, Organizations and Society, 27:6, pp. 497-529.

4 Grafton, J., Lillis, A.M. & Widener, S. (2008). The influenceof evaluation mechanisms on the use of decision-facilitatingperformance measurement information, Working Paper.

5 Idem


Introduction

The large and growing US current account deficithas elicited increasing concern, even alarm, andclaims that it is unsustainable. This lecture arguesthat the large US deficit is a natural consequenceof two significant worldwide developments –demographic change and globalisation offinancial markets. Far from being unsustainable,it is likely to endure for some years. Serious effortsto reduce it significantly are likely to do moreharm than good. While the focus is on the USdeficit, Australia could be substituted for the USand much of the argument would still apply.Although smaller in scale and better endowedwith natural resources, Australia shares some ofthe key features of the US.

The key ‘laws’ of economics

Like physics, economics has its ‘laws’ that cannotbe broken. The key laws of economics areaccounting identities – adding up requirements –that must be satisfied when contemplating anychange from any observed situation. Much ofeconomics is devoted to the study of behaviouralregularities, but these may vary in importantdetail from place to place and from time to time.The accounting identities must always besatisfied. Yet much public and journalisticdiscussion ignores them, and thus implicitlycontemplates changes that are not in fact viable.

Three accounting identities will inform thislecture and, I hope, throw light on the origin and

the sustainability of the current pattern of worldimbalances. The first is that, apart frommeasurement errors, which may be substantial,any country’s current account balance must equalthe difference between its total expenditure and itstotal output or, equivalently, between its domesticinvestment and its national savings. The second isthat current account balances around the worldmust sum to zero – again, apart from measurementerrors. The third is that a country’s current accountbalance is equal, with usually minor qualifications,to its net foreign investment. Thus, a country incurrent account deficit must be experiencing a netinflow of capital from abroad. The US currentaccount deficit must be judged in light of thesethree accounting identities.

Current account deficits andsurpluses

The US current account deficit has grownsignificantly in recent years to around $800billion or six per cent of GDP in 2006. (Itdeclined modestly in 2007 in response to aslowdown of the US economy and a depreciationof the US dollar.) Many attribute this growth to adecline in US savings, and argue that savings mustbe increased to reduce the deficit. But the declinein US savings accounts for only a portion of therise in the US deficit. Moreover, the US economyis part of a complicated, independent globalsystem. Raising US savings by itself (e.g. throughhigher tax rates) would not necessarily reduce thecurrent account deficit, or might reduce it in an

understanding global imbalances

by richard n. cooper

Far from being unsustainable, the large and growing US current accountdeficit is likely to endure for some years – and Australia shares some

of the key features of the United States

A condensed version of the David Finch Lecture given at the University of Melbourne on28 March 2008.


undesirable way, for example by causing a USrecession. The US deficit has its exact counterpartin surpluses elsewhere, implying excess savings inthe rest of the world. Raising US savings will notautomatically reduce savings or increase invest -ment elsewhere, and might indeed have theopposite effect. We must address why thosesurpluses exist, and how easily they will decline,as they must do if the US deficit is to be reduced.

One reason for large savings elsewhere is the sharp increase in oil prices since 2002, greatlyaugmenting the revenues of oil-exportingcountries. These surpluses are likely to decline inthe coming years, as revenues move into theincome stream of the oil-exporting countries andinto imports, and as oil prices decline.

But oil-exporters are not the only countries insurplus. So are China, Japan, Germany, and ahost of smaller European and East Asiancountries. These countries are going throughdramatic demographic change, with increasinglongevity and birth rates well below replacementrate. These developments, other things equal, arelikely to sustain savings but weaken domesticinvestment in such countries, as the need forhousing, schools, and equipment for newentrants of the labour force declines. Returns tocapital are also likely to be depressed. Residentsof these countries have an incentive to place someof their savings abroad, to build assets forretirement, implying current account surpluses.China, while experiencing similar demographicchange, is in a different situation from the richcountries, in that it will continue to experiencesignificant rural-to-urban migration and willthus need to house and equip the new urbanworkers, as well as upgrade the housing of urbanChinese as they become richer.

As globalisation proceeds, the traditional biastoward allocating saving at home will decline,more information on the possibilities for foreigninvestment will become available, andinstitutions will respond to increased interest bymaking it easier for citizens in one country toinvest in another. Thus globalisation of financialmarkets will reinforce demographic change as afactor leading to greater foreign investment. Netforeign investment abroad will necessarily be

reflected in a current account surplus, and,similarly, the net recipients of net inward foreigninvestment will run a current account deficit, asboth Australia and the US do.

Destinations of foreign investments

Why invest in the US? Net foreign investment bysaving-surplus countries takes place in manyplaces, not just in the US. Yet it accounts for overa quarter of gross world product, and for roughlyhalf of marketable financial securities (stocks andbonds). Moreover, property rights in the US aresecure, and dispute settlement is impartial andreasonably quick compared with other countries(not by an absolute standard). Effectiveconfiscations by Argentina, Bolivia, Russia andVenezuela have reminded savers around the worldthat foreign private investment is not alwayssecure in emerging markets. Funds for retirementseek security even more than yield.

Some have emphasised the role of foreign centralbanks in investing in the US, particularly in USTreasury securities. It is true that extensive foreignofficial investment in the US occurred in thisdecade. But it has been dwarfed four-to-one by theinflow of private funds, and has never beensufficient to match the current account deficit.While some apparently private inflows wereundoubtedly beneficially owned by official bodies– for example, in the oil-exporting countries – thechoice of investment has been made by privateinvestment managers. Moreover, some of theofficial funds compensate for the unwillingness(e.g. in Japan) or the inability (e.g. in China) ofprivate parties to invest abroad, when it is in thecountry’s long-term interest to do so. Thus evencentral banks must be viewed as financialintermediaries in a global economy.

Have foreign claims on the US becomeunsustainably large? Surprisingly, the netinternational investment position of the US hasimproved since 2001, despite large and growingcurrent account deficits. Net foreign claims have declined from 23 per cent of US GDP to 17per cent over the period 2001–2006, despitecumulative current account deficits of 27 per centof GDP. The explanation lies in capital gains onUS assets abroad in excess of capital gains on


foreign claims on the US. Some of these capitalgains (measured in US dollars) can be explained bya depreciation of the dollar, since most US claimson the rest of the world are denominated inforeign currencies, and the dollar value rises as thedollar depreciates. But that accounts for onlyabout a quarter of the 2001–2006 gain – the restis due to capital gains on US equity holdingsmeasured in local currency.

The forces of demography and globalisation aredeep-seated and long-lasting. They are not likelyto disappear soon, and indeed may evenstrengthen. But will the US produce enoughfinancial assets to satisfy the world demand forthem? An interesting feature of foreigninvestment in the US, private as well as public,has been its concentration on interest-bearingsecurities. This may slowly change with thegrowth of sovereign wealth funds and theirinterest in pursuing higher yield overseasinvestments. Foreign investment by Americans, incontrast, concentrates on equity investment.

Thus the US serves as a global financialintermediary, exchanging debt for equity, as wellas being a destination for net investment. Thispractice implies that, over time, Americans earnmore on their foreign assets than they pay on theirliabilities to foreigners. It also implies that foreignclaims on the US capital stock are indirect ratherthan direct. So in reckoning the share of foreignownership in the US, and the possibility that itmay become unsustainably high, we need to lookat total financial assets in the US. Due to financialinnovation and the development of ever-morerefined financial instruments to appeal to diversetastes, the financial side of the US economy hasgrown more rapidly than the real side during thepast half century, such that by 2006 financialassets amounted to ten times GDP, up from fivetimes in 1965. Foreign ownership of these assetsamounted to under ten per cent, but up from fourper cent in 1980. The sub-prime mortgage crisisof course signaled that not all of this financialinnovation was sound, and some de-leveraging of the US economy may well occur in 2008.


However, the long-term trend is likely to resumethereafter. There does not seem to be any shortageof US financial assets in the near term.

Future outlook

Of course, eventually, aging societies will reducetheir savings and desire to run down theiraccumulated assets. At some point the excesssavings will disappear, as will the associatedcurrent account surpluses. At that point the USdeficit will undoubtedly also decline. But thatpoint may not be reached for many years.

Some have advocated that to wait would beunwise, even reckless, since the large deficit mightprecipitate a ‘hard landing’ for the US economyand for the world. Thus, there are proposals for alarge engineered depreciation of the US dollar,combined with reduced spending in the US andincreased spending abroad. But depreciation of thedollar implies appreciation of the currencies of thecountries in surplus, and that is likely to depressinvestment in such export-oriented economies asChina, Germany and Japan, not stimulate it. Andwhy should aging consumers spend more nowrather than save for a retirement of ever-increasingbut uncertain length? Furthermore, to avoid worldrecession, such a package deal would requireconsummate management of macroeconomicpolicies across countries. This is improbable andwould require larger government deficits incountries such as Germany and Japan, which havebeen struggling to reduce their budget deficits.

The US has a vibrant, innovative economy. Itsdemographics differ markedly from those of otherhigh-income countries in that birth rates have notfallen so far, while immigration, concentrated inyoung adults, can be expected to continue on a significant scale. In these respects the US,although high-income and politically mature, canbe said to be a young and even a developingcountry. It has an especially innovative financialsector, which continually produces new productsto cater to diverse portfolio tastes. In a globalisedmarket, the US has a comparative advantage in producing marketable securities and inexchanging low-risk debt for higher-risk equity. It is not surprising that savers around the world

have wanted to put a growing portion of theirsavings into the US economy. The US currentaccount deficit and the corresponding surpluseselsewhere, although conventionally described asimbalances, do not necessarily signal economicdisequilibrium in a globalised world economy, andthey may well remain large for years to come.

Professor Richard Cooper has been MauritsC Boas Professor of International Economics atHarvard University since 1981. Previously, hewas Chairman, National Intelligence Council,1995–97; Chairman, Federal Reserve Bank ofBoston, 1990–1992; Under-Secretary ofState for Economic Affairs, 1977–81, DeputyAssistant Secretary of State for InternationalMonetary Affairs, 1965–66, US Department ofState; Frank Altschul Professor of Inter nationalEconomics, 1966–77, Provost, 1972–74,assistant professor, 1963–65, Yale University;senior staff economist, Council of EconomicAdvisers, 1961–63. He is Vice-Chairman ofthe Global Development Network and amember of the Trilateral Commission.

I’d like to start by asking you some questions relatedto your lecture ‘The Industrial Revolution and theMacroeconomics of Ricardo and Marx’. What do yousee as the key lessons, if any exist, that we can learnfrom the experiences of the industrial revolution?

It’s still going on. What has to happen, though,bearing in mind that people are more or less thesame everywhere, as are the laws of economics, isthat it can’t be a permanent situation where peopleon one continent have living standards that are atenth or a fifteenth of people on some othercontinents. It just doesn’t make any damned sense!

I think the industrial revolution, in the sense that itcreates huge gaps of inequality and incomes acrosssocieties, has to end some time. It has to be a storywith an end. And I think, in the end, economieswill be rich and growing, more or less equally. Sohow’s that going to play out? I don’t know.

What have we learned from the industrialrevolution? Everything! That sustained growth ispossible!

How does Karl Marx fit in?

Ricardian theory evolved a dynamics thatreturned the living standards of ordinary workingpeople to some equilibrium point – a kind ofMalthusian subsistence equilibrium level. If youhad the blessing of technology, an invention, orthe discovery of new lands, you would get atemporary increase in living standards, but this

would ultimately come out as populationincrease, and living standards of working peoplewould be restored back to subsistence.

So, when the industrial revolution got under way,Marx thought that this was just as transient. It’slike all the other innovations in human history(and there were many of them): growth is just atransition dynamic to some new steady state, inwhich some people are going to own everything,and the ordinary working people are no better offthan they were in the Middle Ages.

Everything we knew about economic theory, atthat time, was on that side. So Marx thought wehad to break into this process of privateownership. Override this process – these dynamicsthat kept returning us to the same point – andsomehow create something different. Bust out ofthis recurrent process of discovery and new classgrowth and then returning to the old equilibrium.We had to break out of that.

The thing is that industrialisation created a new class that didn’t just peter out – instead, itjust keeps going and going. I think that’s what we’ve learned as an historical observation. TheRicardian/Malthusian model just didn’t work.

Do you feel that capitalism generates a long runequilibrium distribution of income that we can live with?

Absolutely. Let’s just take Japan, as an isolatedsociety. Suppose that was the whole world.


an interview with robert e. lucas, jr.

by ian king

A Nobel Laureate welcomes the closure of the huge gaps of inequality and incomes across societies

Professor Ian King, Director of the Centre for Macroeconomics, University of Melbourne,interviewed Professor Lucas prior to the public lecture delivered at the University of Melbourneon 26 March 2008, and the following is an abridged transcript of that conversation.

24 An interview with Robert E. Lucas, Jr.

There are some differences – some people workharder, some people have a little more luck, butit’s not like there’s one class that’s ruling overeverybody else. That’s not what a capitalist societyis about … there’s not some barrier. Children fromparents with modest incomes can go anywhere inthese societies.

Now, as you start looking at countries that havedisadvantaged groups, and that’s why I pickedJapan, you start getting little blots on this happypicture. And if you start looking at it as the worldas a whole, you get huge blots in the picturebecause two-thirds of the world is left out.

But I think we are heading to the point where thewhole world, more or less, looks like Europe, orNorth America, or Japan. Now, is there too muchinequality? I don’t see it. I think people who dropout of high school, take drugs and so on are goingto be poorer than the guys who worked hard. Itdoesn’t bother me at all. Why shouldn’t they bepoor? It’s hard to work!

You think that the distribution of income reflects effortmore than it does, say, luck?

Both.

But how do you get all this luck? How did BillGates get all this good luck? He wasn’t sitting onhis ass smoking dope or something like that!

But how can we observe that? You say he’s rich becauseof effort, but there are lots of guys who work very hardand get nowhere.

Let me get back to Gates. Gates’ dad is a prettyprosperous lawyer in Seattle. In fact, my brotherwas a partner in his law firm, Gates and Lucas.And Gates went to Lakeside, which was the onlyreally first-class private high school in Seattle. Sohis dad was not only pretty well off, but he spenthis money on education for his kids as opposed toa big yacht or something. He cared, and I’m surethe Gates household, when he was growing up,was a stimulating environment. So Gates had a lotof things going for him. But there were plenty ofpeople who put in a huge amount of devotion,hard work, and risk taking.

Your assessments of the long-run prospects for humanityand the global economy seem considerably more upbeat

than many others today. To what do you attribute thisdifference of views? Why are you so optimistic whenothers seem to be so pessimistic about the future?

Give me an example. Most people don’t knowanything…

Particularly with regard to, say, global warming,resources running out, the ‘doomsday-scenarios’ thatpeople have.

I have no idea what the relative price of oil is going to look like 100 years from now. It could behigher than it is now. When you add taxation,environmental problems are orthogonal [unrelated]to what I’m talking about.

So, you don’t feel the development process itself somehowhas environmental implications?

It’s a pseudo-question. We may not like the factthat China is going to be as prosperous as we are,demanding materials in competition with the restof us – but that’s what’s going to happen. Do youseriously think we would rather keep the Chinesein some sort of concentration camp, and deprivethem of their access to markets?

Surely it’s a blessing that people in China aremoving into the modern world and doing verywell out of it. And the fact is that it means thethings that we rich people want to buy are goingto sell at higher prices because the Chinese aregoing to want them too! If that’s a problem, thenwe should always have such problems. That’srelated to your questions and concerns aboutdistribution. Now you’re saying you’re concernedabout distribution, but when the distributionproblems start to resolve themselves we say, ‘Oh-oh, this has gone too far.’

The Chinese are going to be as rich as we are oneof these days. We’ve got to get used to it. My viewis we ought to take pleasure in it, and doeverything we can to help it.

I’d like to turn to your advice for graduate studentsin economics. For students considering a career inacademic research, if they’re on the cusp and they’redoing their honours, is there one key piece of adviceyou’d like to give to a bright student?

Hang around with smart people, idealisticpeople. The number of people that really want to


advance knowledge, and are good enough, welltrained and smart enough to actually be doing it,is a lot fewer than you think. So, do your best to hang out with smart, idealistic people. Avoidcareerists. If that involves some sacrifices, to bein good places or have opportunities to interactwith good people, do it!

Think about the trade-offs people make – a guygetting a degree in economics can double hissalary if he decides to teach accounting. That’sOK, those guys are going to enjoy their wealthbut they’re not going to be contributing to thefuture development of social sciences in the waythey could be.

When choosing a topic for a PhD thesis, it seems to me there is a trade-off between going after a trulyfundamental question and possibly failing and notbeing able to publish their piece….

…and you never get over it.

There’s a trade-off between going for a big one or goinginto more established ways of thinking and makingmarginal but safer contributions.

You want to work on a problem where you couldlearn something. It usually turns out that if whatyou learn is new to you then it’s new to a lot of therest of us, too. It’s going to get recognised. Maybenot – it’s hard to say.

There are a lot of good problems out there. You’vegot to try to avoid short-cuts and try tounderstand the issue in a way that satisfies you,yourself. Chances are it will end up being, some ofthe time anyway, a contribution the world knowsand recognises – you could make a living out of it.That’s what I think. That’s not very operationaladvice but it’s hard to make it explicit.

When I think of conversations with people I’veworked with – guys like Edward Prescott andLeonard Rapping – when we get deep into aproblem, we don’t give a damn about anythingexcept for solving the problem and satisfyingourselves that we’ve got the answer.

It’s hugely exciting to work with people who havethe same goals, same high ambitions as scientists.It’s different from what I call careerism. You justwant to solve a problem, get really into

something. Of course, sometimes you don’t endup solving it, but when I start out on somethingI just think, ‘God, I’m going to really blast thisproblem.’

If you don’t quite make it – no problem, it’s OK.Just go onto the next one.

It seems to me that, for a lot of papers, the actual endproduct of the research can be quite different from theoriginal question.

I know. It can’t be helped. Sometimes it’s better!

Robert E. Lucas, Jr. is the John DeweyDistinguished Service Professor of Economicsat the University of Chicago. He has heldnumerous prestigious posts throughout hiscareer, including the Presidencies of both theEconometric Society and the AmericanEconomic Association, and the Editorship ofthe Journal of Political Economy. He became aNobel Laureate in 1995 “for having develop -ed and applied the hypothesis of rationalexpectations, and thereby having transformedmacroeconomic analysis and deepened ourunder standing of economic policy.” He iswidely regarded as the central figure drivingthe agenda of macroeconomic research overthe past three decades.

Introduction

Soon after Federation, a distinctive system of‘social protection by other means’ (SPM) emergedin Australia, and has become widely invoked inthe comparative literature as the ‘wage earners’welfare state’. Its foundation lay in the system ofjudicial minimum wage determination whichpersisted – if in diminishing forms – from 1907 to2005. Now seen as a watershed in Australiansocial policy, 2005 was the year that the HowardGovernment passed industrial relations reformsknown as the WorkChoices legislation. Thesereforms were widely thought to reflect a view thatwage minima should be determined more by whatthe market can afford than by welfare criteria. Forsome, this was seen as social policy vandalism,opening the way to a US-style flood of workingpoor. Others saw it as an inevitable consequence ofglobalisation; and proposed that Australia, alongwith other SPM countries, must reckon withcreating new European-style welfare state systemsof ‘flexicurity’ – which can combine a deregulatedmarket economy with a welfare state-regulatedform of social compensation.

I propose that this perception of a social policycrisis created by WorkChoices is fundamentallymistaken and based on a narrow reading of the ‘Australian way’ of doing social policy.

A revisioned history will point the way to a quitedifferent and readily attainable social policyframework which can indeed ‘close the gap’ andpromote a socially inclusive Australia.

Three features of the new industrialrelations agenda

The last decade witnessed the emergence of apolicy and legal vacuum in relation to therespective roles of wage and welfare policies inAustralia. Older pro-regulatory stances in labourlaw were displaced, creating a challenge to forgenew pro-regulatory assumptions which are post-protectionist.

There are three features of the new industrialrelations agenda which are of particular relevanceto this endeavour.

Firstly, labour law has seen a switch of emphasisfrom what is termed ‘protectionism’ to efficiency.The former is said to have expressed twentiethcentury welfare goals concerned with securingworker rights in an employee-employerrelationship conceived as fundamentally unequal.Internationally, this goal of worker protectionhas been overtaken in the last decade and a half by deregulatory approaches emphasisingeconomic efficiency and competitiveness.

Closing the gap?26

closing the gap? the role of wage,welfare and industry policy in

promoting social inclusion

by paul smyth

The perception of a social policy crisis created by WorkChoicesis fundamentally mistaken and based on a narrow reading

of the ‘Australian way’ of doing social policy

A condensed version of the 22nd Foenander Lecture delivered at the University ofMelbourne on 3 October 2007. The full paper appears in The Journal of Industrial Relations,50: 4, September 2008.

The main division of opinion is now betweenthose who see competitiveness best achievedthrough simple deregulation of the labour marketand those who see that the achievement ofcompetitiveness actually requires extensivegovernment intervention.

The second feature of the new labour law has beenthe widening of interest in its regulatory fieldfrom the ‘workplace’ to the broader ‘world ofwork’. This emphasis links issues of efficiency atwork to the requirement for workers to haveappropriate education, training, housing andwork-life balance.

The third aspect of the new labour law relates tothe sites of regulation. The curtailed powers of theAustralian Industrial Relations Commission willnot mean the end of regulation but rather itsdispersal among other regulators, creating newdifficulties for any coordinated approach to wageand welfare policies.

These three themes – protectionism replaced bycompetition, the linking of the market to its socialfoundations, and the challenge of coordinatedgovernance – comprise what I would see asleading edges of contemporary Australian socialpolicy development.

From the ‘Australian settlement’ tothe ‘Australian way’

It is vital that our analysis be informed by anaccurate sense of history. ‘Path dependency’remains a critical factor in the ongoing evolutionof national social policy. The ‘initial steps’ in theAustralian social policy path are still widely andfalsely understood in terms of an Australiansettlement characterised by protectionism. Here,wage protection is seen as an element of a policypackage also comprised of tariff protection andthe immigration barrier of the White Australiapolicy. A more accurate interpretation is in termsof an ‘Australian way’, in which protectionismwas not a distinctive feature at all but rather abias towards regulating in a way which wouldpromote employment and growth while seekingegalitarian outcomes.

The distinctive feature of the Australian way was‘social investment’. Australia initially chose tariffs

over free trade, but the point is that this was notdistinctive. North Americans, continentalEuropeans and all the self-governing members ofthe Empire rejected the British push for free tradein this period. Following more the ideas ofFriedrich List than Adam Smith, these countriesadopted tariff protection as a way of building uptheir own industrial base. Australia chose to useits land-based wealth to steer its economicdevelopment towards the new industrial sectorand so develop a more diverse, higher-wageeconomy which would also be attractive toimmigrants and build a larger population base.

Most distinctive was the level of governmentspending. Along with the US and New Zealand,Australia has led the world in spending oneducation since the 1870s – with the outstandingsocial policy achievement of free public primaryeducation and the beginning of state secondaryand technical education. Importantly, this ‘socialinvestment state’ was as much the product of thebusiness sector as it was of the labour movement.An industry policy which took the high-wagemanufacturing path would require a bettereducated workforce while offering the prize ofhigher wages. Good social policy would also begood for business.

The idea of a ‘living wage’, as set out in theHarvester Judgement, combined with an industrypolicy to set Australia on a high wage path todevelopment – thus creating the national sense ofa ‘fair go’. Adequately rewarded workers wouldbecome self-trusting individuals free fromdependence on charity or the state.

In practice, the living wage had less impact onwage setting than many suppose. It was not untilthe 1920s that it could be said that federal andstate tribunals were applying living wageprinciples consistently. The lack of standardworking arrangements further attenuated itsinfluence. Moreover, the basic wage did not keeppace with prices and living standards; and,following the Great Depression, wage settingcame to be driven more by the capacity of industryto pay than by calculations of family needs.Nevertheless the practice of indexing the basicwage did set a floor under the labour market witha real effect on the wages of the weak.


28 Closing the gap?

At the same time, tariff policy stimulated theemerging manufacturing sector in a way thatenabled Australia to expand its small populationbase. The employment growth with higher wagesallowed for the maintenance of a larger populationthan could have been expected otherwise.

The vision informing the Australian way was thusabout investing in people so that they couldmaster risk. Making work pay through wageregulation was intended to place trust inindividuals and families, that they could managetheir own affairs rather than have them supervisedby charities or the state.

Overlaying the social investmentstate

Three significant transformations to thisAustralian way are necessary to note if we are to fully appreciate the challenges involved in the relayering of the social investment approachto today. These transformations include: the‘economic state’, the ‘welfare state’, and theAccord.

The ‘economic state’ refers to social policy in theKeynesian period (1940s to 1970s). The centralemphasis of policy was stabilising investment toensure full employment. Reliance on agricultureand minerals increased, with tariffs becoming away of avoiding rather than mastering risk. It wasa time of lost opportunities, as Australia’s averageper capita income slipped from fifth highestamong the developed countries in 1950 to tenth in1973. The ‘welfare state’ emerged in the 1960s and70s reflecting an awareness that full employmentwith decent wages was not sufficient to ensure anadequate social infrastructure. Social investment ineducation, health and social services expanded in amuch more planned fashion – although Australialagged behind international trends.

The relationship between wage and welfare policywas fundamentally changed in this period. Wagerises meant that the old ‘living wage’ functionedless and less as a floor against poverty for theordinary worker. Basic wage awards operatedalongside awards for skill, which becameincreasingly significant in workers’ pay.Automatic quarterly cost of living adjustmentswere discontinued in 1956. Wage setting became

less related to measures of adequacy for the needs of families and was driven more by industrycapacity to pay. Eventually, in 1966, the basicwage was replaced by the ‘total wage’ and a new ‘minimum wage’ was created; however, fewdepended on the new minimum and arbitrationtribunals refused to link it to any understanding of needs.

A second postwar development was the entry oflarger numbers of women into the paidworkforce, creating pressure to formally removethe now anomalous ‘family wage’ componentfrom wage determinations. This occurred in1974, when the abolition of the familycomponent was finally declared. In its decision,the Commission pointed to the diversity offamily composition and declared itself lacking inthe necessary information to discriminatebetween the needs of families. Importantly, theCommission declared that it was an industrialarbitration tribunal, not a social welfare agency.

A third layering came with the first integratedapproach to wage, tax and welfare polices underthe Accords; whereby governments and theACTU agreed to trade-offs between ‘social wage’increases – including items like compulsorysuperannuation and public health insurance –and take-home pay. This shifted the institutionalfocus of social welfare provision away from thearbitration tribunal towards social policyinstitutions proper.

However, this development was overtaken by thegrowing free market and neoliberal orientation ofeconomic policy. The welfare state froze into whatseemed like a state of permanent austerity; while in1993, enterprise bargaining was introduced, withaward wage setting focused on a residual safety netof awards rather than award coverage for all.

Reframing the Australian way today

As the twenty-first century has progressed, a neweconomic and social policy agenda has emergedaround the twin goals of investing in humancapital and promoting social inclusion. Ineconomic policy, we observe a shift from costcutting and fiscal stabilisation to a concern aboutthe limits to growth created through poor humancapital development and social cohesion problems.

Insights Melbourne Economics and Commerce

The trend is reflected in two areas: the policyobjective expressed in terms of the three Ps –population, participation and productivity; andthe Council of Australian Governments’ nationalreform agenda embracing the development ofAustralia’s human capital. The new agendareaffirms an open market-oriented framework butassumes that social investment in participationand productivity has emerged as a critical driver offuture prosperity.

To improve human capital, we must address itssocial dimension. Ways to tackle this socialdimension have been shaping up in a second,separately developing, policy agenda associatedwith the goal of promoting social inclusion.Deriving in part from the New Labour in the UK,this involves:

– A shift from monetary-based poverty lines tomultidimensional analyses;

– A focus on the particular social/economicdynamics affecting different spaces andpopulation groups;

– Reintroduction of social cohesion as policyobjective with emphases on trust, social capital,community/neighbourhood strengthening;

– Encouragement of ‘active society’ rather thanpassive welfare; and

– A more people-centred, personalised welfaregovernance.

The convergence of these trends offers anopportunity for a reintegration of economic and social policy which has eluded us for morethan three decades. A new calculus of the humancapital is now emerging, as are well-beingprerequisites for each citizen to participatesuccessfully through each of the key transitionsof the life cycle.

From WorkChoices to the Australianway

WorkChoices reflected the high tide ofderegulatory policy. Today, how might we governthe transition to the human capital and social inclusion model? A vital lesson from ourpast is that Australia has evolved a hybrid of thewelfare society and the welfare state models.

Our preference has been for building up thepublic infrastructure to allow individuals toexercise real freedom, but not constrainingeveryone within a universal welfare state. In thiscontext, the minimum wage ought to remain akey source of welfare.

However, our new model will demand a verydifferent welfare safety net – not just modestincome support but a clearly articulated set ofentitlements that each citizen will need for fulleconomic and social participation. Quantitativeand qualitative indicators should be establishedwhich are benchmarked against the best in theworld; and periodic monitoring, evaluation andreview should occur. Australia’s newly createdSocial Inclusion Board could provide the kind ofagency needed to exercise the concerted socialpolicy management which will be needed.However, such work cannot usefully beundertaken in isolation from Fair Work Australia,the new national agency responsible for setting asafety net within the wage system. The time issurely ripe for us to reshape the principles ofjustice associated with the Harvester Judgementinto a new wage and welfare settlementappropriate for the twenty-first century.

29

Paul Smyth is Professorial Fellow in theSchool of Political Science, Criminology andSociology at the University of Melbourne;and General Manager for Social Action andResearch, Brotherhood of St Laurence.


Introduction

As Chair of the Rudd Government’s BusinessAdvisory Group, I have been concerned to ensurethat the voice of the business community is heardas the Government translates its Forward withFairness policy into legislation.

However, rather than going into the detail of thecurrent reform process in this paper, I want totake a broader view of how this process fitswithin both the historical and global contexts.

Key objectives of workplace reform

I can discern three clear objectives from Labor’sForward with Fairness policy. The Government aimsto come up with a workplace relations system thatbalances the need for:

– National competitiveness;

– Fairness for employees; and

– The flexibility and productivity needs ofbusinesses.

Reconciling this troika of competing objectivesis no easy task. But it is a project that is criticalto Australia’s future economic and socialprosperity. For example, the importance of labour

market flexibility as a determinant of nationalcompetitiveness is highlighted by the WorldEconomic Forum’s most recent ‘GlobalCompetitiveness Index’ (GCI). While Australiais ranked 13th in the GCI on labour marketefficiency, restrictive labour regulations wereidentified as the third-most problematic factorfor doing business in Australia.

I will now focus more closely on the objectives ofworkplace reform that I have identified, bydeveloping two key themes.

1. The lessons of history

In determining the shape of workplaceregulation, it is important to consider howbusinesses are structured, how they operate, andwhat the broader economy looks like.

The economic and workplace setting in‘Fortress Australia’

If we step back in time to the late 1890s/early1900s, we can see that the federal conciliationand arbitration system that emerged in 1904was closely linked to – and designed to meet theneeds of – contemporary business and economicconditions.

forward with fairness: a businessperspective on labor’s reform agenda

by john w. h. denton

How to get the balance right between competitiveness, fairness and flexibility in labour regulation

A condensed version of the 23rd Foenander Lecture delivered at the University ofMelbourne on 20 August 2008. The full paper is available on the Department ofManagement and Marketing website: www.managementmarketing.unimelb.edu.au*

* Footnotes have been omitted from this condensed version. References to all source material are to be found in the full paper.

At the turn of the last century, the Australianeconomy was characterised by:

– A relatively under-developed manufacturingsector;

– Numerous small single-product businessesthat served local markets; and

– The exporting of raw materials for processing/production by foreign manufact urers, whichwere imported back to Australian retailers.

In 1901, the pastoral, agricultural and miningindustries made up 30 per cent of GDP; serviceindustries for the import and export trades (e.g. government, finance, distribution), only athird of GDP; and manufacturing, only 12 percent of GDP.

The policy-makers of the fledgling Federationsettled upon ‘New Protection’ as the preferredmodel for ordering the national economy, withtwo intertwined elements:

– First, significant tariff protections formanufacturers along with various types ofsubsidies for the farming sector; and

– Second, the compulsory conciliation andarbitration system: workers shared in the rentsgenerated by the wedge between domestic andimport prices through a centralised wagefixing system that tied minimum wages toprice increases.

Much has been written about the origins andnature of Australian conciliation and arbitration,so I will simply emphasise a few key points here.The bitter industrial battles of the 1890s led theframers of the Australian Constitution to makeprovision for federal legislative power overinterstate industrial disputes. The Conciliationand Arbitration Act 1904 (Cth) instituted theconcepts of the ‘living wage’ and ‘wage justice’,based on uniquely Australian notions ofegalitarianism and a ‘fair go’.

It is clear – as The Hon Justice Kirby has put it –that ‘The 1904 Act grew out of the legal andeconomic environment of the late nineteenthcentury.’ However, in my view, Australia’s system ofworkplace regulation has failed to keep pace withchanges in both the economy and the world of work.

The economic and workplace setting in‘Networked Australia’

Since the 1980s, the Australian economy has beentransformed from the isolated protectionism ofthe Federation era. The tariff walls have beenvirtually dismantled in the interests of makinglocal firms more efficient and internationallycompetitive. As a consequence, manufacturingindustry has declined from its peak in the early1960s (when it accounted for more than a quarterof GDP) – by 2005, the manufacturing sectorrepresented less than 12 per cent of output and employment. Agriculture and miningaccounted for 8.5 per cent of Australia’s output in2005, five per cent of the workforce, and 55 percent of exports – while services made up morethan 70 per cent of GDP and almost three-quarters of the workforce.

Increasingly, Australian companies – like those in many other countries – are operating in globalsupply chains, or ‘transnational productionnetworks’ based around multinationalcorporations. Globalisation has also brought withit greater international financial integration,foreign investment, trade liberalisation – and newforms and structures of work that reflect the newglobalised businesses.

Some examples of the changed nature ofemployment relations in the global workplaceinclude:

– A shift from internal labour markets to muchlooser connections between firms and workersfocused on cross-utilisation of employees andrecognition of their ‘intellectual capital’;

– Abandonment of the implicit promise ofemployment security in favour of employ -ability – the ability to acquire skills that willenhance employees’ opportunities not just inone firm but in the broader labour market as well; and

– As well as the multinationals, growingnumbers of employers are small businesseswith links to other firms through franchisesand joint ventures – and increasingly, workersare engaged as casuals, homeworkers,subcontractors or on some other flexible basis.

Forward with fairness32

This is the new world economic order that oursystem of workplace regulation has to adjust to,and it will be different again in five years’ time.Whatever system we have, it also has to cater foran ever more diverse workforce, with its complexage and generational mix, as well as workers whowant flexibility in working time andremuneration arrangements to suit theiraspirational, technologically-geared lifestyles.

Forward with Fairness ‘plus’: the furtherreforms Australia needs

I acknowledge that through the implementationof Forward with Fairness, the Government istrying to get the balance right in the system ofworkplace relations regulation. But in my view,the current reforms will not on their own:

– Deliver the kind of flexibility that the modernAustralian workplace requires; nor

– Assist the project of boosting our nationalcompetitiveness.

They will therefore need to be reviewed over time.

Many would no doubt suggest that WorkChoices– and the High Court’s endorsement of it – wasa ‘quantum leap’ away from the Federation-eraIR system based on the constitutional labourpower. And in some respects, I would agreewith them.

However, just consider how much of the ‘old’system – or the remnants of it – will still remain,even after Labor’s Forward with Fairness policy isfully implemented:

– Industrial awards – albeit ‘modernised’ ones –that will contain fairly detailed regulation ofemployment terms and conditions;

– An arbitral body of sorts – Fair Work Australia– with significant powers; and

– Extensive rules governing registered employeeand employer organisations, union right ofentry, freedom of association, and protectedindustrial action.

Added to this, we will have a swag of newprovisions regulating bargaining – designedmainly to deal with agreement negotiationsbetween employers and unions. This all adds up

to a continuing regulatory focus on the concernsof a bygone industrial era – big institutions,employer bodies, and trade unions. But theAustralian economy – and workforce – havemoved on.

I am firmly of the view that in addition to theimportant changes to the legislative frameworkthat Labor is implementing, further reforms willbe needed to drive the productivity agenda thatthe Government is also committed to.

Starting right now, some serious thinking needsto be done about how governments can enablefirms to pursue strategies of alignment andengagement with the workforce – and assistthem to become the kind of innovative, ‘highperformance’ organisations that will be criticalto Australia’s future competitiveness. TheGovernment should look closely at someoverseas models here – such as Ireland’s NationalCentre for Partnership and Performance andNew Zealand’s Workplace Productivity Project.

Reflecting international trends, the RuddGovernment is embarking on a limited ‘re-regulation’ of our national labour laws – mainly,to restore a measure of fairness that the electoratehas expressed that it wants to see in the workplacerelations system.

However, this cannot be the end of theworkplace reform process. Forward with Fairnessshould be seen as a bridge to the next generationof reform, and all stakeholders need to focus on how we will deliver the all-importantflexibility/productivity and competitivenesscomponents of the reform equation.

2. A global perspective

The current workplace reform debate in Australiais a local manifestation of the challenge policy-makers around the world have faced for someyears – how to ‘humanise global capital’. This isnow occurring in a context where leaders inpublic policy debate are, increasingly,questioning the benefits of globalisation.

Despite this, policy-makers in Australia mustmaintain our support for open trade andinvestment borders. The global engagement of


34 Forward with fairness

Australian businesses generates higher levels ofproductivity, growth and living standards – alongwith access to new learning opportunities,technologies, ideas and skills for our people.

As well as acknowledging the international policycontext in which changes to Australia’s workplacerelations laws are occurring, it is useful to examinehow policy-makers elsewhere are addressing thesechallenges. I will now examine how somegovernments overseas have sought to balance theobjectives of competitiveness, fairness andflexibility.

China’s Labour Contract Law

China’s importance to Australia cannot beoverstated. China is the key emerging power inthe East Asian region – and Australian engage -ment with China is critical to our own economicsuccess.

In June 2007, China adopted a new LabourContract Law – in effect from 1 January 2008 –which has significantly increased the legalprotections offered to employees, particularly inrelation to job security, the payment of wages,and the rights of labour hire, casual and fixed-term employees. Importantly, the LabourContract Law also seeks to address the concerns ofbusiness, especially the many multinationalcompanies with operations in China – forexample, it allows employers considerablelatitude in the use of ‘restraint’ or ‘non-compete’clauses in employment contracts.

Increased certainty in the content and enforc -ement of China’s labour regulation will assist thenation’s quest to remain a desirable location forforeign investment.

The UK: ‘regulating for competitiveness’

Under Britain’s ‘New Labour’ governments since1997, deregulation of the labour market hascontinued at the same time as the introduction ofsignificant new individual rights for employees –including a statutory minimum wage, greaterprotections for part-time and fixed-term workers,a right to request family-friendly working hours,and union recognition provisions. However, as

Professor Hugh Collins has observed, labourregulation in the Blair/Brown years has beenmotivated not so much by the traditionalprotective goals of labour law – but by anoverriding concern ‘to improve thecompetitiveness of businesses’. ‘Regulating forcompetitiveness’ in the UK has been accompaniedby a strong policy push in favour of ‘partnership’relationships between management and unions.

A final feature of New Labour’s business-friendlyapproach to labour regulation has been its stancetowards the EU. The trend here has generallybeen one of UK resistance to EU-level regulatoryinitiatives, and failing that, minimalist domesticimplementation of EU directives. This approachreflects ongoing scepticism about the Europeansocial model, which the UK Government views asincompatible with the flexibility needed to meetthe challenges of globalisation.

‘Flexicurity’ in the EU

I have also been critical of the inefficiencies andcosts to stakeholders of the type of regulationimposed by the EU’s many work directives.However, since 1997, the European Commissionhas promoted ‘the importance of both flexibilityand security for competitiveness and themodernisation of work organisation’. ‘Flexicurity’,as it has come to be described, is a means wherebyemployees and companies can better adapt toinsecurities associated with global markets.

Some of the strategies that form part of theflexicurity approach are as follows:

– A focus on employment security, rather thanjob security – recognising that few workersstay in the same job for life;

– Enabling companies, especially small-to-medium enterprises, to adapt their workforceto changing economic conditions;

– Flexible/reliable contractual arrangements;

– Career progression through life-long learningprograms, in-company training, and entre -pren eurship – internal flexicurity;


– More dynamic labour markets, enablingworkers to move easily between jobs – externalflexicurity;

– Promoting gender equality and equalopportunities; and

– Modern social protection systems, namely,adequate income support for the unemployed.

Flexicurity generally has strong support amongthe European social partners, including theEuropean Trade Union Confederation andemployer bodies such as Business Europe.Adaptability to change through flexicurity is nowan entrenched feature of EU social policy.

USA: the Employee Free Choice Act

Early last year, a bill was introduced into the USCongress that would significantly alter thecurrent arrangements for union-based collectivebargaining under the National Labor Relations Act(NLRA).

The ‘Employee Free Choice Act’ (EFCA) proposesthree main changes to the NLRA:

(i) Allowing unions to obtain collectivebargaining rights without having to hold asecret ballot of employees in all cases;

(ii) Setting timelines for mediation and, ifnecessary, arbitration of a ‘first contract’ (i.e. collective agreement); and

(iii) Introducing stronger penalties for employerviolations of the NLRA.

There are strongly divergent views about theEFCA, between its proponents in the US labourmovement, on the one hand, and employerlobbyists, on the other. However, it isinteresting to observe that even in the home of‘muscular free enterprise’, a debate is currentlytaking place that in some ways reflects our ownin Australia – about how to get the balanceright between competitiveness, fairness andflexibility in labour regulation.

Further implications for Australia

A key concern for the countries I have examined,and the EU, is to ensure that workplaceregulation fits with broader economic goals –enabling them to compete in globalised productand service markets, and ensuring they are ableto attract international investment.

Australia faces the same challenges. But theexperience of these other nations suggests thatnew approaches offer better prospects forresolving the tensions between competitiveness,flexibility and fairness, than traditional labourlaw frameworks.

The UK is perhaps the best exemplar of the kindof approach that Australia should adopt, by:

– Focusing labour regulation on a strong ‘floor’of individual employment rights;

– Providing collective negotiation andbargaining processes for those that still wantto use them (but not making them the primaryfocus of the regulatory system);

– Promoting cooperative workplace relation -ships rather than traditional adversarialposturing; and

– Subjecting all regulation to the overarchinggoal of competitiveness.

We can also learn a lot from the EU’s efforts to‘fuse’ the goals of flexibility and fairness throughthe concept of flexicurity – and the harnessing ofthis concept to the project of enhancing theeconomic competitiveness of EU member states.

And, returning to the other main theme of thispaper, China has shown that labour laws mustkeep pace with structural changes in theeconomy. Just as China’s new Labour ContractLaw reflects the profound shift from a centrally-controlled to an open, market economy – somust Australia move away from an IR systemgrounded in its design in an economy andbusiness approach that simply is no longerrelevant for the majority of participants, to onethat meets the needs of a fast-moving, globally-integrated economy.

36 Forward with fairness

Conclusion

In this paper, I have sought to outline two broadarguments that I think are critical – but largelyneglected – in the current workplace reformdebate in Australia:

– First, that the historical development of oursystem of industrial regulation limits ourthinking about what is possible for the future– and we have to remove those historical‘blinkers’ if we’re to move up the international‘league tables’ of competitiveness.

– Second, that the recent experience of anumber of other countries shows that thecompeting goals of national competitiveness,fairness for employees, and flexibility forbusinesses can be reconciled. And while thishas involved a degree of re-regulation of thelabour market, this has only occurred to theextent necessary to temper the sometimesharsh impacts of globalisation – but withoutabandoning the overall project of internat -ionalist economic policy.

In summary, the big challenges for policy-makersin our field include the following:

– To continue to modernise our system ofworkplace regulation, balancing fairness withthe flexibility that our firms need to competeglobally – and that our increasingly savvy,knowledge-rich workforce demands;

– To develop an agenda for workplace reformthat goes beyond statutory regulation –exploring other policy levers that could helpdrive productivity in Australian businesses;

– To stay the course in the global economicorder, through a continued commitment toopen trade and investment policies – thismeans resisting the clamouring of certaininterest groups for a return to the cossetedcomfort of protectionism; and

– To examine how other countries have goneabout addressing these issues, learning fromtheir successes and failures – and mostimportantly, coming up with solutions thatwill work for Australia.

Mr John Denton is Partner & ChiefExecutive Officer of leading Australian lawfirm Corrs Chambers Westgarth. He wasrecently appointed Chairman of theAustralian Federal Government’s BusinessAdvisory Group on Workplace Relations, is Councillor and Chairman of the Trade &International Taskforce for the BusinessCouncil of Australia, and is a foundingmember of the Australian Institute forPublic Policy. He has advised business andgovernment on a wide range of industrialrelations issues, provided strategy advice onmajor power privatisations, mining andmaritime labour negotiations, and corporaterestructuring in a range of industriesincluding manufacturing and airlines.


Judgment and decision-making inaccounting

Accountants and auditors are called upon daily touse their judgment to make crucial decisions.However, questions arise. How good is thatjudgment? What factors affect it? How do theycombine and mentally weigh the numerous factorsthat lead them to make a decision? What do wereally know about how an auditor makes a going-concern judgment or about how an insolvencypractitioner makes a decision to trade on orliquidate a business in financial difficulty?

Over the past twenty years, major accounting firmsturned to technology to assist them with makingsuch judgments. Computer-based intelligentsystems were developed with the aim of makingmore consistent decisions and sharing expertise;and in the hope that novice staff could make thesame decisions as experts. What do we know aboutthe use of intelligent systems in accounting andhow might they be used more effectively?

An intelligent system is a computer-based systemintended to replicate the decisions of a humanexpert. We expect an intelligent system to showsome form of intelligence – that is, it stores expertiseand, given the factors about a particular case,undertakes reasoning and makes recommen dations.

They include the audit support systems used by theBig Four and other major audit firms, althoughsome are more ‘intelligent’ than others.

The Theory of Technology Dominance

In theory, it was assumed that intelligent systemswould allow relatively junior or novice staff tomake the same decisions as experts. Thisassumption was questioned in the Theory ofTechnology Dominance, proposed in the late1990s by Arnold & Sutton as ‘a model forunderstanding the conditions under which success(of intelligent systems) is more likely to occur.’The theory attempts to understand the impact of intelligent systems on a decision maker’sjudgments, including the short-term impacts andthe long-term implications.

Firstly, a basic requirement of success for using anintelligent system is reliance on the system by auser. Reliance implies two conditions – acceptanceand influence on the decision outcomes. Toenhance the likelihood of reliance on the system:

– The task should be highly complex;

– The system should be familiar; and

– There should be good cognitive fit betweensystem and user.

the use and misuse of intelligent systems in accounting: the risk

of technology dominance

by stewart leech

Designing intelligent systems to enable less experienced staff to makedecisions normally made by more experienced staff is possibly not a

good strategy. However, there appears to be potential for success in usingintelligent systems to complement and support experts’ decisions.

A condensed version of the 68th Annual CPA Australia/University of Melbourne ResearchLecture delivered at the University of Melbourne on 10 September 2007.


The second part of the theory explores the short-term impacts. Here, the theory posits that whenthe expertise of the user matches the level of theintelligent system, decision-making will beenhanced; but where the intelligent system hasmore expertise than the user, the system can leadto poorer decisions. Thus, technology dominanceis the state of decision-making whereby theintelligent system, rather than the user, controlsthe decision-making process, and a user withlimited expertise is unable to use the systemproperly and might misinterpret its output.

The theory then goes on to examine theepistemological implications of using intelligentsystems in the long term. Here, the theorypredicts that continued use of intelligent systemscould affect accounting expertise negatively in the longer term. How do we test a theory thataddresses the use and misuse of intelligent systemsin accounting? What intelligent system would weuse? And in what field of accounting? While workon most intelligent systems has been in audit andtax, my colleagues and I decided to concentrate ona little-researched field in accounting that relieson substantial human judgement – that ofcorporate recovery and insolvency.

Corporate recovery and insolvency

We set off on a journey to first build an intelligentsystem (“INSOLVE”) that would allow insolvencypractitioners to input factors about a company infinancial distress, while the system would use itsexpert knowledge to make a recommendation onhow to proceed – to either liquidate or trade thecompany on – and to provide the reasons andexplanations for the decision.

We were motivated by two objectives: firstly, acognitive modelling rationale since we wereinterested in understanding how expert insolvencypractitioners made decisions about companies infinancial distress; and secondly a behaviouralscience rationale that could test the theory oftechnology dominance. Under what conditions isan intelligent system likely to lead to improveddecision-making?

In building INSOLVE, knowledge was acquiredfrom 23 experts from major accounting firms andbanks. INSOLVE was then extensively validated

against insolvency cases, resulting in a high levelof agreement between the experts and INSOLVE.

How are companies in financial distress dealt withby insolvency practitioners? An initial decision ismade to either liquidate or trade on the business.The objectives of trading-on are:

– Reconstructing the business prior to returningthe business to directors;

– Enhancing and/or preserving the sale value ofthe business as a going concern; or

– Complete work prior to liquidation.

Such decisions may extend over a considerableperiod and are made on the basis of both financialinformation and qualitative judgments about the business, stakeholders and the businessenvironment.

The initial assessment is based on several factors:the business has ceased or cannot become viable;there is no cash and no way to generate cash; keystaff vital to the business have left and cannot bereplaced; or essential customers and/or supplierswill not support trading-on. If the decision ismade to trade-on, an assessment is made of thestakeholders – including the directors, staff,secured creditors, customers, suppliers and unions– and the financial situation, which involves acomparison of the auction value of the assets, thesales value as a going concern and the futureprojected profitability of the business. All of thesefactors were included in INSOLVE. Onceprovided with the facts of an insolvency case, thesystem uses its inference engine to undertakereasoning and produce a recommendation.INSOLVE produces a report that recommendseither liquidate, sell as a going concern or handthe business back to the directors.

Testing the Theory of TechnologyDominance

We then used INSOLVE to test the short-termpropositions of the Theory of TechnologyDominance, that is:

– When there is a strong match between the userand an intelligent system, the judgment of theuser will improve;

– When there is a mismatch between the userand an intelligent system in terms of expertise,the risk of poor decision-making increases.

The difficulty in testing these two propositions isthe ambiguity in defining a better or worse decisionin domains that are highly subjective. One of thechallenges was to place the decision environmentinto an observable and measurable context.

One approach recommended in decision-makingresearch is to focus on a specific source ofjudgment error. We used a similar approach byexamining certain specific types of judgment errorduring the completion of a complex task byinsolvency practitioners – some aided byINSOLVE and some without INSOLVE. Theresearch hypotheses can be summarised as follows:for novices being aided by INSOLVE, there willbe an increase in judgement error; for expertsbeing aided by INSOLVE, there will be reducedjudgement error.

A training session (experiment) was used to testthe hypotheses. A real, reconstructed insolvencycase was used with 80 insolvency practitionershaving access to INSOLVE and with 87 who didnot use INSOLVE. Experts were partners andmanagers. Novices were staff and seniors. In each

of three stages of the insolvency case, theparticipants were asked to give an assessment ofwhether they would trade-on or liquidate. Theresults indicated the existence of a detrimentaleffect of the intelligent system on the decision-making processes of novices. On the other hand,the intelligent system was effective at reducingthe judgment error in the decision-makingprocesses of experts. These results supported theTheory of Technology Dominance.

INSOLVE was a basic intelligent system lacking asubstantial explanation facility. We needed toaddress the question: would the provision of afully functional explanation facility in anintelligent system have an effect on the results sofar? This meant providing users with four types ofexplanations: definitions, rule trace, justificationand strategic. Once developed, we testedINSOLVE II (with the explanation facility) in twofurther studies.

The first study was designed to see if and how theexplanation facility affected the decision-makingbehaviour of both novices and experts. The resultsshowed overall that both novices and experts aremore likely to rely on the recommendation of theintelligent system when explanations are provided.

40 The use and misuse of intelligent systems in accounting


However, novices still tended to acceptINSOLVE’s recommendation and move towardsreliance, supporting the previous research.

The second study used INSOLVE with majoraccounting firms in Singapore and compared the results with Australia. Intelligent systemsdeveloped in one country are often used in othercountries by large accounting firms. The resultsshowed that the overall judgements were no moreconsistent between Singapore and Australia whenusing INSOLVE. However we did find that theintelligent system developed in Australia alteredthe way the Singaporeans evaluated some of theevidence of an insolvency case, leading them to bemore in line with Australian decision-makingprocesses. INSOLVE did change the Chineseculture/attitude to aspects of insolvency decisions,which means that an intelligent system could leadto more consistency in judgement across culturalboundaries, if indeed that is considered desirable.

Other evidence from the US using intelligent taxsystems generally supported our results. Insummary, designing intelligent systems toenable less experienced staff to make decisionsnormally made by more experienced staff ispossibly not a good strategy. On the other hand,there appeared to be potential for success inusing intelligent systems to complement andsupport experts’ decisions.

Finally, I turn to the possible long-termimplications of the widespread use of intelligentsystems in accounting. Here, the Theory ofTechnology Dominance posits that continued useof an intelligent system will result in the de-skilling of users’ abilities and have a negative effecton the growth and advancement of knowledge.

There has been virtually no research in this areauntil recently, partly because it is a very difficultquestion to research. There was some evidencefrom one of the US tax studies, where participantsusing the intelligent tax system had difficulty incompleting the tax returns manually, whereasthose who completed manual tax returns firstcould then easily use the intelligent system.

We tested the association between the extent ofdecision-support embedded in the audit support

systems of three major audit firms and thedeclarative knowledge processed by long-termusers (Dowling, Leech, and Moroney, 2007). Werequired auditors, without the aid of their firms’audit support systems, to list the key business riskscommon to clients in an industry familiar to them.We found that auditors who normally use an auditsupport system that was not an intelligent systemwere able to list more relevant risks than auditorswho normally use an audit support system that wasmore of an intelligent system.

While this was a very simple exploratory study, itdoes ring some alarm bells in the direction of thetheory, and suggests that the way audit supportsystems are designed has a role to play inproviding sufficient opportunities for auditors todevelop their knowledge.

Summary

Intelligent systems and the way they are designeddo have an impact on the decision-makingbehaviour of accountants. The expectation thatnovice accountants can use intelligent systemsand perform like experts is not supported by theevidence and can be a possible dangerousassumption in the use of such systems. Thereneeds to be a good match between the expertiseembodied in the intelligent system and the user.A good explanation facility can make a differenceto the decisions being made, and an intelligentsystem developed in one country can affect thedecisions being made in a country of a differentculture. Finally, while the jury is still out on thelonger-term consequences, there are possiblealarms bells that we need to heed.

Professor Stewart Leech is in theDepartment of Accounting and BusinessInformation Systems at the University ofMelbourne. This is a report of research intointelligent systems in accounting thatProfessor Leech has undertaken over manyyears in collaboration with co-researchers,Phil Collier, Vicky Arnold, Steve Sutton, andmore recently Carlin Dowling.

The context

The conference was held in the lead up to the 2008 Commonwealth Budget. After years ofstrong economic growth and declining unemploy -ment, the overriding domestic economic policyconcern was to contain inflation by restraining thegrowth of demand to a pace more in line with the economy’s capacity to supply the necessaryresources. Monetary tightening and fiscal conserv -atism were central to this task.

A range of other policy issues were also prominentat the time. For example, rising interest ratestogether with high real house prices prompteddebate about deteriorating housing affordability.Sustained growth had stretched the capacity of keyinfrastructure to cope, and there were reports ofincipient labour shortages. Treasury modellingsuggested that Australia’s future growth trajectorywould be lower than the past 40 years unless policychanges increased incentives to work orproductivity growth picked up dramatically.Debate continued about reform of education,health and the overlapping responsibilitiesbetween the Commonwealth and the States. Anintense debate on climate change had focusedmainly on the desirability of adopting an emissionstrading scheme. Moreover there were abidingconcerns about the plight of those left behinddespite the sustained strong economy, withrenewed interest in equity and social inclusion,

including for indigenous Australians. These wereamongst the issues covered during the conference.

A decoupled economy?

The fundamental conundrum for policy in theshort term, however, stemmed from the fact thatwhile Australia’s monetary authorities wereraising interest rates, others were easingaggressively. This easing was intended toinsulate major developed economies from credittightening induced by the recent collapse of the sub-prime mortgage market in the US.Although inflation had edged up, the strongerfears overseas were that growth would stall (orworse) in the US and/or that financial contagionand global illiquidity would undermineprosperity in Australia. An important contextualquestion, therefore, was the extent to which theAustralian economy could effectively decoupleitself from these developments.

Two speakers, Phillip Glyde1, Executive Director,Australian Bureau of Agricultural and ResourceEconomics and Chris Richardson, Director, AccessEconomics, addressed this issue, answering firmlyin the negative. After more than a decade in whichAustralia had benefited from an historically strongupswing in demand for commodities such as ironore and coal, some slowing in Australia’s growth isdesirable in order to rein in inflation. However,assuming sensible macroeconomic policies at


new agenda for prosperity

by stephen sedgwick

How much longer can Australia’s current boom last? And how do we build the physical and human capital needed to maximise the growth of

living standards as the population ages?

The election of a new Government late last year presented a unique opportunity to take stock of theframework of economic and social policies currently operating in Australia. This was the backdrop to theFifth Economic and Social Outlook Conference hosted jointly by the Melbourne Institute and TheAustralian. Held over two days – 27-28 of March, 2008 – the conference attracted 65 speakers drawn frompolitics, academia, business, non government organisations and commentators, and a capacity audience.This is a personal summary of some of the proceedings. Copies of most presentations and a recording ofeach speech are available at the Conference website: www.melbourneinstitute.com/conf2008/default.html


home and successful policy interventions by theUS Federal Reserve Board, the consensus at theconference was that any slowdown would betemporary. The Australian Bureau of Agriculturaland Resource Economics (ABARE) predictedstrong growth for the next five years.

Essentially, the dynamism of the developing worldand its weight in world GDP were believed toprovide a significant buffer against a slowdown inthe US for trade-exposed economies such asAustralia. Central to this was an analysis that thestructure of the world economy has changed. Theemerging economies now account for two-thirdsof world economic growth. ABARE also arguedthat, compared to most of the postwar period,there is now much greater openness to world tradeamongst the major economies, growth is broadlydispersed amongst the world’s economies andfinancial markets are more resilient and canrespond well to shocks.

By 2050, China is expected to be the largesteconomy and account for almost one third ofworld output – compared to about 16 per centcurrently. India is also likely to have claimed amuch larger share of world output. Both countrieshave a very large, low-wage labour force, whichwill support their participation in global trade forsome time. Importantly, the World Bank predictsthat the proportion of the world’s population inthe middle class – those earning between$US4,000 and $US17,000 in purchasing powerparity terms – will treble over the next 20 years. Their purchasing power will underpinsignificantly higher demand for manufacturingand agriculture, minerals and energy intensiveproducts as consumption patterns adjust to higherreal incomes. This, in turn is expected to sustainstrong demand for Australian exports but will alsopose significant challenges to securing a globalposition on climate change.

Of course, risks were identified to this generallybenign outlook. Both India and China have deep-seated structural problems. In the case ofChina, significant reform of the legal framework,the financial system and the operations of StateOwned Enterprises is required. Moreover theChinese authorities need to address economic andsocial inequality within China, infrastructurebottlenecks and mounting environmentalproblems. India has similar issues to address.

Infrastructure and incentives

The adequacy of Australia’s ports, rail, road andother economic infrastructure figured prominentlyin the debates. Glyde, for example, suggested suchbottlenecks explain why comparatively littleadditional coal has been shipped from Australia inrecent years, despite the strength of coal prices. Hecontrasted this with the more robust supplyresponse of iron ore shippers. Several, includingRoss Garnaut, suggested that the apparentinfrastructure imbalances were a symptom of abroader issue, namely the strength of debt-fuelledconsumption expenditure which reduced resourcesavailable for investment in infrastructure,including public infrastructure. In essence,resources had been devoted to consumption at theexpense of necessary long-term investment.

The availability of cheap credit and surginghousehold incomes contributed to this. Theformer owed much to a cyclical easing inmonetary policy during a period of sustainedlow inflation from the mid-eighties, coupledwith financial sector innovation. Prolonged lowand stable inflation also removed some of therisk premium built into interest rates, helpingto keep real interest low. Steady declines inunemployment may also have reduced theperceived risk of unemployment and reducedthe precautionary motive for saving. Rising realincomes were fuelled in Australia by fallingunemployment and by the unprecedented rapid and sustained improvement in our termsof trade.

However, achieving an adequate supply of infra -structure requires more than increased investment.Indeed Michael Keating, Chairman, IndependentPricing and Regulatory Tribunal of NSW,challenged whether any increase in the total value ofinfrastructure is required to meet emerging needs.He, and others, argued that the infrastructure dollarneeds to be applied to its highest valued ends, justlike any other scarce resource. At the least thisrequires professional, independent assessments ofthe costs and benefits of investment proposals.Although the method ologies are well established,they are not always well or routinely applied. He questioned whether bad infrastructureinvestments have consumed resources anddiminished Australia’s growth potential.

Much progress has occurred in recent decades inreducing the inefficiencies of the statutorymonopolies that have dominated service deliveryin these areas. Even so, Gary Banks, Chairman ofthe Productivity Commission, reported that itsannual review of the financial performance ofgovernment enterprises found that although theaggregate return on their assets has slowlyimproved over time, more than half still do notearn a commercial rate of return. Their investmentdecision-making remains constrained by unduepolitical interference, ill defined or unfunded non-commercial obligations, constraints on pricingand restrictions on borrowing.

Institutional reform has been on the Council ofAustralian Government’s agenda for some years.However, several speakers argued that progress hasbeen faltering and slow. While they supportedincreased public investment in some areas, RodSims, Director, Port Jackson Partners Ltd, forexample, noted that improved pricing signals,improved access arrangements and strongercompetitive pressures are also required before fasterprogress will occur. Several argued for fasterreforms in a number of areas including not onlyelements of the resources supply chain such as rail,land freight and ports but also urban infrastructure(including traffic congestion), water, broadbandtelecommunications and climate change.

There were a number of common elements inproposals for reforms. These included the betteralignment of prices and, in the case of roads, usagecharges, with economic costs of supply, includingall externalities imposed on others; and regulatoryarrangements that promote competition and allowmarkets to work or to create them, say, to enabletrading of rights to water or to emit carbon. Sucharrangements will promote decisions that betterallocate scarce resources to uses that will secure thehighest returns for society and better matchsupply with demand at least cost.

However, some infrastructure is characterised byeconomies of scale that lead to natural monopolies.Others lead to externalities that cannot becaptured by the provider from users, for examplethe reduction in road congestion facilitated by anefficient urban rail network. Governments shouldintervene to prevent the exercise of undue marketpower by natural or artificial monopolies, and to

ensure that externalities that cannot be capturedin user charging are adequately reflected in thefinancial returns earned via subsidies or requiredfrom publicly owned providers. The regulator hasa delicate job to do in those circumstances. Forexample, while preventing exploitation ofmonopoly power, they need to ensure that pricesare allowed to do their work. The ProductivityCommission has argued that price regulation thatprevents ‘above-normal’ returns may alsointroduce diminishing incentives to invest inlong-lived assets in short supply and thus can becounterproductive at times.

Creating markets

The creation and efficient regulation of markets isa subtle policy problem. Regulations whichchange existing access rights or which permit theefficient trading of rights to use resourcespreviously held in common such as water or theatmosphere not only introduce new signals toguide behaviour but also create new assets orchange the values of existing ones. The adequacyof supply responses will be affected by theperceptions of investors about the security of theirasset values and their capacity to earn a return oninvestment. Investors require predictability aboutthe regulatory regime sufficient to make well-informed business judgments.

Reforms to the regulation of water, telecomm -unications and the generation of carbon emissionsare cases in point. Several speakers reflected on the consequences of such realities. Competitivemarkets leading to efficient pricing of water andeffective opportunities to trade between agri -cultural and domestic uses on the basis of marketreturns do not exist across the world: the policyand institutional challenges are clearly not easy.However, Gary Banks argued that the potentialbenefits are nonetheless substantial and worth theeffort. Michael Keating argued that, short ofestablishing fully fledged markets, efficientpricing of water based on the costs of sufficientsupply would substantially address existing watersupply deficiencies at least cost. Indeed, he arguedthat Sydney’s water supply problems for the nextdecade could be addressed through a relativelyaffordable increase in domestic water prices2 tocover the expected costs of introducing waterdesalination and other recycling schemes.



He argued that a price set at the level of long runmarginal cost would provide sufficient incentivefor investment in the necessary capacity, includingby the private sector.

Some argued for caution and predictability inestablishing a carbon emissions trading regime soas not to unsettle investment patterns in electricitygeneration or other pursuits that are energy andcapital intensive. Garnaut argued in favour ofapproaches to regulation that minimise the scopefor rent-seeking behaviour, relying on wellfunctioning markets and competition to promotebetter economic outcomes than would beachievable by corruptible administrative fiat. Heargued that his proposed approach to an emissionstrading scheme would satisfy this test better thanan equivalent carbon tax, once an emissionsreduction trajectory has been established.

Addressing the regulatory burdenEffective regulation underpins the efficientoperation of a market economy. Several speakersaddressed the case for regulatory reform. DrStephen King, Commissioner, Australian Comp -etition and Consumer Commission, argued thatcompetition, not regulation per se, protectsconsumers. Several speakers argued that theregulators themselves and some companies havevested interests in increased regulation andcomplexity. It is important that the incentives arealigned to confront law makers, business and theregulators. External review mechanisms, such asrequirements to subject new or amended regulat -ions to a Regulation Impact Statement, provide anindependent check on these vested interests.However some argued that these mechanisms havebeen ineffective in Australia, having been imple -mented as a check on compliance with proceduralrequirements rather than as substantive re-assess -ments of alternative approaches. Even so, NicholasGruen, Chief Executive Officer, Lateral Economics,argued that while Australia is not good atregulatory reform, we are, nonetheless, one of thebest in the world.

Several also sought greater harmonisation, if notuniformity, of regulations across jurisdictions inAustralia, claiming that Australia’s market is toosmall to justify the compliance and other costsassociated with having different, state-basedapproaches to regulation, especially for nationally

operating businesses. Two cautions apply, however.Capital and, increasingly, labour is mobile. Adegree of competition between jurisdictions maypromote improved regulatory efficiency. Moreover,the objective is to standardise on the best approach,not the lowest common denominator.

Human capital

Concerns about shortages of infrastructure werematched by concerns about the quantity andquality of labour available to support sustainedstrong economic growth. Industry groups hadcomplained of skill shortages. Modelling reportedin Treasury’s Intergenerational Report 2007predicted slower economic growth for Australia inthe decades ahead and an increase in the ratio ofnon-working to working Australians because ofdemographic trends, principally populationaging. Policies to promote greater work forceparticipation and higher productivity can help toameliorate these trends.

Andrew Leigh, Fellow, Economics program,Research School of Social Sciences, AustralianNational University, argued that the demand forlabour has increased in some industries andgeographic areas in recent years as fast economicgrowth has become entrenched. In the short run,supply is relatively fixed, putting upwardspressure on wages in those occupations and areas.A feature of Australia’s current, more flexiblelabour market arrangements is that these pressureshave been accommodated with less generalisedimpact on wage inflation and inflationaryexpectations than during earlier periods of strongdemand. Leigh argued that the correct policyresponse to the prospect of continuing strongdemand for labour is the introduction of measuresto improve the quality, quantity and equity ofAustralia’s human capital, not greater interventionin the market to attempt to match specificdemand for labour with supply. Suchinterventions would improve workforceparticipation and productivity.

In fact, speakers addressed reform of the educationsystem from a number of different perspectives,reflecting the centrality of human capitalformation to contemporary policy discourse.There was a high degree of commonality abouttheir analysis and policy prescriptions.

Geoff Masters, Chief Executive Officer, AustralianCouncil for Educational Research, acknowledgedthat Australia’s education system performsreasonably well in world terms. Yet there is scopefor improvement. For example, compared to somecountries against which we often benchmarkourselves, considerably fewer Australian teenagersreach international benchmarks of excellence instandard tests, relatively fewer complete secondaryschool and relatively fewer young people who havenot earlier completed school undertake furthereducation between 20 to 24 years of age.Improved teacher preparation and classroompractices, better processes to monitor theperformance of individual students, a moreconsistent and relevant curriculum across thecountry and better targeting of resources toeducational need are required. Rewards systemsthat better recognise teaching excellence andreward teachers who take on hard schools andteaching assignments, for example, in remoteareas, were also strongly supported. Similarlythere was strong support for higher admissionrequirements for student and beginning teachers.

Collette Taylor, Chair of Early ChildhoodEducation and Care, Melbourne Graduate Schoolof Education, The University of Melbourne,amongst others, argued that the educationrevolution needs to start with early childhoodeducation and care. Lifelong learning is shaped byexperiences in early childhood, and anydisadvantage in early education tends to persist.Effective interventions at this early stage can helpto raise average achievement levels and thusimprove human capital and long-termproductivity. Taylor argued that society in generalis the principal beneficiary of improved outcomesfrom early childhood education, justifyingincreased public investment in the sector andbetter integration of education and childcareservices. However, the bulk of the data on whichearly childhood policy is based in Australia isdrawn from overseas. There is an urgent need formore research based on Australian data to supportevidence-based policy development.

There are complex interactions between child -care provision and workforce participation bywomen of child bearing age. Participation byAustralian women in these years lags that of anumber of other countries, for example, Norway.

Social mores contribute. So, too, do economicincentives. Access to subsidised childcare mayassist to close this gap. However, Guyonne Kalb,Principal Research Fellow, Melbourne Institute,also reported evidence that developmentaloutcomes, especially cognitive skills, improve if achild has close support from one or both parentsduring their first year of life. These benefits for thechild can also be long lasting. She, amongstothers, argued that improved access to parentalleave could reduce workforce participation ofwomen temporarily – or encourage only part-timework – but have longer-term benefits that wouldstrengthen the economy’s growth trajectorythrough stronger developmental, learning andeconomic outcomes for children as they progressthrough school, mature and enter the workforce.

ConclusionThis paper has not attempted to summarise everypresentation or issue addressed at the conference. Ithas illustrated two key policy themes that dominatecontemporary policy discourse: how much longercan Australia’s current boom last? And how do webuild the physical and human capital needed tomaximise the growth of living standards as thepopulation ages? The second agenda is broad,reaching well beyond the levels of investment ininfrastructure to embrace the efficiency of pricingand markets, regulatory reform, and the effective -ness of education and training. However, it alsoextends to a range of issues not addressed in thispaper such as the efficacy of the health system, theeffectiveness of administrative and economicincentives to maximise workforce participationamongst those of working age, and the quality ofsocial capital and social inclusion. Despite severaldecades of effort it is clear that the scope of workstill required is large.


1 This section and the next draw heavily on the presentation ofPhilip Glyde.

2 Keating noted that the Independent Pricing and RegulatoryTribunal, NSW, has determined that the cost recovery tariff hasto rise to $1.83 per kl over the next four years in real terms (from$1.31). A typical household would then spend an additional$203pa on water, an annual rate of increase of 6.3 per cent. Theprice of $1.83 for a thousand litres of tap water compares with asimilar price for a single litre bottle of water at the supermarket.

Professor Sedgwick is Director of theMelbourne Institute of Applied Economic andSocial Research at the University of Melbourne.


Distinguishing between financial andreal options

The option to pay a fixed amount in return for ashare during a specified period – a call option –and the option to receive a fixed amount in returnfor a share during a specified period – a put option– are familiar examples of financial options, wherethe fixed amount is referred to as the option’sexercise price. Financial options are options toexchange a financial asset such as a share, a bondor a futures contract for cash. Less familiar, but noless important, are real options, which are optionsto exchange a real asset for some other asset. Forexample, undertaking an R&D program can givea drug company a real expansion option to acquirethe revenues from any new product by paying thecosts of producing and marketing the drug. Thefurther option to discontinue the product later,should an even better mouse-trap be invented, is a real abandonment option to give up the low net cash flows from a failing product and toreceive instead the scrap value of the machinerypreviously used to produce the product.

While financial options only truly blossomed in1973 with the advent of the Chicago BoardOptions Exchange – initially situated in thesmokers’ lounge of the Chicago Board of Trade – and the publication of the Black-ScholesOption Pricing Model, real options to alter the

operations of an enterprise have always been withus. The mathematician and philosopher Thales(circa 635BC-543BC) made his fortune bycorrectly predicting a bumper olive harvest andbuying options giving him the right to rent olivepresses at the time of the next harvest in returnfor a pre-agreed fixed payment. When his fore -cast of high demand for olive presses proved to becorrect, Thales was able to rent presses at wellbelow what turned out to be a very high marketrate that season.

Valuing options

Valuation techniques suitable for financial optionssuch as the Black-Scholes model are ofteninapplicable when one wishes to value realoptions. The fundamental determinants of thevalue of financial options are usually clear and easyto measure. The exercise price and optionmaturity – usually a few months hence – arecontractually defined, the market price of theunderlying share or bond or futures contract isobservable, and the volatility of the underlyingprice over the next few months can generally beaccurately estimated. On the other hand, theopportunities inherent in real options to expand or contract a business are extremely complex.Further, the market can be relatively uninformedabout the current value of the business that might in the future be expanded or contracted.

real options analysis and investmentappraisal: the opportunities and

challenges

by bruce d. grundy

Real Options Analysis allows us to recognise in a systematic manner the impact of future expansion and contraction decisions on value today,

and hence on whether an initial investment is worthwhile

A condensed version of his Alumni Refresher Lecture delivered at the University ofMelbourne on 13 August 2008.

alumni refresher lecture series

48 Real options analysis and investment appraisal

The estimation of the volatility of the future valueof the business can be more an art than a science.Yet, valuing and operating the business todayrequires an understanding of how to optimallyvalue and manage the inherent options to growand shrink the business in the future.

The CEO of Berkshire Hathaway has expressed his view on the difficulty of valuing future growthoptions by musing: ‘On the final exam [for abusiness valuation course], I’d probably take anInternet company and [ask], How much is itworth? And anybody that gave me an answer I’dflunk…’ Most finance academics warm to thesewords, and not just because of Warren Buffet’stacit approval of such a speedy method of gradingexam scripts. Much of the difficulty lies in thelooseness of language when discussing realoptions. The common practice of confusing choicesand valuable options is at the root of the problem.Simply having a choice about how to manage abusiness does not imply that the choice, or thebusiness itself, has any value.

When are property rights valuable?

Property rights that allow you to choose to give upone asset in exchange for another at off-market ratesare valuable. Acquiring (or selling) an asset at off-market rates means acquiring (or selling) it for less(or more) than its market value. An option hasvalue only to the extent the option-holder has anability to do something others cannot – namely, anability to exchange assets at off-market rates. Acall option on BHP Billiton gives its holder anoption to acquire a share in BHP at a fixed price,which is valuable precisely because everyone elsewho desires a BHP share must pay the marketprice – the option to buy a share at its marketprice is a valueless right. I might be happier to beable to include BHP in my portfolio, but havingthat right along with everyone else does not makeme a wealthier man. The source of market value inany option, whether the option is real or financial,must be traceable to some property right that theowner of the option has.

An analogy may help. I have the option ofremembering my beautiful wife’s birthday. Andhaving optimally exercised that option I dutifullyplace $50 in my wallet and consider the option of

buying flowers or chocolates. Again I know thatlife will be even more pleasant if I make the rightoperating decision and stop at the florist. Surely Iam adding value. I then consider roses or tulips.Perhaps a difficult problem for some, but in mycase I know that the optimal exercise strategy is toselect tulips. I am feeling wealthier still. Thechoice between purple and red tulips is resolvedappropriately and having made this series ofimportant strategic choices the purple tulips areto be gift-wrapped. Now I feel like a king andwith my Midas touch open my wallet and find buta single $50 note. Optimally exercising all myoptions has not added any value. My ability toexchange $50 worth of chocolates for $50 worth ofpurple tulips is not a valuable property right.Similarly, a company may face boundless choicesand yet still be valueless.

Exercising a financial option

Even where the property right is clear, the optimalexercise policy of a real option may differ fromthat for a financial option. Consider a call optiongiving the right to acquire 1,000 ounces of gold ata fixed price of $500 per ounce at any time overthe coming year. Call options on gold are financialoptions traded on the Commodity Exchange inNew York. Suppose spot gold is trading for $900,the interest rate is seven per cent per annum andthe one-year gold futures price is $963. Theoption must be worth at least $400 since theoption-holder could immediately pay $500 cashto acquire $900 worth of gold.

The spot-futures differential in our example issuch that gold is being priced as a store of value.The spot price is simply the present value of thefutures price: i.e. $900 = $963/1.07. Suppose youwere considering exercising your call today andnetting the $400. You would be better off by notexercising today and instead:

(a) Committing to exercise at the end of the year;

(b) Selling forward the gold you will receive whenyou do exercise at year-end thereby locking inthe receipt of $963; and

(c) Borrowing $900 today against your futurereceipt of the forward price.


This alternative strategy dominates becauseinstead of paying $500 today when you exerciseimmediately, you can earn one year’s interest on$500 by delaying any exercise on your call untilyear-end. And you would be better off still notcommitting to exercise your call at year-end,instead delaying till year-end and then exercisingyour call only if the gold price is above $500 atyear-end. This is an illustration of the familiarinjunction: never exercise a call option on a non-dividend-paying asset early. Since gold is typicallypriced as a store of value there is no convenienceyield built into its price.

Exercising a real option

Now consider an apparently analogous realoption. Suppose you manage a one-year lease on asite that you know contains 1,000 ounces of gold.For simplicity assume that at any time during the life of the lease the gold can be extractedinstantaneously at a cost of $500 per ounce. Thelease is in effect a call option on 1,000 ounces ofgold with an exercise price of $500 per ounce anda one-year life. But what would happen if youmanage the lease on behalf of a public companywhose shareholders are concerned that this may beanother Bre-X situation? (For some particularlysobering reading see http://geology.about.com/cs/ mineralogy/a/aa042097.htm ‘The Bre-X GoldScandal: First there is a mountain of gold, thenthere is no mountain, then there is no gold miningcompany named Bre-X.’) If you simply announcethe existence of the lease then, rather than netting$400 today, you would be delaying extraction tillyear-end. In the circumstances, the capital marketmay conclude that the shares are near valueless andyour tenure as a manager would be brief. There -fore, you may find yourself forced to exercise thereal option early to reassure investors that theunderlying gold exists: information asymmetriesbetween insiders and outsiders can affect theoptimal exercise policy for real options when thefirm’s goal is to maximise the current share pricebeing set in a relatively uninformed market-place.

As a final example of the importance of under -standing the property right underlying a valuablereal option, suppose you are considering thepurchase of acreage in a finger of the Yarra Valley

at the edge of Melbourne with a view to plantinggrapes. The land is currently used for dairying.The investment in land and vines will amount to$10 million. In six years you will taste your firstbottling, at which point you will discover whetheryou have produced a premium wine or yet another‘blah’ wine. You must then decide whether toexercise your growth option and invest in themarketing and facilities necessary for a winery, or,alternatively, exercise your abandonment optionand instead turn the property into a residentialsubdivision. Unless the wine is great it will beoptimal to abandon grape-growing. You estimatethe likelihood of producing a great wine. You alsoestimate the costs and revenues associated withproducing wine and the costs and revenuesassociated with a residential development. Youthen estimate the expected payoff from yourventure in seven years time, assuming that youexercise your growth and abandonment optionsoptimally. Finally, you discount back at yourestimate of the opportunity cost of capital andobtain an estimated present value of $25 million.On these calculations, the investment has a netpresent value of $15 million.

The skill source underlying thisprofitable venture

It is necessary to identify the source of the skill thatenables an investment of $10 million to create abusiness that you value at $25 million. If youcannot identify your relative skill as either avintner or a land developer, you should concludethat the present value is at best $10 million.Absent a comparative advantage, you can expect tolose rather than make money. But suppose you dohave a rare skill. You have observed somethingunknown to others, namely, that the clay soil injust this finger of the valley is surprisingly similarto that of the Coonawarra region. You may wellhave discovered cool-climate Coonawarra country.Having identified your property right you mustthen seek to enhance it. For example, you mightbuy options to acquire the surrounding dairyfarms. You will buy the options in case, some yearslater, when you may be winning wine medals basedon the ideal soil of this property, your neighboursthen want a much higher price for their land.

50 Real options analysis and investment appraisal

And, if you lack the capital to buy both thisproperty as well as options on the surroundingproperties, you should hide the real source of thevalue of the venture – the quality of the soil – byinstead lauding the skills of your winemaking.

However, what if the valuable property right is infact the skill of your winemaker? And that whatyou in fact possess is the ability to identify auniquely gifted member of the graduating class ofRoseworthy College in South Australia whoseskill is currently not appreciated by others. In thecircumstances, the present value of the expectedfuture cash flows associated with your venturemay really be $25 million. But who will beentitled to those profits if the winemaker doesprove to be so skilled and you have immediatelypromoted her to chief winemaker? Your staremployee is likely to demand the rents to her rareskill and you as the winery owner may enjoy onlyone gloriously profitable initial year. Thereafter,she will enjoy all the rents and you may as wellsubdivide the property.

Having understood that your particular skill isthe ability to recognise skill in people beforeothers also recognise it, how can you profit fromyour skill? Perhaps you need to try to convinceyour winemaker – and any would-be buyers ofher services – that her skills are worth nothingwithout the unique blend of the soil on theproperty. Further, in initial contract negotiationswith her, you might offer deferred compensationthat gives her a large claim on the future profitsfrom the winery in the form of restricted stockthat will only fully vest if she works with you for10 years. That way, you may also enjoy a share of10 years of profits.

Readers who mutter that only a finance professorcould recommend ‘underpaying’ young talentedemployees should remember that if you do notconceal certain facts and/or contract in a way thatlocks her in, you will have spent $10 millionproving to the world just how valuable she is.Once you then find that you cannot afford toretain her and you are forced to subdivide, youwill simply have lost money in giving her careersuch a great start.

The real promise of real optionsanalysis

What, then, is the real promise of real optionsanalysis (ROA)? First, ROA allows us to recognisein a systematic manner the impact of futureexpansion and contraction decisions on valuetoday, and hence on whether an initial investmentis worthwhile. Second, option valuation formulaecan sometimes be used in addition to, but not as asubstitute for, a traditional discounted cash flow(DCF) approach. A correctly implemented DCFapproach to the valuation of a business willrecognise and value the expected future net cashflows by optimally exercising any expansion andcontraction options inherent in the business.When the two valuation techniques appear toyield different answers, it will be becauseinconsistent assumptions have been made aboutthe business when applying the two techniques.Identifying and eliminating such inconsistencieswill improve the accuracy of your valuation.Finally, and most importantly, the property rightsthat make the real options valuable must beidentified and protected. If you cannot identifythe property right, then any purported positivenet present value associated with an investmentopportunity will be no more than a mathematicalerror on your part. However, if you can identifythe property right, then you can be confident thatyours is truly a real option.

Professor Bruce Grundy is in theDepartment of Finance at the University ofMelbourne.


What is inflation targeting?

Inflation targeting is the practice of monetarypolicy where the central bank aims to keep inflationwithin a quantitatively-defined band and, just asimportantly, where the central bank communicatesthe policy to the public. To date, inflation targetingis practiced in 26 countries around the world (seeTable 1 for a chronological list).

Table 1: Inflation Targeting Countries

Year of adoption of inflation targeting Country*

1989 New Zealand

1991 Chile, Canada

1992 Israel, United Kingdom

1993 Sweden, Australia

1998 Czech Republic, South Korea, Poland

1999 Mexico, Brazil, Columbia

2000 Switzerland, South Africa,Thailand

2001 Norway, Iceland, Hungary

2002 Philippines, Peru

2005 Indonesia, Romania, Slovakia

2006 Turkey

2007 Ghana

* Various sources: Finland and Spain abandoned inflationtargeting when they joined the European Monetary Union inJanuary 1999; Slovakia, Poland, Czech Republic and Hungaryare expected to give up inflation targeting when they join theEuroZone.

As shown, inflation targeting is practiced bydifferent types of economies, for example, indust -

rialised countries such as New Zealand, Canada andthe UK, and newly industrialised and emergingeconomies such as Chile, Korea and Mexico. Theoperational details vary and the practice has beenvariously described as pure inflation targeting,flexible inflation targeting, full-fledged inflationtargeting, forward looking inflation targeting,strict inflation targeting – just to name a few.

Inflation targeting policy frameworks

Table 2 shows the operational details of inflationtargeting for Australia, compared to NewZealand, Canada and the United Kingdom.

Table 2: Inflation Targeting Policy Frameworks*

Country Measure Target band Policyof inflation and horizon timeline

Australia Consumer Average of No explicitPrice Index 2-3% over timeframe(underlying) the medium to correct

term deviations

New Consumer Average of No explicit Zealand Price Index 1-3% over timeframe

the medium to correct term deviations

Canada Consumer Midpoint 2% 6-8 quartersPrice Index +–1% band to correct (core) deviations

United Consumer Midpoint 2% If deviation Kingdom Price Index 1% band > 1%, the

Governor must provide a written explanation to the Chancellor

*For updates and details, see the websites of the central banks.

inflation targeting

by guay c. lim

A review of the theoretical foundations of inflation targeting and current research in the area, with special reference to the Australian experience

A condensed version of a lecture presented at the Faculty of Economics and Commerce 2008Alumni Refresher Lecture Series.


The consumer price index (excluding volatileelements) is generally used as the measure ofinflation. The target band for Australia isbetween two and three per cent, a range of oneper cent compared to the more common range oftwo per cent adopted by many other countries.Like all central banks that have adopted inflationtargeting, the Reserve Bank of Australiacommunicates its policy stance and releasesmonthly updates explaining its policy decision.But, unlike other countries’ institutionalstructures, the Reserve Bank of Australia is notfaced with an explicit timeline to correctdeviations from the target band. This allows theReserve Bank the flexibility to pay attention tothe state of the economy as measured by, say, theoutput gap or the employment gap, in itsdeliberations about the stance of monetarypolicy. Inflation targeting as practiced inAustralia is by no means strict! The ReserveBank is not an ‘Inflation Nutter’; a term coinedby Mervyn King, the Governor of the Bank ofEngland, to describe central banks which focusexclusively on inflation.

A simple graphical way to present inflationtargeting with respect to the unemployment gap is shown in Figure 1. The vertical axis showsthe inflation gap (deviation of actual inflationfrom the mid-point of the target band of 2.5 percent), while the horizontal axis shows theunemployment gap (deviation of actualunemployment from an underlying nine-quartermoving average value). The top left-handquadrant shows the occasions when the inflationgaps were high and the unemployment gaps low,indicating that tightening monetary policy(positive changes in the cash rate) werewarranted. In contrast, the bottom right-handquadrant shows the occasions when looseningmonetary policy (negative changes in the cashrate) were warranted as the inflation gaps werelow and the unemployment gaps high. Thegraphical analysis in Figure 1 provides someindication of the importance of unemploymentin the Australian inflation targeting policyframework.

Figure 1: Scatter plot of the inflation gap, and theunemployment gap; positive changes in the cash rate(grey); negative changes in the cash rate (black);1993:1-2007:4

Why adopt inflation targeting?

The quantity theory of money equation (MV=PY)serves as a convenient framework to think aboutthe development of inflation targeting. If outputY is determined by real factors, it follows thatprice P is determined by the nominal term MV(quantity of money multiplied by the velocity ofmoney). In the past when velocity V was fixed bytechnology, it followed that P was determined bythe supply of money M. Hence maintaining pricestability became tantamount to managing themoney supply. When the velocity V became morevolatile and less predictable due to financialinnovations, controlling the money supply tocontrol P was no longer feasible. Instead, thepolicy strategy became the direct management ofP – in other words, inflation targeting!

Australia’s history of monetary policy mirrors thispoint. In the 60s, monetary policy was aboutcontrolling the money supply, in particular bank deposits. During this time, the exchangerate was fixed and it served as the nominal anchor.However, in the 70s, the breakdown of theBretton Woods system of exchange rates sawmany countries abandon fixed exchange rates in favour of flexible rates. The Australian dollarwas floated in December 1983. These were also the years of increased globalisation andfinancial innovations, so much so that it becameincreasingly difficult to define the money supply.Management of the growth of money, or monetarytargeting, was abandoned, and the checklistapproach to monetary policy was adopted.


Over the next few years, the Reserve Bankgravitated towards managing inflation directly; andfinally, in April 1993, Australia formally adoptedinflation targeting as the strategy for monetarypolicy. Note that a floating exchange rate system isa requirement for a well-functioning inflationtargeting system, since in a world of high capitalmobility, independent monetary policy cannot co-exist with a pegged exchange rate regime – the so-called impossibility of the holy trinity!

In parallel with globalisation and financialinnovations, there were two critical developmentsin economic theory that promoted monetarypolicy as a short-run demand management toolfocused on inflation. These were the relationshipbetween inflation and unemployment, and theimportance of commitment and credibility inanchoring expectations.

Inflation and unemployment

In 1958, A.W. Phillips published his famousarticle that demonstrated a negative relationshipbetween unemployment and the rate of change ofmoney wages in the UK. Put simply, duringperiods of high unemployment, employees areunlikely to demand big increases in pay. In 1959,when Phillips was on sabbatical leave in Australiaat the University of Melbourne, he estimated hissecond ‘Phillips Curve’ and once again establishedthe negative relationship between changes inmoney wages and the unemployment rate, thistime for Australia over the period 1947–1958.Since wage inflation and price inflation are highlycorrelated, research by academic economistsbecame increasingly focused on the negativerelationship between price inflation and theunemployment rate. In particular, the burningquestion became this: if there exists a negativerelationship between inflation and unemploy -ment, does it mean that we have to accept highinflation to have low unemployment?

Figure 2 shows the scatter plot of wage and priceinflation rates against unemployment rates for theperiod 1965–2007. It would be difficult indeed tosee any empirical evidence to support a negativerelationship between inflation and unemploymentfor Australia.

However, there have been many structural changesin the sample period of more than 40 years. Figure3 illustrates the changing nature of the relationshipbetween inflation and unemploy ment. We see apositive vertical relationship before the break-down of the Bretton Woods system of exchangerate determination (1964–1974), a negativerelationship before the floating of the Australiadollar (1975–1983), a steeper relationship beforeinflation targeting (1984–1992) and a flatterrelation since 1993, after allowing for theintroduction of the GST in 2000. Mucheconometric research has gone into estimating theslope of these relationships as they provideinvaluable information about the ‘trade-off’between inflation and unemployment.

Unemployment rate Unemployment rate

Unemployment rate

Figure 3: Phillips Curves over time

Figure 2: Scatter plot of wage and price inflationagainst the unemployment rate 1965–2007


Alongside the empirical research, developments ineconomic theory began to question the existenceof a long-run tradeoff between inflation andunemployment. Put simply, while attempts by acentral bank to change the inflation rate mightproduce a nominal ‘surprise’ (with real short-runconsequences), rational agents would factor theprice changes into their decision-making process.Thus, over time, there would be no real effectsand, consequently, no long-run trade-off.

More importantly, academic economists began toargue that since unemployment is a realphenomenon, issues about labour supply andproductivity were better managed as long-runproblems via the fiscal arm of government. Incontrast, inflation is a nominal phenomenon andshould be managed by monetary policy. So withfinancial innovations and globalisation, inflationtargeting became the preferred monetary policystrategy to manage short-run demand issues.

Anchoring expectations

The second influential strand of economic theorythat had a significant bearing on inflationtargeting was the body of academic research thatshowed that commitment to a strategy enhancedcredibility. This in turn ‘anchored’ expectationsand led to better outcomes. In other words, if acentral bank sends a clear signal that inflationcontrol is a priority and the policy is then well-communicated, people soon expect and act on theexpectation of stable prices, and actual inflationwill remain low and stable.

The left-hand side graph in Figure 4 shows thehigh correlation between actual underlyinginflation and the Melbourne Institute measure ofconsumer inflationary expectations. Moreinterestingly, look at the behaviour of wageexpectations over the recent period of cash rateincreases (see the graph on the right). When theReserve Bank began its period of monetarytightening, wage expectations remained stableand in fact turned down, suggesting a strongbelief in the downturn of inflation and thecredibility of the inflation targeting policy. Wageexpectations only began to creep up when theReserve Bank kept raising the cash rate becauseinflation stayed stubbornly high.

The practice of inflation targeting

The interest rate is the instrument used to achievethe inflation policy objective. In practice, theReserve Bank of Australia meets on the firstTuesday of every month to determine the cash rateand its deliberations are announced. The effectivetransmission of the policy change is thendependent on the banks and changes in privatesector behaviour. Much empirical research hasbeen devoted to improving our understanding ofhow a change in the policy interest rate istransmitted to the rest of the economy.

Australian economic performance pre andpost inflation targeting

Figure 5 shows the performance of the Australianeconomy, pre and post inflation targeting. Thelevel of inflation has certainly come down; GDPgrowth remains high but is less volatile; theemployment to population ratio is trending up;and the unemployment rate is trending down. By all accounts, the economic indicators are morefavourable post inflation targeting, but how muchthis is due to good luck from the resources boomor good management is still debatable.

Figure 4: Inflation and wage expectations


Criticisms of inflation targeting

The strategy of inflation targeting has beencriticised mainly on two fronts. The first criticismis that a narrow inflation-only focus can lead toundesirable outcomes for growth and employ -ment. This criticism is not relevant in Australia,as we have already noted.

The other criticism is that inflation is mainlyimported and hence beyond the control of theReserve Bank. But is this the case for Australia?The graph on the left in Figure 6 shows the recentdivergence in the rate of growth in the price indexof tradables and non-tradables; while the graph on the right shows the smaller contribution oftradables to overall inflation. It would seem, inrecent times, that inflationary pressures in Australiaare predominantly homegrown, notwithstandingthe contribution – direct and indirect – of therecent hikes in energy and food prices.

Concluding remarks

We have looked briefly at the internationalpractice of inflation targeting and noted theimportance of the quantitative target and thecommunication of policy. Developments insupport of inflation targeting include: financialinnovations and globalisation; and academicresearch about the nature of the trade-off betweeninflation and unemployment, the role of monetary

policy as a short run demand management tool,and the importance of commitment andcredibility. The Australian experience, to date, hasbeen favourable; but how much is due to goodluck and good management is something still tobe explored. A lot of research, much of which isbased on dynamic stochastic general equilibriummodels, is currently focused on exploring ways toenhance the strategy of inflation targeting in theface of a range of shocks, especially asset-priceshocks. There is still much we can research andlearn about the strategy of inflation targeting.

Figure 5: Some macroeconomic indicators –1984–2007

Inflation Rate GDP Growth Rate

Employment to Unemployment RatePopulation Ratio

Figure 6: Tradables and non-tradables

Growth in Price

Contributions to Aggregate Inflation

12

10

8

6

4

2

0

Jun-84 Jun-90 Jun-96 Jun-02 Jun-08 Jun-84 Jun-90 Jun-96 Jun-02 Jun-08

8

6

4

2

0

-2

Jun-84 Jun-90 Jun-96 Jun-02 Jun-08

65

63

61

59

57

55

Jun-84 Jun-90 Jun-96 Jun-02 Jun-08

12

10

8

6

4

2

Professor Guay C. Lim is ProfessorialResearch Fellow, Melbourne Institute ofEconomic and Social Research. She is alsoAdjunct Professor in the Department ofEconomics at the University of Melbourne.


Revelations of night photos fromspace

The US space agency NASA publishes compositephotos that show us night-time views of the earthfrom space.1 What is striking about these maps isthat the casual observer is usually able to identifyparticular locations, with little more than thegeographic scattering of light to help them along.For the purpose of this lecture we take light that is visible from space as a useful indicator ofurbanisation.

This lecture discusses the New EconomicGeography (NEG) literature in Economics.Among other things, the NEG literature isfocused on explaining the pattern of light in thesemaps. Why do the (brightly lit) heavily populatedurban areas and (dark) rural areas coexist? Why arethese urban areas so often located near one anotherin economic space? These are not simply questionsabout why the world looks as it does at night.Rather, they are fundamental questions abouthuman behaviour and the organisation ofindustrial societies.

A related topic, though one not as well captured bythe night photos, is the extreme localisation ofparticular types of production activities. Why, forexample, did Pittsburgh, Pennsylvania, becomethe home of several steel companies; while Detroit, Michigan, was the home of several autocompanies? Why are most US band instrumentsproduced in the small city of Elkhart, Indiana;while most carpet and flooring materials areproduced in Dalton, Georgia? The recent revival ofeconomic geography has focused on these topics.

Head and Mayer (2004) provide a guide to thecharacteristics of a standard NEG model. They notethat an NEG model typically has five components.

First, there are increasing returns to scale inproduction, and these are internal to the firm.Second, the existence of increasing returnsgenerates market power, and this must bemodelled appropriately. Third, there are costs oftrading over geographic space. Fourth, firmshave the ability to choose their locations. Fifth,there is endogenous location of demand, eitherthrough mobility of households, or via the effecton the demand for intermediate goods thatoccurs through the location decisions of down -stream firms.

A model of this type has the followingimplications. Increasing returns to scale implythat production will occur in a limited number oflocations, because spreading out production overmultiple places would mean that scale economieswould go unexploited. Because there are tradecosts, firms choose to locate near the bulk ofdemand. Trade costs will also give consumers anincentive to locate near the firms, to avoid payingmore for the goods.

Core and peripheral areas

This basic model thus generates co-location offirms and workers in a single location (i.e. a city).There are forces in the model that push some firmstoward breaking away and locating in peripheralareas, but these are typically overcome by thebenefits generated by increasing returns and tradecosts for being in the geographic ‘core’. The core-periphery structure of equilibria in these models isthe common outcome that makes the modelsuseful and interesting.

Among the outcomes that emerge from themodels is that in some equilibria, higher wages aresustained in the core rather than in the periphery.

new economic geography andmanufacturing

by russel hillberry

Understanding the existence of cities and regularities about the location of manufacturing activities within countries

58 New economic geography and manufacturing

The core may also be able to support higher taxrates and more generous public services, than canbe supported in the periphery. The advantagesmaintained by the core can sometimes persistagainst certain shocks (i.e. changes in trade costs).However, the effects of such shocks are non-linear.In some cases, such shocks will lead to rapidunravelling of the core.

These results offer us a way to understand notonly the existence of cities, but also regularitiesabout the location of manufacturing activitieswithin countries. The example that is most oftenused in the literature is the ‘manufacturing belt’in the northeast part of the US. From the late1800s to the mid 1900s, US manufacturingprowess was unrivalled in the world. Its workersreceived very high wages by world standards, yetwere often able to produce on a scale that madetheir goods seem cheap by world standards.During this period of US manufacturingdominance, much of its manufacturing activitywas geographically clustered in a small section ofthe country – the Great Lakes region and theNortheast.2 Estimates reported in Krugman(1991) suggest that 70 per cent of US manu -facturing activity occurred within this belt in1900, and 64 per cent as late as 1957.

A map showing the distribution of night-timelight in the late 1950s would have made clear tothe naked eye the unusual levels of activity inthis region. Much of the country’s populationlived inside the manufacturing belt. Consistentwith the models, manufacturing firms and thebulk of final demand were co-located. As someNEG models indicate, the manufacturing beltwas able to sustain higher wages than the rest of the country. The region also sustained highertax rates and better quality public services. Forexample, this region hosted the bulk of thecountry’s great cultural institutions, includingthe most prominent universities, museums andsymphonies.

An important feature of economic activitywithin the US manufacturing belt was theimportance of intermediate goods trade. Detroitproduced autos, so auto parts were produced innearby areas of Michigan, Ohio and Indiana.

NEG models have been adapted to includeintermediate goods. A typical result fromthinking through this exercise is that theinclusion of intermediate goods trade magnifiesmany of the results from the basic model – thecore pays an even larger wage premium, evenlarger gaps between core and periphery taxes canbe supported, but that the unravelling of the corecan be even more disruptive.

Intermediate goods trade can also be understoodas a reason for the high levels of localisation thatare sometimes observed. Note the co-location ofauto parts producers and auto producers in theregion surrounding Michigan. The existence ofauto producers in Michigan (along with tradecosts) made it too costly for auto parts producersto locate anywhere else. Once the auto partsproducers are located in the region, the autoproducers have an additional reason to stay in thislocation. It is in this way that intermediate goodstrade magnifies the results of the basic model. Ahigher wage gap between core and periphery canbe maintained, as can higher tax rates. However, ifa shock is large enough to induce firms to leave(i.e. low wage manufacturing in China, lower costsof trading auto parts over distance), theimplications for the core are more severe.

As an aside, let me note that I believe that manyof the current political and economic tensions inthe US have to do with the unravelling of the corethat was once the manufacturing belt. Lower tradecosts, rising incomes in the rest of the world, theemergence of low-wage manufacturing in Asia –all these could result in the unravelling of the belt.Indeed, manufacturing activity is movingoffshore, but it is also moving to other parts of theUS. States that were in the core are finding itdifficult to maintain more generous publicspending and welfare provisions to which theircitizens had become accustomed. Wages in muchof the old manufacturing belt are stagnant orfalling, especially when compared to the rest ofthe country. These tensions have to do with theunravelling of the core that was the USmanufacturing belt, which is a large enoughphenomena to affect political and economicchoices at the national level.


China and India

The causal empirical lessons we learned from theUS manufacturing belt are also useful for helpingus think about China and India. Rapid growth inChinese manufacturing is often attributed tovery low wages there. While that has certainlybeen important, another part of the story maywell be that China is in a very good position tofully exploit any scale economies that exist, bethey external or internal. Not only does Chinahave a vast domestic market, but because oflowered tariffs, it also has access to a vast worldmarket. Thus, it seems likely that China is ableto reap all the benefits of scale that the US oncedid, and more.

Given that this is the case, we might also expectto see certain features of the US manufacturinglandscape appear in China. Just as cities in the USbecame so specialised that they became identifiedwith particular products, we are seeing the samein China. For example, Qioatau, in Wenzhouprovince, is known as the button city, for itproduces 60 per cent of the world’s buttons, and80 per cent of the buttons produced in China.Other products, including lampshades andbadminton racquets, seem to be localising inmuch the same way.

As in the US, it also appears that Chinese manu -facturing is beginning to co-locate withinparticular geographic regions. At the moment,there seem to be about three main agglomerations(around Shenzhen, Shanghai and Beijing) thatcontain much of the activity. While these cities aredistant from one another, it is notable that theyare all located in China’s east – close to much ofChina’s population and the global marketplace.

As in China, the NEG models have policy lessons for India. Compared with China, Indiaremains relatively rural and poor. There do notappear to be the same vast agglomerations ofmanufacturing activities – for which at least twopolicies are partially responsible. First, India hashad an explicit policy of retaining some sectorsfor small firms. This policy limits the ability of Indian firms to achieve scale economies.Fortunately, this is rapidly being changed.

A second policy constraint that limits agglom -eration is a number of interstate trade barriersthat limit trade within India. Faced with suchrestrictions, it can be more appropriate toproduce in multiple states than to produce in acore region and export to the periphery.

Despite these tensions, there remain greatprospects for further development in India andChina. China seems to have already begunexploiting the scale economies that can beachieved in large-scale agglomerations ofmanufacturing activity. It may well be that aChinese core will remain competitive even afterChinese wages rise. One big threat to such a corewill be India, which also has the potential to be acore manufacturing centre that serves the world.

References

Head, Keith, and Thierry Mayer. (2004) “The Empirics of Agglomeration and Trade,”Handbook of Regional and Urban Economics: Citiesand Geography, Volume 4, Amsterdam: North-Holland, 2004.

Krugman, Paul. (1991) Geography and Trade,MIT Press, Cambridge.

1 http://nssdc.gsfc.nasa.gov/planetary/image/earth_night.jpg

2 Incidentally, much of Canada’s manufacturing activity liesjust over the border from this region.

Dr Russel Hillberry is Senior Lecturer in the Department of Economics at theUniversity of Melbourne.


Introduction

A key area of health expenditure is thereimbursement of services provided by doctors.In 2005-6, 1.6 per cent of GDP ($15.5bn) was paid to doctors through Medicare fees,representing around 19 per cent of recurrenthealth care expenditure. This excludes the cost of doctors employed by public hospitals. Thetreatment decisions made by doctors – such asprescribing, referrals, admission to hospital anddiagnostic tests – indirectly determines the levelof most other types of health care expenditure.The decisions doctors make are the key toimproving efficiency and equity in health care.

The methods through which doctors are paidhave been shown to influence the decisions theymake, and therefore the quality and costs ofhealth care provided. The aim of this short paperis to examine the role of fee-for-service (FFS)payment and suggest options for the reform ofphysician payment in Australia. The paper isconcerned with how doctors receive theirremuneration rather than higher level fundingarrangements. In practice, any type of third partypayer, from the Health Insurance Commission to proposed managed care or social insurancemodels, can adopt different payment schemes forthe doctors it contracts with.

Current payment arrangements fordoctors in Australia

There are a number of issues with the current FFSpayment which deserve further attention. Thesecan be illustrated with the following quotation.

“That any sane nation, having observed that youcould provide for the supply of bread by givingbakers a pecuniary interest in baking for you,should go on to give a surgeon a pecuniary interestin cutting off your leg, is enough to make onedespair of political humanity.”

George Bernard Shaw, The Doctor’s Dilemma, 1911

The first issue raised is the objectives of thepatient when visiting a physician. What dopatients want from their physician? Better healthis a clear objective, depending on how it isdefined, but there are other possible outcomes thatcan influence a patient’s welfare, such as theprovision of information and reassurance, and alsothe process by which treatment is delivered, suchas whether a procedure is invasive or not. To linkthese objectives to a payment scheme requires thatthey can be both measured and attributed to thedoctors’ actions. A ‘fee-per-health improvement’would be the ideal payment system. However, thehealth status of patients is not routinely measuredbefore and after they receive a treatment. The only outcome that is routinely measured is death.

for love or money? paying doctors to improve the quality of health

by anthony scott

The methods through which doctors are paid have been shown to influence the decisions they make, and therefore the quality and costs

of health care provided


62 For love or money?

Even if an improvement in health could bemeasured, it may be difficult to attribute this tothe actions of the doctor, given the many otherfactors that influence health status. Attributionmay be easier where good evidence from clinicaltrials links a health intervention to better health.However, this evidence-based approach is far fromcomplete. And so, the usual metric for FFSsystems is the number of services. This is easilymeasurable, but depends on the volume of servicesprovided, and its relationship with quality andoutcomes is uncertain.

The second issue that is raised by the abovequotation is the motivation of doctors. If theywere purely motivated by self-interest and money,as in the above quotation, and alternativetreatments attracted a lower fee, then doctorswould undertake many amputations. However, weknow that doctors also care about their patients’health status, and most adopt a more conservativepractice style that is more closely aligned with the patients’ best interests – they have intrinsicmotivation. Some doctors would therefore tradeoff a higher income for the benefit of patients. If this is the case, then there is no need for such a complicated fee schedule as we have now. Thenature of and variations in doctors’ motivationsshould, therefore, determine the type ofremuneration system used.

A key issue here is the absence of evidence formany health-care interventions. In many diseaseareas there are a number of alternative treatmentsthat could be pursued (including doing nothing)but there is little or no evidence to guide doctors’recommendations. In the case where there isdiscretion as to which treatment to recommend,then in an FFS system the physician is more likelyto recommend the most highly remuneratedoption. Where fee relativities are not based onevidence of relative cost-effectiveness, theninefficiency will prevail and the system willprovide the wrong incentives for doctors.

FFS also creates a culture where new technologiesrequire new fees. Because some doctors areextrinsically motivated, they will not provideservices unless they are paid, even where there isclear benefit to patients. There is a propensity toadd on services and fees as technology advances

rather than replace services. This is less likely tohappen in other types of remuneration systems.

The ability of doctors to determine the level oftheir own fees means that costs over and above theMedicare reimbursement are passed on to patients.Although patient charges are not new inAustralia, there is much evidence to suggest thatthose who are deterred from using the health caresystem are more likely to be relatively poor and inworse health – those most in need of health care.So we see a rise in health care costs while fewerpatients are being seen.1 FFS and doctors’ abilityto set fees and determine the volume of careprovided means that although user charges doreduce demand, they do not reduce doctors’incomes. This also depends on the responsivenessof demand to changes in patients’ out of pocketpayments.

FFS also discourages team working, continuity ofcare for patients with chronic disease, working inunder-served and rural areas, universal access forequal need, and specialty choices that meet theneeds of the population.

Alternatives to FFS

The economic theory of incentives argues that incomplex jobs and where quality and outcomes aredifficult to measure, then FFS payment is likely tobe inefficient.2 This is because the costs ofcontracting and monitoring are too high, andbecause doctors will only do what they are paid fordoing.3 In a complex job, it is therefore difficult todetermine an efficient fee schedule.

The largely theoretical literature suggests that amixed system of payment or a salaried paymentoption accompanied by subjective performancereview, and with incentives for effort providedthrough the career and promotion structure, maybe more efficient.

There have been almost 30 years of internationalempirical research into physician paymentsystems, and a number of reviews of this literaturehave been published.4 Compared to salaried andcapitation payment, FFS has consistently beenshown to lead to a higher volume and intensity ofcare being provided. What this literature has yetto show, however, is whether this represents ‘too


much’ care or over-servicing. For this, it isnecessary to examine the effect of differentpayment systems on the health outcomes ofpatients. This is a key area where the literature islacking. Capitation payment, where doctors arepaid according to the number of patients they areresponsible for, has been shown to lead to lowlevels of health care provision and a moreconservative approach to treatment by doctors.Salaried payment has again shown lower levels oftreatment provided in comparison to FFS,although there has been no empirical research onthe role of incentives contained within salaryscales and careers.

In order to avoid the more extreme opportunitiesto provide too much or too little care, blended ormixed systems of remuneration have beenadvocated as the way forward.5 Such systemsmight involve a number of elements:

1. A proportion of income that is fixed, with anadditional element to reflect experience orseniority. This may be paid to all doctorsproviding a ‘core’ set of agreed services tominimum standards. Alternatively it couldform the basis of a salaried system of payment.This fixed element could also be determined bycapitation payment, which is perhaps moresuitable for GPs rather than specialists.

2. The addition of an FFS element is desirable iffees can be linked to health improvements (e.g.immunisation) or to evidence-based guidelinesof good practice in certain priority disease areas (e.g. cost-effective prescribing in coronaryheart disease, chronic disease management),where they exist. This is a pay-for-performanceelement.

3. The addition of ‘non-core’ payments for servicesthat doctors can choose to provide, such as afterhours care.

A further aspect of alternative payment schemesthat has not been researched in health care is the role of the payment scheme in influencingthe relative attractiveness of jobs for doctors.Workforce issues are a key area in Australia and other countries, and it is important toexamine how the payment system can influencerecruitment and retention. The level of expectedfuture income has been shown to influencerecruitment into certain specialties in the US.The type of remuneration scheme is also likelyto influence recruitment and retention intogeographical areas, as it will influence othernon-pecuniary job characteristics. It may,therefore, be necessary to have a plurality ofpayment schemes, such that doctors can choose to be salaried employees, for example.

64 For love or money?

This may be beneficial in rural areas and isalready happening in Australia to a small extent.It may also be beneficial for those doctors whodesire more flexible working hours, or who do notwant to run a small business or bear the costs ofthe red tape associated with FFS payment.

Evidence from Australia

The Practice Incentive Program (PIP) for GPs inAustralia was introduced in 1999. In addition to the usual FFS payments, the PIP providedcapitation payments to improve practice infra -structure, and incentive payments to improvequality of care for patients with diabetes, asthma,mental health problems, and to improve coveragein cervical screening. This pay-for-performancescheme was recently evaluated in relation todiabetes treatment, and found that the HbA1ctest (blood glucose test) was between 15 per centand 20 per cent more likely to be ordered by GPsin the PIP scheme compared to GPs not in thePIP scheme. The study controlled for a widevariety of patient and GP characteristics, and alsocontrolled for the self-selection of GPs into thePIP scheme. The results suggest that modific -ations to the FFS scheme can have marked effectson quality of care.

Conclusions

Fee-for-service payment is widely regarded asbeing potentially inefficient and inflationary. Anyproposed alternative payment system for doctorsshould follow a number of principles. Wherepossible, remuneration should be linked toperformance in terms of patients’ health outcomes.This requires the linkage of evidence-basedclinical guidelines and standards to the paymentsystem, which will not be achievable for manydisease areas. A blended or mixed system ofremuneration should be used to avoid the extremeincentives of under- or over-servicing, and itshould also be tailored to reflect the differentmotivations of doctors. A plurality of paymentschemes should, therefore, be available for alldoctors. This would have a positive effect onrecruitment and retention. Finally, there should beexperi mentation and rigorous evaluation of anynew payment schemes.

1 Scott A. (2006) ‘The productivity of the health workforce.’Australian Economic Review, 39:312-317.

2 Prendergast C. (1999) ‘The provision of incentives in firms.’Journal of Economic Literature, 37, 7–63. Burgess S., MetcalfeP. (1999). ‘Incentives in organisations: a selective overviewof the literature with application to the public sector.’Centre for Market and Public Organisation, University ofBristol, Working Paper no. 99/016.

3 Eggleston K. (2005) ‘Multitasking and mixed systems forprovider payment.’ Journal of Health Economics 24(1), 1-223.

4 Gosden T., Pedersen L., Torgerson D. (1999) ‘How shouldwe pay doctors? A systematic review of salary payments and their effect on doctor behaviour.’ Quarterly Journal ofMedicine, 92(1), 47-55; Gosden T., Forland F., Kristiansen I.S., Sutton M., Leese B., Guiffrida A., Sergison M., PedersenL. (2001) ‘Impact of payment method on the behaviour ofprimary care doctors: a systematic review.’ Journal of HealthServices Research and Policy, 6, 44-5; Robinson J. C. (2001)‘Theory and practice in the design of physician paymentincentives.’ Milbank Quarterly, 79:149-177.

5 Scott A., Schurer S., Jensen PH., Sivey P. (2008) The Effectsof Financial Incentives on Quality of Care: The Case of Diabetes.Working Paper No. 12/08. Melbourne Institute of Applied Economic and Social Research, The University of Melbourne, 2008.

6 Robinson, op.cit; Eggleston, op.cit.

Professor Anthony Scott is a ProfessorialFellow and leads the Health EconomicsResearch Programme at the MelbourneInstitute of Applied Economic and SocialResearch at the University of Melbourne.


Introduction

This article sets out some key ideas aboutinnovation in organisations. It attempts to answersome important questions: what it is, how do youget it, and what is the business value of pursuinginnovation. In its broadest sense, innovation is abusiness strategy that might be applied to broadlydifferentiate your firm from others or to assist it ina niche-based strategy of specialisation. It may be one-off – a software package that you havedeveloped in-house, a new product or serviceoffering, an analytical technique, or an efficientway to do your work. Such one-off innovations cancreate significant value, however nothing lastsforever. So truly excellent organisations, large orsmall, aspire to be systematically innovative –coming up with a stream of new products andservices, processing and operating methods, oreven business models. Systematically innovativeorganisations have new ideas coursing through theDNA of all aspects of the firm, and while not allideas are successful, they get enough things rightto provide an overall handsome reward.

Examples of well-known companies in this realmare Apple, Sony, 3M and Toyota. All of thesecompanies have had their share of failures, becauseinnovation means taking some risks, howevercarefully evaluated these might be. There is noreason why all companies cannot pursue a similarsystematic innovation capability. Indeed, many aredoing it and are delivering superior outcomes andperformance to their stakeholders.

Innovation: what is it?

Innovation generally implies new things – but notnecessarily new to the world. It can mean

something new to a firm, or part of it; or new to acustomer, client, industry or country. It is notconfined to technical innovation or a new productor service line. Rather, it may be a new way oforganising the internal processes of an organisationor an innovative business model or structure. Thepoint is that the creation of innovation in any ofthese domains brings an opportunity to create newbusiness value. The latest buzz word for this in‘management-speak’ is Blue Ocean Strategy, whichrefers to the finding of a new market space for newproducts and services.

Innovation can refer to big things or little things,and in my view the best large organisation in the world that achieves both is Toyota. At the ‘biginnovation’ end was the massive developmentproject of the Hybrid Synergy Drive; while at the other end of the scale, in many plants, asubstantial number of improvement suggestionscome from employees. Each of these is a relativelysmall innovation – mostly process driven – and,after evaluation, the majority of them are worthyof implementation.

Innovation can occur in any and every industry,not just in high-technology product sectors. Forexample, there is tremendous innovation activitygoing on in the commodity industries of mining,oil and gas. In mining, for example, great processinnovations are occurring, such as ‘block caving’mining methods, and using biological methods(‘bugs’) to extract valuable minerals and metalsfrom rock. There is plenty of innovation inservices too, including everything from the use ofthe Internet for banking, retailing and travel,through to new service business ideas – forexample, women-only gyms, premium seats inmovie theatres, and downloadable music.

innovation: a high value-added strategy

by danny samson

Systematically innovative organisations have new ideas coursing through the DNA of all aspects of the firm, and while not all ideas are successful,

a culture of innovation will reap significant benefits

How to evaluate innovation andinnovativeness

As the old saying goes, ‘If you want to lead andmanage something, you have to be able to measureit.’ Driving forward on innovation requires a clearstrategy, leading to resourcing of that strategy into operating activities, and clear expectationsand measures of innovativeness. It is possible tomeasure innovativeness at three points: inputs,process intensiveness and outputs. An inputmeasure would answer the following question:relative to a firm that is just pushing out standardsolutions in standard ways, what total effort anddollar resource are we putting into differentiationthrough innovation?

Innovation intensity inside the firm is moredifficult to quantify but it can be assessedqualitatively. Ask your staff whether their keypriority is to push fairly standard solutions toclient needs – with solid productivity and qualitybuilt in – or whether they can and do take thetime to ‘think outside the square’, at least some ofthe time. And in terms of internal process issues,to what extent do they, and you, look for new andbetter ways to run your business operations,marketing activities, and so on?

As to innovation outputs and its performanceimpact, you can make a list of innovations thatyour firm has achieved and, as well as that, anaggregate that enables you to calculate a totalfinancial return outcome. In other words, seek to‘show me the money!’ On this measure, 3M has asone corporate measure the percentage of totalrevenue that comes from new products. 3M insiststhat its divisions achieve over 10 per cent of salesrevenue from new products every year. For servicefirms, this does not mean new contracts or clientsfor whom the same or similar works and projectsare being served up, but new lines of business, newtechniques or new market segments. For example,you could ask, ‘What percentage of this year’srevenue comes from products and service linesthat were not in place last year?’ If it is one or twoper cent, then it is hardly a systematicallyinnovative firm, but if it is more than 10 per centthen it is very likely.

Innovation: much more than invention

Innovation includes the creativity stage whennew ideas are born, but it goes far beyond this.There is a great deal of hard work involved inbringing a new idea to market, no matter howbrilliant the breakthrough might be. Innovationcan be considered as the act of invention plus allthat is involved in commercialisation. The fullinnovation cycle involves everything fromhaving the initial idea to scaling it up to achievecommercial success, and turning the innovationinto economic surplus, or put simply, wealthcreation.

With this in mind, if you have a new idea for anew product or service, what tests should youapply in order to determine the feasibility ofturning that concept into reality? The followinglist of seven key tests may help in yourassessment of its viability:

1. The functionality test: does the new product,service, technology or process provide benefitsin a manner that is clearly superior to existingservices or methods? Can you articulate the‘value proposition’ of what is new and why it isbetter in terms that customers or clients canappreciate?

2. The mass production test: can the concept be mass-produced in volumes and with the consistentquality to its specification in order to satisfythe market need? There have been many ideasthat made it to prototype, but when it cametime to scale up, they failed to be ‘mass-producible’ or proved to be prohibitive from acost perspective.

3. The marketing test: have you determined orassessed demand, and do you have a channel tothe client or consumer base? Many inventorsend up with a garage or warehouse full of theirproducts, because they did not do theirhomework on the marketing test. The wholemarketing mix must be planned as part of the commercialisation process. This includesdesign, branding, pricing, distribution, sales,and other factors.

Innovation: a high value-added strategy 66


4. The intellectual property control test: you have to make decisions around your IP, and eitherbuy, own or licence-in the core technologiesinvolved.

5. The leadership test: do the people involved inthis initiative have the knowledge, skills,experience and courage to take it through tofruition?

6. The ROI (return on investment) test: thisrepresents the financial bottom line of theinnovation. Will it pay? The new concept mustgenerate enough profit to make it worthwhile,including accounting for risk and the timediscounted value of money.

7. Finally, more and more, new concepts mustpass the corporate social responsibility test. Thisis also sometimes referred to as the sustainabledevelopment or sustainability test, and refers to the environmental sustainability of theinitiative and also the social/communityoutcomes. Products, services and technologiesmust now at least not harm the environmentand community, and where possible areadvantaged by producing positive bottom lineoutcomes on these dimensions.

A new product, service, technology or businessprocess must pass all of the above tests and mustbe compelling in the level at which it clears thehurdle on most of them. These tests are useful for inventors, but also for investors who areconsidering the merits of underwriting a newinvention, or for banks which are consideringlending money to fund the development of a newservice or product.

Managing the intellectual property inthe venture

It is important to plan and execute a strategy for how to preserve the core knowledge involvedin a new idea as it is taken to the world. Thereare four generic strategies for attempting tocontrol and maximise value from an invention in taking it through to commercialisation. Firstis to ‘run’ – meaning to simply keep ahead of the competition, by continually updating

technology and designs, such that by the timecompetitors have learned and perhaps copied oradapted your invention, you have already movedit into a new and better phase. Apparel designersoften use a ‘run’ approach, knowing that theirwork will be copied, and rely on continuallycoming up with new ideas for the market.

It may be possible in some circumstances to ‘hide’the core knowledge in an innovation. Famousexamples of this are KFC and Coca Cola. Theyhave kept their recipes secret for many years, andtheir distinctive edge has remained very profitablewhile they have kept their IP under control.

A well-known strategy for protecting knowledgeis to ‘block’ others from using it by using legalmeans such as patents, trademarks and copyrightlaws. These laws exist to provide incentives forfirms and individuals to take risk and invest ininnovative activities, and can be effective inproviding protection. However, they requiresignificant investment, especially when taking outpatents in a substantial number of countries.

The fourth IP strategy is to form a network ofcooperating firms in order to use combinations oftechnologies, which can be called ‘teaming up’. Insome industries such as biotechnology, while asingle firm may only have a part of the technologyneeded to solve a problem and pass thefunctionality test, there may be advantages fromteaming up with other companies that satisfyother tests.

Encouraging innovation inorganisations

For an organisation to be systematicallyinnovative, there are some clear and importantrequirements. First, strong leadership toimplement strategies and policies, offer resourcesto make it happen, and develop a rewards systemto focus staff on innovation. 3M does this verywell. Another key ingredient is the organisation’svaluing of new knowledge, its creation andexploitation. This goes with the tolerance of risk, because the innovative firm must acknow -ledge that not everything it tries will work.

68 Innovation: a high value-added strategy

Indeed, firms that succeed with systematicinnovation will manage a portfolio of investmentsin new activities, and these are professionallyproject-managed so that effective ‘go/no go’decisions are taken at critical stages ofdevelopment. Finally, culture and behaviour areimportant. Staff in innovative companies are welltrained and expected to think outside the square,take calculated risks when appropriate and toshow initiative and tenacity in problem-solving.They are customer and benefit focused.

What benefits arise from innovation?

Many great advances come from new services,products and technological processes. Society-wide benefits are clear and valued. For example,most of us have benefited from penicillinderivatives at some time of our life. But let usconsider the benefits of innovation from thesupply side – what are the benefits to thosebringing the innovation to market? First, there isobviously the revenue growth that comes from theinnovation. For example, think of the monetarygains had by Google, Microsoft, Facebook, 3M’sPostIt notes, Apple’s Ipod and iPhone and theToyota Hybrid Synergy Drive.

A further benefit often comes with a company’sreputation for innovation, in the form of a pricepremium. Apple’s design capability and itsunique products allow it to command suchpremiums over products that are technically asgood, yet don’t carry the innovation credentials.Likewise, some services companies, such asarchitects, engineers and research firms, haveinnovation reputations and so can charge apremium price relative to those competitors thattrot out only standard solutions and designs.Futhermore, being an innovative organisationhelps firms to win the ‘war for talent’ in thelabour market. Most people would rather workin a firm that is doing interesting and excitingthings by investing in new knowledge, thanwork for one that is not. Finally, there is a lot ofevidence over a few decades, which shows thatwhen innovation is done well, there is a soundreturn on investment to firms that areinnovative. Such firms are often 20 per cent to 50 per cent more profitable than the market.

Professor Danny Samson is Professor ofManagement in the Department ofManagement and Marketing at theUniversity of Melbourne. Comments [email protected]

Decision without reason?

Imagine for a moment that you are in your localliquor store, shopping for a bottle of wine. Youhave a delicious meal planned for the evening,and a good bottle of red will add the final touch.Imagine that your gaze falls on two bottles, sideby side on the shelf. One French, and oneGerman. The bottles are a similar price, a similarstyle, and to all intents and purposes, they appearto be of similar quality. You feel that either ofthese will meet your needs, but how do youchoose? Imagine that as you ponder your choice,the sound of a very French piano-accordionmelody gently floats through the store. Will itaffect your choice? And if so, will you be awarethat your choice has been swayed?

Recently, a group of researchers examined exactlythis question, and found striking results. Wineshoppers were roughly three times more likely to purchase wine of the same nationality asbackground music. Striking enough, butcritically, only one of forty-four shoppersinterviewed suggested that the background musicinfluenced their purchase decision, and over three-quarters specifically said that the backgroundmusic did not affect their choice of wine! Howcould they have been so out of touch with theinfluences on their behaviour?

Mounting evidence suggests that the wineshoppers are not alone. Indeed, there is increasingevidence from psychology and neurosciencesresearch to suggest that very few of us are aware ofsome of the main determinants of our decisions.We fancy ourselves as rational decision-makers,able to weigh up the factors relevant to ourdecisions to arrive at reasoned choices. However, itappears that much of our decision-making isdriven by thought processes that occur ‘below-the-surface’. Indeed, increasing evidence suggeststhat much of our decision-making occurs viamechanisms that are inaccessible to our morerational and conscious thought processes.

This mounting evidence provides a majorchallenge for marketing researchers and theindustries they supply with consumer insights.Consumers provide valuable insights toorganisations about their attitudes and likelybehaviour towards products, services and ideas.Communication industries, in particular, areheavily reliant on consumers’ insights to informthe design of marketing communications, such astelevision advertisements. There is ample data tosuggest that such research can provide valuableinsights to organisations, but in the light ofmounting evidence, we must seriously questionthe emphasis we place on consumers’ explicitthoughts regarding their choices.


neuromarketing – marketing insightsfrom neuroimaging research

by phil harris

Increasing evidence suggests that much of our decision-making occurs via mechanisms that are inaccessible to our more rational and

conscious thought processes


Neuroimaging research informsmarketing models

Neuroscience-based research methods areincreasingly being viewed as a means to providethese types of insights. The nascent field of ‘neuro -marketing’ seeks to access the thought processesunderlying decision-making by capturingconsumer responses to marketing materials at themoment they are presented. By examining howdifferent regions of the brain ‘light up’ on a second-by-second basis when exposed to stimuli, andlinking this information with an understanding ofhow different brain areas contribute to thought,this novel approach is providing unique insightson the thought processes underlying choices inreal-world situations.

As an example, consider a recent study examiningneural responses associated with the Coca-Cola®/Pepsi® taste test. Coke and Pepsi are similarcola-flavoured carbonated drinks. The marginallysweeter Pepsi flavour is typically preferred by itscore target market aged between 16 and 24 years.However, this preference is strongest whenconsumers are unaware of the cola brand they are

consuming. In branded tasting tests of Coca-Colaand Pepsi, preferences favour Coke. Since 1975,Pepsi has promoted the ‘Pepsi Challenge’ toemphasise the advantage of the Pepsi taste in orderto provide a rational basis for brand preference.However, neuroimaging research, which hasrecorded the brain’s responses while these factorsare at play, shows the limited role of rationaldecision-making factors in determining overallbrand preference. It provides a fascinating insightinto the mechanics of marketing.

In 2004, researchers replicated the PepsiChallenge while consumers’ brain activity wasrecorded. When consumers sipped cola drinksfrom unlabelled cups, cola preference for eitherbrand activated a region of the brain linked with preferences based on sensory information.The greater the sensation, such as taste, the morethis region of the brain lit up. This responsemirrors the Pepsi Challenge findings when tastealone is used as the basis for choice.

However, what about responses in a morerealistic choice situation? How does the additionof brand information affect choice? The 2004research showed that preferences for Pepsi didnot change when the Pepsi brand was identified,whereas Coke preferences increased. BrandedCoke preferences stimulated activity in acompletely different neural system in the brain,this time associated with long-term memory –memory embedded for life. It appears that asconsumers experience the flavour of Coke,exposure to the Coke brand image evokesassociations that have been stored in long-termmemory circuits. Critically, the memory regionsare strongly connected with brain regions thatbias preference. As a result, associations held inmemory influence other brain areas that respondto taste. Thus, the research shows that byexamining the neural responses associated withbrand effects, we can see the mental mechanics ofthe strongest brand at work.

Emotional influences on decisions

In another recent study, researchers offeredconsumers a choice between familiar beer andcoffee products of similar quality and with similarattributes. In this case, the researchers were

70 Neuromarketing


interested in strategies consumers would use tomake a choice between similar products when the comparison is not well supported by a rationalcomparison of product features. Interestingly,products that were not chosen ‘lit up’ the brainregion associated with the use of reasoningstrategies. In this case, the authors suggest thatwhen consumers applied a rational approach toevaluate products with no tangible differentialadvantage, these products were not favoured.

In contrast, products that were eventually chosen‘lit up’ the brain region linked to the use ofemotional experience to guide decision-making.This region draws on the emotional value ofprevious experiences to subtly bias decision-makingin future encounters. In this case, the authorssuggest that emotional associations with the brand,developed either through exposure to marketingcommunications or actual experience, bias theproduct evaluation process or result in a preferencefor that brand most strongly associated withpositive emotional cues. Note that the evaluationprocess involved comparison of nearly identicalproducts, yet in this case, the decision was based onintangible brand-related factors. In sum, thisfascinating research suggests that two very differenttypes of thought processes underlie consumerdecision-making: a reasoning chain which conductsa rational analysis of purchase factors; and anemotional chain which biases the decision-makingprocess as a result of previous emotional experience.

Figure 1

A growing body of research indicates that subtleemotionally-driven thinking processes perform afundamental role in everyday decision-making.Individuals automatically draw on cues thatreflect the emotional value of stimuli derived fromprevious experience. These automatic processes areso important that without the impact of thesesubtle emotional biases, individuals demonstratepoorly adaptive behaviour in everyday life.

Importantly, this ‘emotional chain’ of decision-making draws on mental processes that, to a largeextent, occur covertly or unconsciously. Consumersmay be simply unaware of the impact of theseemotional biases on decisions. In this connection,the question arises whether research methods thatprobe rational and conscious processes are able to obtain reliable information on consumerbehaviour. For example, common among many ofthe methods used to test the effectiveness ofadvertising stimuli, are survey or interview-basedapproaches which gauge the extent to whichconsumers consciously recall advertising contentand ‘get the message’. In the light of increasingevidence demonstrating an impact on consumers’reactions to advertising and brands at a subtlerneural level, communications research methodsmust adapt to these new insights.

Assessing these emotionally-driven covertconsumer responses presents a formidablechallenge to researchers. However, with increasingevidence of the impact of unconscious thoughtprocesses on behaviour and a growing dissatis -faction with conventional testing methods, thedrive for these unique insights has prompted therise of commercially-oriented marketing researchservices based on brain activity responses.

Neuroscience techniques as tools forbusiness

What are these measures, and how useful are theyfor business? Typically, research firms attemptingto capture these implicit thought processes assessbrain responses to marketing stimuli in the formof electroencephalography (EEG) – the electricalsignal generated by neural regions firing simult -aneously – or by using medical imaging technol ogysuch as magnetic resonance imaging (MRI).

Choice alternatives

Emotionalchain

Reasoningchain

Choice

Image adapted from Deppe, Schwindt, Kugel, Plassman and Kenning (2005)

Reasoningstrategies

Facts

Options Out-comes

Evaluationboost

Evaluationcircle

Covert activation of biases related toprevious emotional

experience with the brand

To collect EEG data, participants are fitted withspecial headgear, which records the electricalsignal on the scalp while viewers are exposed to marketing stimuli. Using this approach,responses of individual brain regions to stimulimay be examined continuously to providediagnostic information regarding the impact ofspecific elements of the marketing stimulus. By contrast, functional MRI (fMRI) researchprovides more detailed but less dynamic‘snapshots’ of brain responses.

Opinions differ regarding the value of thesemeasures in commercial contexts. Proponents ofEEG research point to the unique ability of thesemeasures to reflect dynamic changes in viewerresponses to marketing stimuli. For the first time,advertisers and media organisations may captureaudience responses linked to specific scenes ormessages with little interference from rational andexplicit thought processes.

However, others point to the weak link betweenbrain electrical activity measures collected inmarket research settings and constructs thatusefully predict consumer behaviour. For example,Brian Knutson, professor of neuroscience andpsychology at Stanford University, has likened theuse of EEG for marketing research purposes to‘standing outside a baseball stadium and listeningto the crowd to figure out what happened.’Clearly, the value of brain activity measures forcommercial research is dependent on the extentthat these measures can capture responses incommercially viable settings and still providereliable and useful marketing research constructs.To date, peer-reviewed research literature provideslimited support for the use of these techniques incommercial contexts. At this early stage, the juryis still out regarding the long-term prospects formarket research techniques drawing on brainresponse metrics. Additionally, ethical issuesassociated with the use of brain responses to guidemarketing programs remain an important butrelatively unexplored source of debate.

Neuroimaging methods provide the scope for a better understanding of the complexity ofhuman decision-making processes. Commercialapplication of neuroscience techniques aside,rigorous implementation of these techniques in

academic research contexts will support uniqueinterdisciplinary advances in the application ofmarketing and neuroscience theory. Betterunderstanding of human responses to marketingstimuli will play a key role in the future for more informed policy development regardingmarketing communications and stimuli.Importantly, knowledge gained through the use of these scientific methods will provide bothconsumers and marketers alike with a betterunderstanding of the role played by ubiquitouscommercial stimuli in our everyday decision-making. Fancy a Coke, or Pepsi?

72 Neuromarketing

Dr Phil Harris is a Lecturer in theDepartment of Management and Marketingat the University of Melbourne.

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DisclaimerInsights is published by the University of Melbourne for the Faculty of Economics and Commerce. Opinions published are notnecessarily those of the publisher, printers or editors. The University of Melbourne does not accept responsibility for the accuracyof information contained in this journal. No part of this journal may be reproduced without the permission of the editors.

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Published by the Faculty of Economics and Commerce, November 2008© The University of Melbourne

Melbourne Economicsand Commerce

volume 4 november 2008

Big brother or a fair go By Graham Sewell

Market competitiveness By Bryan Lukas

Accounting induced performance anxiety

By Anne Lillis

Understanding global imbalances By Richard Cooper

An interview with Robert E. LucasBy Ian King

Closing the gap? By Paul Smyth

Forward with fairness By John Denton

Intelligent systems in accounting By Stewart Leech

New agenda for prosperity By Stephen Sedgwick

Real options analysis By Bruce Grundy

Inflation targeting By Guay Lim

New economic geography By Russel Hillberry

Paying doctors to improve health By Anthony Scott

Innovation: high value-added strategy By Danny Samson

Neuromarketing By Phil Harris

INSIGHTS

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