Tuesday, 25 December 2007

Incentives matter: Adam Smith file

Adam Smith recognised that in many economic situations incentives matter. Smith's most precise discussion of incentives appeared in An Inquiry into the Nature And Causes of the Wealth of Nations, book 3, chapter 2. Here Smith wanted to explain the discouragement of agriculture in Europe after the fall of the Roman Empire. He described the metayers in the following manner:
The proprietor furnished them with the seed, cattle and instruments of husbandry. The produce was divided equally between the proprietor and the farmer. Smith (1776, book. 3, chap. 2)

Basically the relationship is a form of sharecropping. The metayer cultivates land, owned by a landlord, for a share (usually one half) of its yield, receiving stock, tools, and seed from the land owner.

In Smith's writing on this topic we see discussion of a number of incentive issues. There is the fundamental trade-off between incentives and the distribution of the gains from trade. The metayers get only half of the returns to any investment they make and this limits their incentive to invest. Smith also saw serious incentive problems in the absence of tenants' investment in the land, and in the unobservable misuse of husbandry instruments provided by the proprietor. Smith discusses these issues in the following terms:
It could never, however, be the interest even of this last species of cultivators [the metayers] to lay out, in the further improvement of the land, any part of the little stock they might save from their own share of the produce, because the lord, who laid out nothing, was to get one-half of whatever it produced. ... It might be the interest of metayer to make the land produce as much as could be brought out of it by means of the stock furnished by the proprietor; but it could never be in his interest to mix any part of his own with it. In France ... the proprietors complain that their metayers take every opportunity of employing the master's cattle rather in carriage than in cultivation; because in the one case they get the whole profits for themselves, in the other they share them with their landlords. Smith (1776, book 3, chap. 2.)
The example of the alternative use of the cattle is what is today referred to as a moral hazard problem.

Smith's view of sharecropping coloured economists view of it for the next 200 years. Today sharecropping is thought of as a trade-off between incentives and risk. Farming is risky, in part because of the uncontrollable nature of the weather. What if the metayer paid a fixed rent? This would leave him with maximum exposure to risk, which we assume he would not like, but minimum incentive to shirk, which we assume the landowner would like. On the other hand a fixed wage would provide the metayer with maximum shelter from risk but minimum incentive to do any work. The landowner will maximize her return from a contract by finding the optimal trade-off between providing incentives and providing shelter from risk. In this case farming often takes the form of sharecropping. The metayer gets a fixed share of the returns to the farm, say a half. If returns falls by 100 then the metayer's share falls by 50, not by 100, so there is some insurance against risk. When profit increases by 120 as a result of the metayer's effort the their payoff increases by 60, so there is at least some incentive to supply effort, although it is clearly not the maximum incentive. So we can see sharecropping as a way of handling risk-incentive trade-off.

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