Hire Workers or Buy a Firm?

An interesting article in the Atlantic got me out of summer vacation mode and inspired me to blog. (Click here for article).

There has been an increase in merger and acquisition activity recently and the author questions why firms would do this when there is so much unemployment. The implication seems to be that firms can grow by buying up another company with its existing employees and capital, or go into the labour market and hire more workers for their own company. Either way the company grows.

The article indicates that the reason lies in uncertainty and the difference between short run and long run decisions. An interesting argument to be sure, but one that does not fit well with either corporate finance theory or with labour market theory.

The answer lies in the speed at which prices adjust, particularly stock prices and wage rates. A decline in economic activity decreases the demand for labour. It also reduces the expected profits of firms and thus the demand for stocks. With no change in supply, a decrease in demand causes prices to fall.

Stocks are homogeneous and the markets for them are very efficient. Labour markets are relatively slow to react. Stock markets reach new equilibriums very quickly based on new information. Labour markets, for a variety of reasons, do not. Unemployment is caused by a decline in labour demand without a fall in price.

Since stock prices adjust faster that labour prices, it is more profitable to acquire an existing firm whose stock price reflects the high wage, than to hire new workers at a wage above equilibrium. This argument is the same with or without uncertainty. Risk only changes the discount rate, not the decision making process.