Friday, 16 November 2018

Revised version: Being neoclassical before it was cool to be neoclassical: the case of the theory of the firm

This essay looks at the contribution made by pre-1870 writers to what would later become the neoclassical theory of the firm. In particular it briefly considers the work of Dionysius Lardner, Johann von Thunen, John Stuart Mill, Charles Ellet, Jr. and Antoine Augustin Cournot. The neoclassical theory of the firm should, in many ways, be more properly called the proto-neoclassical theory of the firm

Scott Lincicome: in defense of free trade

From Conversations with Bill Kristol comes this interview with Scott Lincicome on a defense of free trade.
Scott Lincicome is a leading international trade attorney, adjunct scholar at the Cato Institute, and senior visiting lecturer at Duke University. In this Conversation, Lincicome explains the system of free trade agreements and alliances that the U.S. has built over many decades and how the system contributes to peace and prosperity for America. Lincicome also shares his perspective on the renegotiation of NAFTA, the decision not to participate in the Trans-Pacific Partnership (TPP), and other trade agreements. Finally, Kristol and Lincicome consider where Republicans and Democrats stand on trade today—and where the parties are likely to go in the future.

Don Boudreaux on free trade, protectionism, and the China shock

From David Beckworth’s podcast series, Macro Musings comes this audio of an interview with Don Boudreaux on Free Trade, Protectionism, and the China Shock.
Don Boudreaux is a professor of economics at George Mason University as well as the co-director of the Program on the American Economy and Globalization at the Mercatus Center. He joins the show today to talk about the future of trade and globalization. David and Don also discuss the history of protectionism in the US, President Trump’s trade policies, and why the China Shock thesis may signal bad economics.

Thursday, 15 November 2018

Broken market or Broken policy? The unintended Consequences of restrictive planning

Is the title of an article by Paul Cheshire in the National Institute Economic Review, Volume 245, No. 1, August 2018.

The abstract reads:
This paper summarises the evidence from recent research relating to the British Planning system’s impact on the supply of development. Planning serves important economic and social purposes but it is essential to distinguish between restricting development relative to demand in particular places to provide public goods and mitigate market failure in other ways, including ensuring the future ability of cities to expand and maintain a supply of public goods and infrastructure; and an absolute restriction on supply, raising prices of housing and other urban development generally. Evidence is presented that there are at least four separate mechanisms, inbuilt into the British system, which result in a systematic undersupply of land and space for both residential and commercial purposes and that these have had important effects on both our housing market and the wider economy and on welfare more widely defined.
The article's conclusion reads,
The evidence shows, then, that our planning system is restrictive in terms of the overall supply of land and housing space in the aggregate. It is not just locally restrictive in order to preserve land of significant environmental quality which in its unbuilt state generates amenity or has recreational value. Such purely local restrictions are likely to have positive welfare effects although the costs they impose also need to be taken into account. Overall restrictiveness of supply relative to demand, in the absence of such environmental gains, does not increase welfare but does increase the price of housing relative to incomes, so reduces welfare, and has, as we have seen, unintended adverse consequences; for example on the length of commuting.

Our planning system imposes this overall restrictiveness by means of at least four separate mechanisms. Its decision making is systemically restrictive because results of applications and conditions imposed for ‘affordable’ housing are unpredictable, so development risk is increased; it imposes quantitative restrictions on the supply of space (where it is most valued) by its imposition of Green Belts and height controls; its mechanism for deciding how much land to allocate for housing ignores the most important determinant of demand, so systematically undersupplies land; and there is substantial variation in local restrictiveness measuredby the proportion of applications refused.

Since all have the effect of reducing the supply of housing and other development relative to demand this drives up prices in real terms. Not only has this made housing increasingly unaffordable but it has had very regressive distributional effects, especially redistributing assets to older home owners. There are other unintended effectsof more restrictive planning. A more restrictive pattern of local decisions on housing proposals causes a substantial increase over time in the proportion of local homes that are empty. Not only that but greater local restrictivenesssignificantly increases the average length of commutes for those working locally. There is also evidence consistent with Green Belts increasing commuting distances as workers leap frog out to buy less expensive housing space. This increases the spatial extent of cities even if it reduces the footprint of urbanisation.

The extent of the price distortions induced by restrictions on the supply of land and housing mean that there is a misallocation of resources. Even in the US, where overall restrictiveness has historically been considerably less than in Britain, it has been estimated (Hseih and Moretti, 2017) that GDP would have been some 13.5 per cent higher had not restrictions on building slowed the flowof labour to the highest productivity locations over the period 1964 and 2009. No similar estimates have been done for other countries. Cheshire et al. (2015), however, did estimate that the loss of total factor productivity in the supermarket sector in England, as a result of forcing them to locate on particular sites in ‘town centres’, was 32 per cent just between 1996 and 2008. Cheshire and Hilber (2008) estimated that the restriction on the supply of office space in British cities reached the equivalent of a tax on construction costs of 800 per cent in London’s West End and even in less prosperous cities, such as Birmingham, averaged 250 per cent: there is certainly evidence that the economic effects of planning which is generically restrictive, can be large.

To sum up, there seem to be many reasons for concluding that our policies determining housing supply are broken but no obvious reason to conclude that the housing crisis results from a ‘broken housing market’.
So the answer to the question in the title seems to be broken policy. This raises the interesting and important question of, if you did a similar study for New Zealand would you get similar results? I'm very afraid you would. But just how broken are New Zealand's housing policies? And how costly are these blunders?

Housing and the economy

Two minutes on the topic of "Housing and the Economy" from Jagjit Chadha, Director of the National Institute of Economic and Social Research in the UK. The sorts of issues he talks about apply in New Zealand as well as in the UK.

Thursday, 1 November 2018

Being neoclassical before it was cool to be neoclassical: the case of the theory of the firm

This essay looks at the contribution made by pre-1870 writers to what would later become the neoclassical theory of the firm. In particular it briefly considers the work of Dionysius Lardner, Johann von Thunen, John Stuart Mill, Charles Ellet, Jr. and Antoine Augustin Cournot. The neoclassical theory of the firm should, in many ways, be more properly called the proto-neoclassical theory of the firm

Monday, 22 October 2018

JS Mill and the firm

Another, possible, proto-neoclassical, who wrote on the economics of the firm, if not strictly on the theory of the firm, was John Stuart Mill. While Mill is most often thought of as a classical economist, Ekelund and Hebert (2002: 198) argue he can be considered as a proto-neoclassical economist.

According to Schumpeter (1954: 556), Mill introduced the concept of the entrepreneur to the English speaking economics literature. The influence of J. B. Say helped Mill go beyond just analysing the role of the owner of the factors of production and begin focusing on the role of the entrepreneur and on the internal organization of the firm (Zouboulakis 2015: ???).

For Mill, the number of collective organisations, including firms - both investor controlled and co-operatives, would increase as wealth increases,
"[a]s wealth increases and business capacity improves, we may look forward to a great extension of establishments, both for industrial and other purposes, formed by the collective contributions of large numbers ; establishments like those called by the technical name of joint-stock companies, or the associations less formally constituted, which are so numerous in England, to raise funds for public or philanthropic objects, or, lastly, those associations of workpeople either for production, or to buy goods for their common consumption, which are now specially known by the name of co-operative societies" (Mill 1848: 699).
Mill gave the first discussion of joint production and of the importance of the scale of production. With regard to joint production, George Stigler writes,
"Mill clearly formulated the problem of joint production, i.e., production of two or more products in fixed proportions. He gave the complete and correct solution: the sum of the prices of the products must equal their joint cost, and the price of each product is determined by the equality in equilibrium of quantity supplied and quantity demanded" (Stigler 1955: 297).
As to the significance of the scale of production Stigler adds that,
"Mill's chapter (Bk. I, c. IX), " Of production on a large, and production on small, scale", is the first systematic discussion of the economies of scale of the firm to be found in a general economic treatise. It would take us afield to analyse this chapter in detail, but we may point out that Mill was the first economist to notice that one can deduce information on the costs of firms of different sizes from their varying fortunes through time" (Stigler 1955: 298).
Zouboulakis (2015: ???) writes that "[a]mong the advantages of production on a large scale, he [Mill] mentions the more advanced division of labour, the less than proportionate increase of "the expenses of a business”, the greater possibility of investment to "expensive machinery" and ``the saving in the labour of the capitalists themselves" (1848, 132-6)".

Mill also scrutinised the advantages and disadvantages of the joint stock company. "On the one hand, only such a company can afford the amount of capital necessary to build important projects such as a railway, and to guarantee the continuity of such costly and risky business operations such as banking and insurance. On the other hand, he recognizes that "joint stock or associated management" has some disadvantages over ``individual management"" (Zouboulakis 2015: ???). Mill, like Smith, saw the potential for, what today we would call, principal-agent problems in the relationship between the owners and the managers of joint stock companies. The interests of the managers may not be aligned with the interests of the owners. When discussing methods to the alleviate such problems Mill makes the observation that
"[i]n the case of the managers of joint stock companies, and of the superintending and controlling officers in many private establishments, it is a common enough practice to connect their pecuniary interest with the interest of their employers, by giving them part of their remuneration in the form of a percentage on the profits. The personal interest thus given to hired servants is not comparable in intensity to that of the owner of the capital ; but it is sufficient to be a very material stimulus to zeal and carefulness, and, when added to the advantage of superior intelligence, often raises the quality of the service much above that which the generality of masters are capable of rendering to themselves" (Mill 1848: 141).
Interestingly, such observations give Mill more of a proto-modern feel than a proto-neoclassical feel. But, again, like Smith, Mill did not develop his insights into a full-blown theory of the firm.

Refs.:
  • Mill, J.S. (1848). Principles of Political Economy with some of their Applications to Social Philosophy, 7 th edition 1873, re-edited by William J. Ashley 1909, New York: A. Kelley reprint, 1973.
  • Schumpeter, J.A. (1954). History of Economic Analysis, London: Allen & Unwin.
  • Zouboulakis, Michel S. (2015). 'Elements of a Theory of the Firm in Adam Smith and John Stuart Mill'. In George C. Bitros and Nicholas C. Kyriazis (eds.), Essays in Contemporary Economics: A Festschrift in Memory of A. D. Karayiannis (pp. 45-52), Heidelberg: Springer Cham.

Sunday, 21 October 2018

Johnann von Thunen and the (proto)neoclassical theory of the firm

Johnann Theunen has been described as a proto-neoclassical. One reason for this is the, before his time, contribution he made to the theory of the firm. While Dionysius Lardner analysed the firm's output market, Thunen looked at the firm's input markets. He argued that the firm should use inputs up to the point where the value of the marginal product of the input equals the price of that input. His treatment of the issue has become known as the marginal productivity theory of distribution. To illustrate Thunen's argument we will look at the simplest possible model.

We will assume a central marketplace which is surrounded by agricultural land, all of which is of equal fertility. There will be one good, which we call wheat. The landowners hire a single input to production, labour. L units of labour produces W(L) units of wheat. The price of wheat in the marketplace is p while the costs of transporting the wheat to the market is $t per mile per ton. Thus the earnings generated from wheat grown m miles away from the marketplace is p-t.m per ton. Total revenue from the wheat will be W(L).(p-t.m). Assume that the landowner pays workers a wage of w resulting in a total wage bill of w.L. This means that the landowner's profit from producing wheat m miles from the marketplace will be W(L).(p-t. m)-w.L.

Further, assume that the landowner selects L to maximise profits. This results in a problem we can represent mathematically as
max_L W(L).(p-t.m)-w.L
Maximising this objective function with respect to L gives the first order condition,
(dW(L*)/dL).(p-t.m)-w=0
this implies
(dW(L*)/dL).(p-t.m)=w
where dW(L*)/dL is the marginal product of labour and (dW(L*)/dL).(p-t.m) is the value of the marginal product of labour. Equation \ref{thunen} tells the firm it wants to select the level of labour such that the value of the marginal product of labour equals the marginal cost of labour, the wage rate.

Put more generally, a profit maximising firm will choose the level of an input so that the value of the marginal product of the input equals the price of that input. Therefore, from the point of view of a firm, the theory indicates how many units of a factor it should demand.

Blaug (1985: 17-8) sums up Thunen's analysis by saying,
[h]is analysis culminates in the perfectly modern statement that net revenue is maximized when each factor is employed to the point at which its marginal value product (Wert des Mehrertrags) is equalized to its marginal factor cost (Mehranfwand). Although the discussion proceeds in verbal terms, illustrated by numerical examples, Thunen correctly points out that the marginal product of a factor is a partial differential coefficient of a multivariable production function. Moreover, apart from clearly recognizing the distinction between fixed and variable factors, and between the average and the marginal returns of a factor, he took great care to define the inputs of capital, labor, and land in strictly homogeneous units, observing that this condition was rarely obtained in practice--this too was literally more than sixty years ahead of his time.
Refs.:
  • Blaug, Mark (1985). 'The Economics of Johann Von Thunen', Research in the History of Economic Thought and Methodology, 3: 1-25.
  • Thunen, Johann H. (1826; 1850; 1863). Der isolierte Staat in Beziehung auf Landwirtschaft und Nationalokonomie. Pt. I: Untersuchungen uber den Einfluss, den die Getreidepreise, der Reichtum des Bodens und die Abgaben auf den Ackerbau ausuben. Hamburg: Perthes; Pt. II: Der naturgemasse Arbeitslohn und dessen Verhaltniss zum Zinfuss und zur Landrente. Rostock: Leopold; Pt. III: Grundsatze zur Bestimmung der Bodenrente, der vorteilhaftesten Umtriebszeit und des Werts der Holzbestande von verschiedenem Alter fur Kieferwaldungen. Rostock: Leopold. English translation, The Isolated State, Volume 1. Carla Wartenberg, trans. Oxford: Pergamon Press, 1966; Volume 2 in The Frontier Wage. B. W. Dempsey, trans. Chicago: Loyola University Press, 1960.

Wednesday, 10 October 2018

Sam Hammond on co-determination, corporate governance, and the accountable capitalism act

From David Beckworth’s podcast series, Macro Musings comes this audio of an interview with Sam Hammond on Co-Determination, Corporate Governance, and the Accountable Capitalism Act.

Sam Hammond is a policy analyst and covers topics in poverty and welfare for the Niskanen Center. Sam is a previous guest on Macro Musings, and he joins the show today to talk about his new article in National Review which addresses Senator Elizabeth Warren’s new proposal, the Accountable Capitalism Act, and its potentially negative effects. David and Sam also discuss the problematic stereotypes surrounding ‘corporate bigness’, the positive and negative features of co-determination, and why we need universal safety nets.