A voluminous congressional attack on free political speech

A massive new plan unveiled by Democrats is a wish list of restrictions on free political speech. If this kind of attack on free speech can occur in the US why not New Zealand?

Jacob Vigdor on the Seattle Minimum Wage

An interesting discussion of many of the issues to do with the effects of minimum wage increases and how to work them out and estimate how big they are. Well worth the hour to listen to.

Jacob Vigdor of the University of Washington talks with EconTalk host Russ Roberts about the impact of Seattle's minimum wage increases in recent years. Vigdor along with others from the Evans School of Public Policy and Governance have tried to measure the change in employment, hours worked, and wages for low-skilled workers in Seattle. He summarizes those results here arguing that while some workers earned higher wages, some or all of the gains were offset by reductions in hours worked and a reduction in the rate of job creation especially for low-skilled workers.

Partial versus general equilibrium: the theory of the firm example

A point worth making about the modern models of the theory of the firm is that they illustrate a general issue to do with post-1970 microeconomics, namely, the retreat from the use of general equilibrium (GE) models.

Historian of economic thought Roger Backhouse writes that

 “[i]n the 1940s and 1950s general equilibrium theory [ ...] became seen as the central theoretical framework around which economics was based” (Backhouse 2002: 254)

and that by the

“[ ...] early 1960s, confidence in general equilibrium theory, and with it economics as a whole, as at its height, with Debreu’s Theory of Value being widely seen as providing a rigorous, axiomatic framework at the centre of the discipline” (Backhouse 2002: 261), 

but

“[ ...] there were problems that could not be tackled within the Arrow-Debreu framework. These include money (attempts were made to develop a general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models, often dealing only with a specific part of the economy or with a particular problem. The search for ever more general models of general competitive equilibrium, that culminated in Theory of Value, was over” (Backhouse 2002: 262).

As early as 1955 Milton Friedman was suggesting that to deal with “substantive hypotheses about economic phenomena” a move away from Walrasian towards Marshallian analysis was required. When reviewing Walras’s contribution to GE, as developed in Walras’s famous Elements of Pure Economics, Friedman argued,

“[e]conomics not only requires a framework for organizing our ideas [which Walras provides], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall” (Friedman 1955: 908).

By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

All the models considered in this book are partial equilibrium models, but in this regard, the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back, presumably temporarily, on GE theory and has worked almost exclusively within a partial equilibrium framework. This illustrates the point that there is a close relationship between the economic mainstream and the theory of the firm; when the mainstream forgoes general equilibrium, so does the theory of the firm.

One major path of influence from the mainstream of modern economics to the development of the theory of the firm has been via contract theory. But contract theory is an example of the mainstream’s increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of GE. As Salanie (2005: 2) has argued,

“[t]he theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well defined institutional settings”.

The Foss, Lando and Thomsen classification scheme for the theory of the firm clearly illustrates the movement of the current theory of the firm literature away from GE towards partial equilibrium analysis. The scheme divides the contemporary theory into two groups based on which of the standard assumptions of GE theory is violated when modelling issues to do with the firm. The theories are divided into either a principal-agent group, based on violating the ‘symmetric information’ assumption, or an incomplete contracts group, based on the violation of the ‘complete contracts’ assumption. The reference point approach extends the incomplete contracts grouping to situations where ex-post trade is only partially contractible.

The introduction of the entrepreneur, as in the models proposed by Silver, Spulber and by Foss and Klein, also challenges, albeit in a different way, the standard GE model since, as William Baumol noted more than 40 years ago, the entrepreneur has no place in formal neoclassical theory.

“Contrast all this with the entrepreneur’s place in the formal theory. Look for him in the index of some of the most noted of recent writings on value theory, in neoclassical or activity analysis models of the firm. The references are scanty and more often they are totally absent. The theoretical firm is entrepreneurless−the Prince of Denmark has been expunged from the discussion of Hamlet” (Baumol 1968: 66).

The reasons for this are not hard to find. Within the formal model, the ‘firm’ is a production function or production possibilities set, it is simply a means of creating outputs from inputs. Given input prices, technology and demand, the firm maximises profits subject to its production plan being technologically feasible. The firm is modelled as a single agent who faces a set of relatively uncomplicated decisions, e.g. what level of output to produce, how much of each input to utilise etc. Such ‘decisions’ are not decisions at all, they are simple mathematical calculations, implicit in the given conditions. The ‘firm’ can be seen as a set of cost curves and the ‘theory of the firm’ as little more than a calculus problem. In such a world there is a role for a ‘decision maker’ (manager) but no role for an entrepreneur.

The necessity of having to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms or other important economic institutions. Bernard Salanie has noted that,

“[ ...] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models” (Salanie 2005: 1).

This would suggest that to make GE models a ubiquitous tool of microeconomic analysis - including the analysis of issues to do with non-market organisations such as the firm - developing models which can account for information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions and the like is not so much desirable as essential. One catalyst for the development of such a new approach to GE is that partial equilibrium models can obscure the importance of the theory of the firm for overall resource allocation, a point which is more easily appreciated in a GE framework.

Rosolino Candela interviews Peter Boettke on Hayekian ideas

Widely considered as one the most influential economists of the 20th century, F. A. Hayek continues to command the attention of scholars with his life and work. On this episode, Peter Boettke and Rosolino Candela sit down to discuss Boettke's new book F. A. Hayek: Economics, Political Economy and Social Philosophy (Palgrave, 2018). Boettke presents this new book as focusing less on Hayek as an individual and more on Hayekian ideas. Throughout the discussion Boettke and Candela examine Hayek's uniting theme of epistemic institutionalism, the competitive market process, and how Hayek's contemporaries picked up on his work. They also discuss the limitations of 'Big Data' to answer the important questions of social science. These Hayekian ideas, Boettke and Candela contend, are still as pressing and worthy of research today.

Trade: the effects of a border between East and West Germany

From the Peterson Institute for International Economics comes this interview in which Soumaya Keynes and Chad Bown talk with Stephen Redding (Princeton University) about his research on the border between East and West Germany erected in the mid-20th century. They discuss the loss of market access for cities near the border, and how being cut off from one's neighbours affected the local economy. Spoiler: It wasn't pretty ...

Harold Demsetz 1930-2019

Harold Demsetz has passed away. He was a longtime member of the UCLA economics department and one area he wrote on was the theory of the firm. Here he took an anti-Coaseian view of the firm. Ten years ago I wrote on Demsetz's view:

In an provocative and interesting paper written for the Markets, Firms and Property Rights: A Celebration of the Research of Ronald Coase conference, Harold Demsetz articulates a somewhat non-standard view of the firm as it appears in the neo-classical model of the competitive economic system. A common attack, one which I would make, on the neo-classical model is that it has no theory of the firm in it. It is a theory with firms but without a theory of firms. The model has no theory of the structure and methods of firms and no theory of why a firm should even exist in an economy in which prices are treated as the sole guides to the opportunities available for putting resources to work. As Foss, Lando and Thomsen (2000: 632) summarise it:

"The pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist".

Demsetz takes issue with all of this. He argues that the neo-classical model offers both a definition of the firm and a rationalisation for the existence of firms, but, he notes, these are mostly implicit. For Demsetz the concern of the neo-classical model is with the function of the firm. The function is what defines the neo-classical firm: this function being the production of goods and services for purchase by persons who, in the main, are not involved in the production of what they buy. The firm is an institution specialised in production for use by others. The rationale for the existence of firms in this theory is implicit in this function. They exist because specialisation is productive.

But what form does this institution being called the firm take? Demsetz explains that the internal organisation of the firm is largely irrelevant to the neoclassical theory of a private, decentralized economic system. If the firm has no internal organisation, then how does production take place? The view of the firm Demsetz is arguing for is one in which the theoretical task served by the firm is that of creating a grand coordination problem whose resolution is sought in the price system. He argues this view of the firm is very different from that of Ronald Coase. For Coase the firm stands in contrast to the market, it becomes less vertically integrated and less important in the economic system the smaller are the costs of using the price system, ie lower are the costs of using the market. For Demsetz the firm stands in contrast to self-sufficient production within households. The firm becomes more important the lower is the cost of using the market. This is simply because low transaction costs facilitates the substitution of specialised production destined for others for self-sufficient production for oneself. The lower is the cost of using the price system the more effectively firms can bring their products to consumers and the more effective are households in supplying inputs to specialised producers.

I think this still leaves the question of the institutional structure that production takes place in unanswered. If production does not take place via Coase-type firms, how does it take place? Is it, as the Foss, Lando and Thomsen quote above would suggest, taking place via groups of autonomous agents who enter into very elaborate (complete) contracts with each other. That is, production takes place over the market. If this is so it would, in turn, make the firm look, perhaps unsurprisingly, like a "nexus of contracts".

The nexus of contracts view was developed in papers by Alchian and Demsetz (1972), Jensen and Meckling (1976), Barzel (1997), Fama (1980) and Cheung (1983). The important innovation here was to see that it is difficult to draw a line between firms and markets, firms are seen as a special type of market contracting. What distinguishes firms from other forms of market contract is the continuity of the relationship between input owners.

Most famously in the Alchian and Demsetz version of this approach, they argue that the authority relationship between the employer and employee is in no way the defining characteristic of a firm. The employer has no more authority over an employee than a customer has over his grocer. "Firing", of either the employee or grocer, is the ultimate punishment that either the employer or customer can use in cases of "disobedience". Alchian and Demsetz argue that, in economic terms, the customer "firing" his grocer is no different from the employer firing his employee. In both cases one party stops dealing with the other, terminating the "contract" between them. In this approach the firm is seen as little more than a nexus of contracts, special only in its legal standing and characterised by long term nature of the relationship between the input owners. In this approach it is not generally useful to talk about firms as distinctive entities, a nexus of contracts could be called more firm-like if, for example, the residual claimants belong to a concentrated group but the term "firm" has little meaning beyond this.

Would such a burring of the lines between markets and firms make sense within the neo-classical model? Given the implicit use of complete contracts in the neo-classical approach I would argue that it does. Under complete contracts any institutional form is able to mimic any other institutional form. A well known example of this is the neutrality theorems of the theory of privatisation literature, under whichstate-ownership and private ownership of firms results in the same outcome. In the case of the neo-classical model, production via the market would achieve anything that production via (Coase-type) firms could achieve and thus there is no need for (Coase-type firms in the model.

But I'm not sure we are left with a role for a firm of any type in the neo-classical model. If the firm is defined by its function, production for outsiders, in a zero transaction cost world it is not clear to me that we have any form of firm at all. What we have is production via the market, which doesn't result in a real meaning being given to the term "firm".

In the neo-classical model, then, I think we are left with having to take production for outsiders as the definition of the firm, without knowing how that production takes place, or we have to say that the model doesn't really have firms in it at all. The grand coordination problem is resolved by the price system, by the market, but without recourse to firms. Demsetz's definition of the "firm" and his rationalisation for their existence is, if I understand it correctly, a definition and rationalisation for production, but production via the market, without firms.

If we accept this position, then we also have to ask, What meaning can we give to the "household" in the neo-classical model?

Of course it could all just be semantics.

Update: Thinking about this a bit more, I wonder if perhaps another way to see the point I’m trying to make is to follow the Alchian and Demsetz argument a bit further. As noted above Alchian and Demsetz argue that it is meaningless to try to draw a hard line between markets and firms. They go on to say that the reason that firms are special has to do with the technology of team production., that is, production where the individual production functions are inseparable from one another. This gives raise to the problem of free riding since team production can act as a cover for shirking. Alchian and Demsetz’s answer to this principal-agent problem is to appoint a monitor to oversee the workers. So in this framework team production is the underlying reason that the "nexus of contracts" can be considered a firm. But there are no team production or principal-agent problems within the neo-classical framework. So while the neo-classical firm may be a "nexus of contracts", it is a "nexus of contracts" without team production and thus there is no rationale for firm based production as opposed to market based production.

References:

• Alchian, Armen and Demsetz, Harold (1972 ). 'Production , Information Costs, and Economic Organization', American Economic Review, December, v. 62, iss. 5, pp. 777-95.
• Barzel, Yoram (1997). Economic analysis of property rights Second edition. Political Economy of Institutions and Decisions series. Cambridge; New York and Melbourne: Cambridge University Press.
• Cheung, Steven N.S. (1983). 'The Contractual Nature of the Firm', Journal of Law and Economics, 26(1) April: 1-21.
• Fama, Eugene F. (1980). 'Agency Problems and the Theory of the Firm', Journal of Political Economy, April, v. 88, iss. 2, pp. 288-307.
• Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics, Volume III, Cheltenham U.K.: Edward Elgar Publishing Ltd.
• Jensen, Michael C. and Meckling, William H. (1976). 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure', Journal of Financial Economics, October, v. 3, iss. 4, pp. 305-60.

A conversation with Ronald H. Coase

From Newmedia at UFM.edu comes this 2001 video of  A Conversation with Ronald Coase.