Drunk driving

The Undercover Economist makes the following points about drunk driving,

It has always been difficult to test the effect of alcohol on drivers let loose on the roads. The difficulty is this: if half of all crashes involve drunks, that may be because drinking impairs your driving or it may be because there are a lot of drunks on the road – and we can only guess at how many drunk drivers there are.

But the economists Steven Levitt and Jack Porter realised that it was possible to say more, by looking at how often drunk drivers crashed into each other. If 10 per cent of drivers drink, and if drunk drivers are as safe as any other kind of driver and randomly mixed among the sober drivers, then only 1 per cent of two-vehicle crashes should involve two drunks.

Drunk-on-drunk crashes are much more common than one would expect, given the number of drunk-on-sober crashes, allowing Levitt and Porter to reach firm conclusions about the risks of drink driving.

They find a very large effect. Drivers who have been drinking are seven times more likely to cause a fatal crash; those who have drunk over the legal limit (in the US) are 13 times more likely to cause a fatal crash. You might also bear in mind another finding from the paper: "The great majority of alcohol-related driving fatalities occur to the drinking drivers themselves and their passengers." That should be sobering.

Perspective on Trade

Don Boudreaux at Cafe Hayek tries to clear up a misunderstanding on the nature of the effects of trade on people. He writes,

Of course freer trade almost surely reduces, at least for a time, the incomes of some producers, but such a downside is in no way unique to trade. It is true of almost any economic change and of competition.

And adds

When the population ages and buys fewer baby diapers and toy rattles, some workers in diaper and rattle factories are likely harmed. When computers replace typewriters, some workers in typewriter factories are harmed. When the latest fad diet sweeps the country, some producers and retailers of the newly verboten foods are harmed.

Boudreaux then makes two points in response,

First, the fact that economic change causes some immediate losses to some persons does not, standing alone, create a presumption in favor of skepticism, or even of agnosticism, toward economic change -- a skepticism or agnosticism that mindlessly intones that the reality of such losses must in any real-world case be weighed against the benefits in order to "see" if economic change is good or not good. Second and relatedly, the immediate consequences of economic change are not the only consequences; the long-run consequences are real and they matter; they, too, must be reckoned when we make claims about economic change and policies proposed to govern it.

What if Paul Krugman were right about trade and wages?

Tyler Cowen has his say on the recent New York Times article by Paul Krugman on trade and wages. See here for more on that article.

Incentives matter: Adam Smith file 2

When writing about slavery Adam Smith pointed out the lack of proper incentives,

[Tlhe work done by slaves, though it appears to cost only their maintenance, is in the end the dearest of any. A person who can acquire no property, can have no other interest but to eat as much, and to labour as little as possible. Smith (1776, book. 3, chap. 2)

The idea that slavery was therefore inefficient became the standard view in economics following Smith. As Robert Fogel has written in his book "The Slavery Debates, 1952-1990: A Retrospective",

Since a long list of public figures, historians, and economists, dating back to Benjamin Franklin and Adam Smith, had argued that slave labor was quite inefficient, and since this view was in varying degrees embraced by all of the reigning historians, we had little reason to doubt that this was the case.

He goes on to say,

Early in 1968, [Stanley] Engerman and I decided to measure just how much less efficient southern slave agriculture was than the northern system of free family farming. The project seemed straightforward. Economists had for some time been working on the problem of how to compare the relative efficiency of two economies or two sectors of the same economy. In this connection they had devised an index (called "the geometric index of total factor productivity") that was relatively easy to compute. We did not feel that we needed a very precise version of this index. Something that gave us a rough idea of the relative level of the inefficiency of southern agriculture was good enough. For such a task, we thought, the data on agricultural production in the published census of 1860 would do. The whole enterprise could be completed in a few weeks.

The only problem was the result of the enterprise. Their crude index showed that southern slavery based agriculture was 9% more efficient than free northern agriculture. Not what Smith would have thought. And not what Engerman and Fogel thought. So they set about reworking their analysis, only to find that the advantage of slave agriculture rose to 39%. Fogel continues,

Still, the result did not sit well with us and we did not rule out the possibility that we had fallen into some unsuspected analytical trap. Our instincts continued to resist the implications of our findings. How could a system so impoverished in labor skills be efficient? How were the masters and the overseers able to overcome the indisputable sluggishness of the slave labor force, whether this sluggishness was because slaves had been reduced to Sambos, as Stanley Elkins believed, or because of their resistance to exploitation, as Kenneth Stampp argued. How could one account for the peculiar dichotomy under which slave labor apparently was quite efficient in an agricultural setting but by all accounts so inefficient in the city that urban slavery was on the verge of collapse?

The effort to resolve these issues led to Engerman and Fogel's controversial book "Time on the Cross" and the now huge literature that followed.

Krugman vs Krugman

Paul Krugman has a column in the New York Times in which he argues that while trade makes the US wealthier overall it will reduce the incomes of a majority of workers. On his blog Greg Mankiw makes two points in response to Krugman. The first being that the numbers underlying Krugman's argument are omitted from the column, leaving a critical reader to wonder about the magnitude of the claimed negative effects and the size of the affected worker population. The second being that Krugman seems to be struggling with the implications of this outlook.

It seems to me that Paul is still struggling with the implications of this view. He concludes the column by saying, twice, that he is not a protectionist, but he also says that we should respect "those who are worried about trade." But what if those who are worried about trade are protectionists? Should we still respect them?

The response from the Free Exchange blog is here, while at Cafe Hayek Don Boudreaux makes the point that back in the mid-90s a famous trade economist argued that concern with the pauper-labour theory for why trade with low-wage countries is likely to harm typical workers in high-wage countries, which Krugman's column restates, is misplaced,

In a 1996 essay, this economist - responding to a protectionist who fretted that western trade with low-wage countries would harm workers in the west - wrote that this protectionist "offers us no more than the classic 'pauper labor' fallacy, the fallacy that Ricardo dealt with when he first stated the idea, and which is a staple of even first-year courses in economics. In fact, one never teaches the Ricardian model without emphasizing precisely the way that model refutes the claim that competition from low-wage countries is necessarily a bad thing, that it shows how trade can be mutually beneficial regardless of differences in wage rates."

The famous trade economist is none other than Paul Krugman. Krugman could give the Keynes reply, "When the facts change, I change my mind. What do you do, sir?". But, as Mankiw states, we are not given the facts; so how do we know they have changed?

Why is New Zealand poorer than Australia?

Tyler Cowen asks this question at Marginal Revolution. His argument is,

Via Craig Newmark, here is one short article. the conclusion:

"Prosperity does not come by accident," Mr Rennie said. "Australia has a stronger political consensus around policies for growth, which contributes to investor confidence."

Sorry but I can't buy it. Throughout the 1990s New Zealand economic policy probably "led" Australian policy, yet Australia has gained on New Zealand since that time. I'll instead cite booming resource prices (there is more gain in selling minerals to China than agricultural products), economies of scale from having a larger country, and most of all the Kiwi brain drain. In percentage terms, many more of the smartest New Zealanders leave their home country -- often for Australia I might add -- than vice versa.

I'm not sure New Zealand did lead Australian policy in the 90s, may be we did in the 80s. But one thing Cowen misses is that New Zealand's growth rate has be less than that of Australia for the most part for over 100 years, this is not new. As Greasley and Oxley show in "Growing Apart? Australia and New Zealand Growth Experiences, 1870-1993", New Zealand Economic Papers; 33(2), December 1999, pages 1-13. "New Zealand's growth performance rejects both convergence and catching-up with Australia" and "... the New Zealand data is incompatible with her belonging to a trans-Tasman Convergence Club. A conjunction of smaller size, more insular economic policies, and a less favourable resource endowment distinguishes New Zealand's economic development from Australia's." To answer Cowen's question we must look at a time horizon longer than just the post 1990 period.

Robert Rosenthal Memorial Lecture for 2006 and 2007

Marshall Jevons at The Bayesian Heresy provides links to videos of Boston University's Department of Economics Robert Rosenthal Memorial Lecture for 2006 and 2007:

Jean Tirole, "Economic Incentives, Self Motivation, and Social Pressure"

Alvin E. Roth, "What Have We Learned From Market Design"

Incentives matter: regulation file

There is a new NBER working paper out by Severin Borenstein, Meghan Busse and Ryan Kellogg dealing with "Principal-agent Incentives, Excess Caution, and Market Inefficiency: Evidence From Utility Regulation". (NBER Working Paper No. 13679, Issued in December 2007)

The abstract reads,

Regulators and firms often use incentive schemes to attract skillful agents and to induce them to put forth effort in pursuit of the principals' goals. Incentive schemes that reward skill and effort, however, may also punish agents for adverse outcomes beyond their control. As a result, such schemes may induce inefficient behavior, as agents try to avoid actions that might make it easier to directly associate a bad outcome with their decisions. In this paper, we study how such caution on the part of individual agents may lead to inefficient market outcomes, focusing on the context of natural gas procurement by regulated public utilities. We posit that a regulated natural gas distribution company may, due to regulatory incentives, engage in excessively cautious behavior by foregoing surplus-increasing gas trades that could be seen ex post as having caused supply curtailments to its customers. We derive testable implications of such behavior and show that the theory is supported empirically in ways that cannot be explained by conventional price risk aversion or other explanations. Furthermore, we demonstrate that the reduction in efficient trade caused by the regulatory mechanism is most severe during periods of relatively high demand and low supply, when the benefits of trade would be greatest.

Bureaucrats vs. cats

This from Daniel J. Mitchell at Cato@Liberty,

Tens of millions of Americans have cats in their homes, notwithstanding the possibility that some cat hair may get in their food. Bureaucrats in New York City, however, want to save consumers from this horrifying possiblity, so they fine store owners who keep cats on their premises. But the Grinches at the Health Department fail to realize that the cats are the most effective way of controlling rodents. This creates a no-win situation for entrepreneurs. They can keep a cat in the store and risk getting fined, or they can go without a cat and get fined for rodent infestation.

I can't help thinking cats are nicer than rats ... and bureaucrats.

Unintended consequences

One of the worst blights on humanity is the continued existence of slavery. In his book "Discover Your Inner Economist: Use Incentives to Fall in Love, Survive Your Next Meeting, and Motivate Your Dentist" Tyler Cowen has the following example of one attempt to deal with the suffering associated with it,

Nicholas Kristof, a reporter at the New York Times, had a novel idea for how to reduce suffering. He got on a plane to Cambodia and decided to buy and free two slaves. It cost him $150 and $203, respectively, to free each slave, plus of course plane fare and expenses. The girls were, most likely, otherwise destined to lives of prostitution, rape and quite possibly AIDS. A number of charities have been buying and freeing slaves in Sudan.

This sounds, and is, virtuous, but is it the answer to slavery? On a large scale there is a danger with such a policy. If we buy out a large number of slaves we bid up the price of slaves. This makes slavery an even more profitable business to be in than it already is. Which is not what we want. Any increase in the profits from slavery would lead to even more victims becoming enslaved. It may mean that a given person is a slave for a shorter period of time but more people would becomes slaves for that shorter period. This honest and well meaning attempt to deal with the problem could be counterproductive, we may end up with a bigger problem than we started with.

Adverse Selection, Gresham's Law, and the Austrian School

At The Austrian Economists blog Peter Boettke has a follow up posting to his earlier question "Do People Say Silly Things About Monetarism, New Institutionalism, and Public Choice as well?" In this new posting Boettke writes,

I asked earlier why critics of Austrian economics tend to focus on the least charitable reading of the position held within the school. But today I'd like to ask why the Austrian School of Economics often appeals to individuals who lack the intellectual prowess to make scientific contributions and the good sense to get along with others rather than antagonize them.

I just hope it's not true !!!!!!!

From Greg Mankiw's blog,

What my kids got for Christmas

Comic books from the New York Fed (plus a few other things).

Father Christmas???

From Alex Tabarrok at Marginal Revolution,

A conversation between the 6yr old and the 9yr old.

"Big fat man. Flying reindeer. All around the world in one night. That's crazy."

"Yeah."

"But who does bring the presents? Do you think Daddy brings the presents?"

"Nah, if it was Daddy we would just get cash."

Got to be the kids of an economist!

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.

Let the Fed do its work?

In his latest New York Times article Greg Mankiw tell us "How to Avoid Recession? Let the Fed Work". Peter Boettke at The Austrian Economists isn't so sure about the Fed, if fact he asks "What Happens When The 'Cure' is Actually the 'Cause'?"

Questions you dare not ask (updated)

There are some questions even Tyler Cowen hesitates to ask, like this one,

The question is, when inflation comes, why doesn't the expectation of that inflation lead to proportional increases in nominal interest rates, thus keeping the real rate constant? The studies I've seen all indicate a less than one-to-one Fisher effect.

Tyler offers six possible explanations here.

Update: Arnold Kling puts his two cents worth in.

Just stop printing money

The Scotsman newspaper has an article stating that Zimbabwe has introduced three new bank notes, a Z$250,000 note, a Z$500,000 note and a Z$750,000 note. But none of them is enough to buy you a single loaf of bread. The article also says that "Officially, Z$750,000 is worth £12.50. But at this week's widely-used parallel exchange rates, it is worth about 8p."

The importance of information

That information matters, or rather that asymmetric information matters, is one of the most obvious, if not fully appreciated, ideas in economics. While reading Charles Wheelan's book "Naked Economics: Undressing the Dismal Science" I came across a nice illustration of this. Wheelan begins his chapter on the economics of information with the following story:

"When Bill Clinton ran for president in 1992, he floated the idea of Hope Scholarshps. The Clinton plan (based on an earlier experiment at Yale) was seemingly elegant: Students could borrow money for college and then repay the loans after graduation with a percentage of their annual income rather than the usual fixed payments of principal plus interest. Graduates who went on to become investment bankers would owe more in student loans than graduates who counseled disadvantaged teens in poor neighborhoods, which was exactly the point. The plan was designed to address the concern that students graduating with large debts are forced to do well rather than do good. After all, it is hard to become a teacher or a social worker after graduating with $50,000 in student loans.

In theory, the program would finance itself. Administrators could determine the average postgraduation salary for eligible students and then calculate the percentage of income they would have to pay in order for the program to recoup its costs-say 1.5 percent of annual income for fifteen years. Students who became brain surgeons would pay back more than average; students who fought tropical diseases in Togo would pay less. On average, the high and low earners would cancel each other out and the program would break even."

But as Wheelan points out there is a problem here. To make this scheme work it would need an ongoing government subsidy. Why? The answer is, of course, asymmetric information. Students know more about what they want to do after university than the administrators of the loan scheme do. The students can use this information to help them estimate whether or not the Hope Scholarship would be more or less expensive for them than a conventional loan. If you are an aspiring Wall Street baron, or the next Bill Gates, the Scholarship would be a bad idea. Who wants to pay back, say, 1.5% of $5 million, or what ever Wall Street tycoons make, when a normal loan would be cheaper. On the other hand, for a future kindergarten teacher or volunteer social worker, a Hope Scholarship looks great, their repayments would be less than on a conventional loan.

The scheme suffers from adverse selection. Future graduates sort themselves into or out of the program based, in part, on their private information about their career plans. The Hope scheme attracts mainly those with low future earning prospects. The repayment calculations, based on the average postgraduate wage, are no longer relevant and the program is unable to cover its costs. Wheelan notes that the Yale experiment, on which the Clinton plan was based, was closed down after five years, both because repayments were less than projections and because the schemes running costs were prohibitive.

Perhaps this helps answer Stephen Dubner's question 'What Does A Presidential Candidate's Economic Adviser Actually Do?' They can explain adverse selection to their candidate.

Dollar parity between the U.S. and Canada and duty on clothes

This story from Tyler Cowen at Marginal Revolution. Tyler writes,

Canadian shoppers taking advantage of the parity between the U.S. and Canadian dollars are leaving behind more than cash when the head home.

They're leaving behind their old clothes.

Some Canadian shoppers wear their new clothes home to avoid paying a duty when they cross back into Canada. The old clothes get left behind in parking lots, dressing rooms and restrooms at malls and shopping plazas in the Buffalo-Niagara Falls region.

At the Fashion Outlets mall just outside the city of Niagara Falls, managers have placed collection bins near the exits where Canadians customers can deposit their unwanted items.

Why not competing commodity currencies?

Over the past week or so the blogger Megan McArdle has offered several critiques of the gold standard and particularly Ron Paul's case for it, see for example, here, here, here, here, here and here. In response Pete Boettke at The Austrian Economists has suggested that she should read what George Selgin and Larry White have written on the topic of competitive monetary regimes. Now Larry White himself has jumped in over at Division of Labour.

Boettke asks a good question.

Peter Boettke at The Austrian Economists blog asks "Do People Say Silly Things About Monetarism, New Institutionalism, and Public Choice as well?" The reason he asks this is,

... because it seems to me that people feel very free to say things about Austrian economics that they would never say about other schools of thought. And, I cannot really understand why.

My answer would yes. Economics seems to be a subject about which people say silly things no matter what school of thought they claim to be a member of. Economists tend to know well only the areas in which they work and thus can say stupid things when they go outside their areas. This is just a result of us taking advantage of the division of labour, we know a lot about a little. While non-economists tend to know very little about a lot and thus just don't know (or don't care) that they are not making sense. Do you really think that Hillary Clinton believes the comments she made on trade in the recent interview with the FT? Or is she just vote chasing? Also, and I think this is a problem in particular for the Austrian school, some supporters of schools teat their beliefs more as a religion than a science.

Incentives: Alex Tabarrok version

Over at Marinal Revolution Alex Tabarrok tells us:

When I come to my office, I take my sweater off. When I go home, I put my sweater back on.

The relationship between English and the entrepreneur

Over at Free exchange they are asking "But what's the English word for entrepreneur?". They point to new reseach that argues that the US and the UK "maintain an interesting dominance over other vital aspects of modern cultural and economic life. According to new research presented at VoxEU, nearly three quarters of the world's most highly-cited researchers (hereafter HCRs) work in America or Britain (with America alone accounting for 66 percent of such researchers). The wealth is shared with former British colonial possessions; when ranked by top researchers per million inhabitants, Australia, Canada, and New Zealand join America and Britain in the top ten."

The reason for this is, according to the authors of the VoxEU study, "two principle factors: the institutional design of "Anglo-Saxon" universities (emphasising efficiency and performance), and a nation's English-language proficiency. Many of the other high performers are northern European nations with high levels of English proficiency, and Israel also makes the top ten."

Mankiw on carbon tax

On his blog Greg Mankiw notes that National Public Radio have an interview with Greg Mankiw on the reasons he supports a carbon tax.

Kennedy on Adam Smith: Proto-Austrian

Yesterday I noted Peter Klein's posting on Adam Smith: Proto-Austrian? Now Gavin Kennedy at Adam Smith's Lost Legacy has entered the debate. Kenendy take issue with two paragraphs in Klein's message:

'Mises and Hayek admired Smith as a social theorist and system builder while rejecting much of his technical apparatus, especially the labor theory of value.'

and

'In "Adam Smith's System of Natural Liberty: Competition, Contestability and Market Process" Bradley characterizes Smith's system of "perfect liberty" as an ancestor of the Austrian model of the competitive market process, not the neoclassical model of perfect competition.'

Kennedy responds,

'Given that ever one of Adam Smith's contemporaries, including John Locke before him, and his successors, Malthus and Ricardo, were far more firmly attached to the labour theory of value, particularly as an embodied value inside the product, I am astonished that they [the Austrians] pick on Adam Smith, whose commitment to labour as a measure of value was tenuous to put it at its strongest.'

and

'It is somewhat misleading to state: 'Smith's system of "perfect liberty" as an ancestor of the Austrian model of the competitive market process’. This is a fairly common association, though it is inaccurate. Some neoclassical economists refer to Natural Law theories as if they are identical with perfect competition. If Austrians are stopping short of that and confining the association to an 'ancestor' of a 'competitive market process', the problem remain.

Adam Smith was taught 'Natural Law' theories by Francis Hutcheson in the Scotch philosophical tradition passed on from Grotius, Pufendorf and Carmichael. This theory was not Adam Smith's; he taught Natural Law in the Scotch tradition; apparently 'Bradley' is either forgetful, or is not acquainted with the authors of the theory.

The theory was about jurisprudence, not competition in commercial society. In fact Natural Law rights applied, in theory, to any type of society and were independent of the form of government.'

Cowen v. Hanson

At Free Exchange they are commenting on the ongoing debate between Tyler Cowen and Robin Hanson on method in economics. They write,

Mr Hanson's answer to the following question sets their differences in relief:

For good policy advice, what is the best weight to place on economic theory, versus (individual or cultural) intuitive judgment?

Mr Hanson:

My guess is over 75% weight, so I try to mostly just straightforwardly apply economic theory, adding little personal or cultural judgment.

Mr Cowen replies:

Theories are always applied and interpreted through our personal and cultural filters and there is no other way it can be. Robin believes in an Archimedean point for using theory, I do not.

Adam Smith: Proto-Austrian?

Peter Klein at Organizations and Markets raises the always controversial question of the relationship between Adam Smith and the Austrians. Klein points out the fact that "Austrian economists have mixed views on Adam Smith and classical economics. Mises and Hayek admired Smith as a social theorist and system builder while rejecting much of his technical apparatus, especially the labo[u]r theory of value. Menger taught Smithian political economy to his most famous pupil, Crown Prince Rudolf. Rothbard considered Smith grossly overrated."

But Klein also points to a new paper by Michael Bradley in which Bradley argues that the distinction between classical and Austrian analysis is overdone. "Bradley characterizes Smith's system of "perfect liberty" as an ancestor of the Austrian model of the competitive market process, not the neoclassical model of perfect competition. "[F]or the classical economists from Smith to Cairnes, the only explicit properties of 'perfect liberty' are resource mobility and freedom of entry and exit. The other assumed properties of perfect competition [perfectly elastic demand and supply curves, complete and perfect information, identical products, etc.] are either implicit in, or absent from the classical literature."."

Incentives Matter: Pretrial Release Edition

This from E. Frank Stephenson at Division of Labour;

From the Bureau of Justice Statistics:

Compared to release on recognizance, defendants on financial release were more likely to make all scheduled court appearances. Defendants released on an unsecured bond or as part of an emergency release were most likely to have a bench warrant issued because they failed to appear in court.

Flat Tax

Over at Cato-at-liberty they have two messages to do with flat tax. The first points out that Bulgaria Now an Official Member of the Flat Tax Club:

The Sofia News Agency reports that a 10 percent flat tax has cleared a final hurdle in the Bulgarian Parliament. The article notes that the new tax system requires a signature from the President, but this is expected to be a formality.

The second notes that Swiss Canton Voters Overwhelmingly Adopt 1.8 Percent Flat Tax,

More than 90 percent of voters in the Swiss Canton of Obwalden have voted for a flat tax of just 1.8 percent. This is positive news for tax competition within Switzerland, and it doubtlessly will put even more pressure on Europe’s welfare states to reform oppressive tax regimes. Presumably voters in other Cantons will now petition for a chance to vote for low-rate flat tax systems, and maybe it is just a matter of time 'til one of them decides to completely eliminate the income tax.

Fat Tax

The Press in Christchurch had a nice article in its business section on Monday by economist Eric Crampton pointing out that the idea of a "fat tax" is both bad economics and poor policy. Crampton attacks the case for taxing fatty food based on fiscal externalities. He points out that to deal with such problems would require a huge range of taxes and subsidies on almost very activity anyone could possibly be involved in. It would be hugely costly to administer and dangerous in terms of personal liberty. The optimal solution may be to do away with the public health system and have people take out private insurance. Optimal insurance rates would reflect your lifestyle. If you don't like the idea of getting rid of the public health system because of the inefficiencies that result from it, then the answer is to learn live with the externalities. The costs of dealing with the problems would be greater than the costs of living with them.

The article is well worth reading, but doesn't seem to be online, so you will need to find page B2 of The Press for Monday 17/12/07.

Incentives matter: academic version

This from the insidehighered.com website

"A series of new policies in the humanities and the social sciences at Harvard University are premised on the idea that professors need the ticking clock, too. For the last two years, the university has announced that for every five graduate students in years eight or higher of a Ph.D. program, the department would lose one admissions slot for a new doctoral student. The results were immediate: In numerous departments that had for years had large clusters of Ph.D. students taking eight or more years to finish, professors reached out to students and doctorates were completed."

Incentives matter: another example

This example comes from a review by John Blundell of "Freakonomics: A Rogue Economist Explores the Hidden Side of Everything" by S D Levitt & S J Dubner at the Institute of Economic Affairs website. Blundell writes

"Jeremy Bentham too came to mind as he stood by Millbank prison on the bank of the Thames watching boatloads of convicts head for the penal colony Australia. "50% will die en route!" he lamented. "How do you pay the captains?" asked his economist chum Thomas Hodgkin. "Per head loaded" said Bentham. "You idiot" said Hodgkin "Make it per head landed!" Well they did and survival went up to 98%. Under their new set of incentives captains loaded fewer prisoners, fed them better and [for better or worse] had a doctor on board."

The UN's Human Development Index: A Critique

Richard Posner and Gary Becker offer their critiques of the UN's Human Development Index; Poser's is here while Becker's comments are here.

Incentives matter: history file

The province of Canterbury in New Zealand was founded by a private company, The Canterbury Association, headed by Edward Gibbon Wakefield and John Robert Godley. The Association sent four ships from England to the port of Lyttelton for the settlement of Canterbury and its main town, Christchurch. The Association paid for a chaplain, a surgeon and a schoolmaster for each of the ships. The interesting point of the doctor's contract is that he received 10 shillings for every passenger who arrived safely at Lyttelton, but had to pay back 20 shillings for every passenger who died. Moral hazard was recognised even in 1850.

No blood for oil

Over at EconLog Bryan Caplan takes on the issue of "blood for oil", he writes;

Stephen Smith makes an argument that seems popular across a wide swath of the political spectrum:

Yeah, and how many billion dollars per year does the United States need to spend even on just the military to make this oil available? How much does it cost just to perpetuate the House of Saud?

The left-wing take on this argument is that it's bad to spend blood for oil; the right-wing take is that it's good (or at least necessary) to spend blood for oil, and we should just face facts. In a recent piece in Public Choice, however, I argue that - whatever else you think about U.S. foreign policy in the Middle East - it's an economically illiterate way to get oil.

And he's right, it is an economically illiterate way to get oil. Think about it this way, its just the theory of the firm writ large. Invasion amounts to a form of vertical integration, a very hostile takeover. That is, one "firm", the US, wants to vertically integrate with another "firm", Iraq, who is a supplier of an input for US production, oil. The question is does integration make sense? In a world of incomplete contracts we know integration makes economic sense when there is a possibility of a hold-up problem due to the relationship specific nature of investments. Given that oil is an more or less homogeneous good and there are a number of different supplies it is not clear what relationship specific investments have to be made and thus its not clear what the danger of hold-up is. Or to put it another way, our two firms should merge if they have highly complementary assets and not merge if they have independent asserts. Given there are a number of other supplies of oil its not obvious that oil from Iraq is highly complementary to US assets. If you think of this as a "make" - invade Iraq - or "buy" - purchase on the open market - decision, its not clear why a "make" decision is optimal.

Interview with Eugene Fama

From the Federal Reserve Bank of Minneapolis's "The Region" magazine comes an interview with Eugene Fama. The interview covers many of the areas that Fama has worked on. Topics covered include Principal-Agent Issues, CEO Compensation, Efficient Market Theory, Irrational Exuberance, International Equity Markets, Has Fama Softened? Dimemsional Fund Advisors, Three-Factor Model, Momentum, Housing Markets, Credit Markets, New Financial Technologies, Equity Premimum, Are Banks Still Special?, SSRN, Finance/Macro, Time Allocation.

On threat of outside takeovers Fama says

... it's a unique discipline that corporations have that other forms of organization don't have. For example, it’s very difficult to attack the University of Chicago in that way. It doesn't need a takeover defense because there’s no real way to attack it. For a corporation, on the other hand, there was a way. That allowed corporations to have expert boards because the board wasn't the court of last resort. But the institution of all antitakeover amendments threw a wrench in the process.

On CEO compensation he says

If the [compensation] process gets captured by the CEO, then it can get corrupted. But if what you're seeing is a market wage, then I don't know why you would say it's too high. If it's a market wage, it's a market wage. I don't know of any solid evidence that the process was corrupted. So my premise would be that you're just looking at market wages. They may be big numbers; that's not saying they're too high. It's easy to say that people are paid too much, but when you're on the other side of the fence trying to hire high-level corporate managers, it turns out not to be so easy.

Bebchuk and Fried would seem to offer evidence that the compensation process is corrupted. The Bebchuk and Fried view is that, in fact, the process has been captured by CEOs. Their whole point is that executives use the power they have to pay themselves large amounts which are not related to performance. Pay is not being determined by the market.

Central bank independence

Many counties today have what is called an independent central bank. But as this article by Alister McFarquhar from the Adam Smith Institute argues that independence may be purely cosmetic. McFarquhar points out that in the UK the Bank of England is "... culpable when inflation targets are missed, but when they try to avoid moral hazard by not bailing out Northern Rock, the Treasury takes over." For McFarquhar what this shows is the weakness of ex-chancellor, now PM, Gordon Brown's tripartite system of financial regulation where the boundaries are blurred and the Treasury maintains close control, thereby nullifying the "independence" of the Bank of England.

Carter on cotton

Johan Norberg comments on the economic understand (or rather the lack of) of ex-president Jimmy Carter. Carter understands that cotton subsidies in the US hurt cotton farmers in Africa (this bit is good) but still some how comes out in favour of subsidies! (not so good) Carter's reasoning is

"Cotton production costs 73 cents per pound in the United States and only 21 cents per pound in West Africa, so American farmers do need protection in the international marketplace."

Back to econ101, Mr President.

Leaving Economics Be: Accepting the market, with all its limitations.

Greg Mankiw offers a link to an article in the Harvard Independent by Joseph Jampel on the alternatives to cost-benefit analysis.

Battle on the left

Dani Rodrik blogs on the difference between Joe Stiglitz's views on development and his. One may ask what is Joe's vew?

Econ Bashing

A nice example of econ bashing is pointed out by Nicolai Foss over at Organizations and Markets.

How do the right and left differ?

On his blog Greg Mankiw tells us that he asks this question in his first year economics class. A summary of his reasons for the fact that right-leaning and left-leaning economists differ in their policy views, even though they share an intellectual framework for analysis, is given below:

1) The right sees large deadweight losses associated with taxation and, therefore, is worried about the growth of government as a share in the economy. The left sees smaller elasticities of supply and demand and, therefore, is less worried about the distortionary effect of taxes.

2) The right sees externalities as an occasional market failure that calls for government intervention, but sees this as relatively rare exception to the general rule that markets lead to efficient allocations. The left sees externalities as more pervasive.

3) The right sees competition as a pervasive feature of the economy and market power as typically limited both in magnitude and duration. The left sees large corporations with substantial degrees of monopoly power that need to be checked by active antitrust policy.

4) The right sees people as largely rational, doing the best the can given the constraints they face. The left sees people making systematic errors and believe that it is the government role’s to protect people from their own mistakes.

5) The right sees government as a terribly inefficient mechanism for allocating resources, subject to special-interest politics at best and rampant corruption at worst. The left sees government as the main institution that can counterbalance the effects of the all-too-powerful marketplace.

6) There is one last issue that divides the right and the left—perhaps the most important one. That concerns the issue of income distribution. Is the market-based distribution of income fair or unfair, and if unfair, what should the government do about it?

More on Smith and the size of government

Earlier I linked to a comment by Gavin Kennedy at the Adam Smith's Lost Legacy blog on the question Did Adam Smith Favour Large Government? Kennedy continues his discussion in The Boundary of Government Spending is a Political Decision

The carbon cost of Christmas

Tim Harford, the Undercover Economist, looks at the the carbon cost of Christmas. And the cost? "2.5p per reveller"!

Did Adam Smith Favour Large Government?

Another interesting question about Adam Smith's thought from the Adam Smith's Lost Legacy blog. Gavin Kennedy aims to put Smith's ideas on the role of government into context. Smith was writing in the context of 18th century Britain and this must be remembered when looking at Smith's views on government. Smith is often quoted as limiting the state to three important functions: national defence, administration of justice (law and order), and the provision of certain public goods (e.g., transportation infrastructure and basic and applied education). But as Kennedy points out

It was not so much that Adam Smith wanted government expenditures to be restricted to ‘national defense, administration of justice (law and order), and the provision of certain public goods (e.g., transportation infrastructure and basic and applied education)’ but, in important functions in that list, he wanted government expenditures to expand substantially to provide the necessary elements of the listed functions.

The whole article is worth reading.

Boettke on Austrian economics

At EconTalk Pete Boettke, of George Mason University, talks with Russ Roberts about the origins and tenets of Austrian economics. This acts as an introduction to how the so-called Austrian economists look at the world and how they continue to influence economics, if in fact they do.

Nobel lectures

The Nobel lectures by the three winners of the 2007 Economics Prize are available from Nobelprize.org:

But Who Will Guard the Guardians? by Leonid Hurwicz

Mechanism Design: How to Implement Social Goals by Eric S. Maskin

Perspectives on Mechanism Design in Economic Theory by Roger B. Myerson

Kennedy on the history of the phrase Laissez faire

The ever informative Gavin Kennedy of the Adam Smith's Lost Legacy blog, writes the following, in answer to the question, Who first coined the phrase Laissez faire?

‘So where did the idea of laissez faire originate? Not surprisingly, the words were first uttered by a merchant in the French dirigiste regime of M. Jean-Baptiste Colbert (1619-1683), the French minister of finance under Louis XIV. The merchant’s name was M. Le Gendre, described as a ‘most sensible and plain spoken’ merchant and, reportedly, he responded to Colbert’s question: 'Que faut-il faire pour vous aider?' (what do you want from me to assist you?), with: 'laisser nous faire' (leave us alone). Colbert was the finance minister whose regulation of merchants was notorious for its oppressive licensing, inspection and control which personified French bureaucracy at its worst (plus ça change …).

Jean Vincent, Seigneur de Gournay, popularised a version of Le Gendre’s appeal to be freed of petty regulation, but the author who took Le Gendre’s words, dropped ‘nous’ and turned laissez nous faire’ (let us alone) into ‘laissez faire’ (let alone) into a principle of economic policy, was the Marquis d’Argenson (1694-1757), who was an active promoter of economic theory and a member of the world’s first economics club (salon), the Club d’Entresol (1726). He was also a Foreign Minister of France at the Court of Louis XV for two years. He did not publish his ideas, but circulated them, as was the custom, in manuscripts around the French intelligentsia. To govern better, he said, one must govern less. The true cause of the decline of our manufactures, he declared, is the protection we have given to them. Interestingly, Francois Quesnay, for example, did not include laissez faire in his General Maxims of Government.

‘Laissez faire’ was first used in English by George Whatley, a contemporary, friend and correspondent of Benjamin Franklin in 1774. Keynes reported that Jeremy Bentham in 1793 used the expression 'laissez-nous faire'. Bentham, who was not an economist, presented ‘the rule of laissez-faire, in the shape in which our grandfathers knew it’, adapted into the service of the Utilitarian philosophy. For example in A Manual of Political Economy, he [Bentham] writes: 'The general rule is that nothing ought to be done or attempted by government; the motto or watchword of government, on these occasions, ought to be - Be quiet ... The request which agriculture, manufacturers, and commerce present to governments is as modest and reasonable as that which Diogenes made to: Stand out of my sunshine.’

The positive v. the normative

Greg Mankiw points out that "One of the things we teach in introductory economics is the distinction between positive and normative statements. It is useful when reading (or writing) op-eds to keep the distinction in mind." And then takes Robert Frank to task for forgetting this.

Ben Friedman reviews 'A Farewell to Alms'

A Farewell to Alms: A Brief Economic History of the World by Gregory Clark is reviewed by Ben Friedman in the New York Times.

In case anyone has missed it, here, via her website, is Deirdre McCloskey's review of Clark's book.

Maskin, Myserson interview

From Nobelprize.org comes an interview with two of the 2007 Laureates in Economics, Eric S. Maskin and Roger B. Myerson, conducted on 6 December 2007. The interviewer is Adam Smith, Editor-in-Chief of Nobelprize.org.

Mankiw v's Diamond

Greg Mankiw points out that Peter Diamond takes issue with one of Mankiw's papers. Mankiw and Diamond have different views on to evaluate a theory. Read Mankiw's blog for a discussion of the issue and see what you think. For my part I think I'm with Mankiw on this one.

Can cartels benefit the environment?

Can cartels benefit the environment? According to the Free Exchange blog maybe they can. They write,

"It seems that way from the experience of fisherman in Australia and New Zealand. Instead of their earnings' coming from their individual catches, they get a share of the revenue of the industry as a whole. This has lead to an increase in profits because it gives the individual less incentive to fish, increasing fish stocks. Now, when the fishermen venture out they do not have to go as far to find fish, lowering their costs. Higher prices for the fish, and lower operating expenses, translate into higher profits. More fish in the ocean and higher profits for fisherman — it seems to be a clear Pareto improvement."

But there are also problems, as with any cartel. However the article concludes,

Still, if these inherent problems can be overcome, an interesting policy question presents itself. If overproduction of the good in question has negative externalities, does imposing a cartel provide an alternative to credits or taxation?

How Laissez Faire was Adam Smith?

Gavin Kennedy at Adam Smith's Lost Legacy sets about answering this question. Kennedy writes:

"Adam Smith did not recommend laissez faire economics, though he had many opportunities to do so. He doesn't mention laissez faire (leave alone; or ‘laissez nous faire’, leave us alone', in its original format) in Wealth of Nations, nor in anything else he wrote, including his correspondence." ...

"To the generally accepted roles for government, Smith added others of a more controversial nature. For some, it is an issue of fundamental principle; for others it is a boundary dispute. Among these issues Smith identified:

● The Navigation Acts, blessed by Smith under the assertion that ‘defence, however, is of much more importance than opulence’;
● Punishment and enforcement after acts of dishonesty, violence, and fraud;
● Sterling marks on plate and stamps upon linen and woollen cloth
● Enforcement of contracts by a system of justice;
● Wages to be paid in money, not goods;
● Regulations of paper money in banking;
● Obligations to build party wars to prevent the spread of fire;
● Rights of farmers to send farm produce to the best market (except ‘only in the most urgent necessity’);
● Premiums and other encouragements to advance the linen and woollen industries’;
● Police or preservation of the ‘cleanliness of roads, streets, and to prevent the bad effects of corruption and putrifying substances’;
● ensuring the ‘cheapness or plenty [of provisions]’;
● patrols by town guards, fire fighters and of other hazardous accidents;
● Erecting and maintaining certain public works and public institutions intended to facilitate commerce (roads, bridges, canals and harbours);
● Coinage and the Mint;
● Post office;
● Regulation of institutions, i.e., company structures (joint stock companies; co-partneries, regulated companies);
● Temporary monopolies, including copyright, patents, if fixed duration;
● Education of youth (publicly funded ‘village schools’, curriculum design,);
● Education of people of all ages (tythes or land tax)
● Encouragement of ‘the frequency and gaiety of publick diversions’:
● The prevention of ‘leprosy or any other loathsome and offensive disease’ from spreading among the population;
● Encouragement of martial exercises;
● Registration of mortgages for land, houses, and boats over two tons;
● Government restrictions on interest for borrowing (usury laws) to overcome investor ‘stupidity’;
● Limiting ‘free exportation of corn’ only ‘in cases of the most urgent necessity’ (‘dearth’ turning into ‘famine’)
● Moderate export taxes on wool exports for government revenue"

This does raise the interesting question of where the boundary between public and private enterprise should be. In the modern literature one paper to address this issue is Hart, Oliver D., Shleifer, Andrei and Vishny, Robert W. (1997). 'The Proper Scope of Government: Theory and an Application to Prisons'. "Quarterly Journal of Economics", 112(4) November: 1127-61. The HSV model considers the choice between in-house production and contracting out. The provider, government or private, can invest in improving the quality of service or reducing cost. Given incomplete contracts, the private provider has a stronger incentive to engage in both quality improvement and cost reduction than a government employee has. However, the private contractor's incentive to engage in cost reduction is typically too strong because he ignores the adverse effect on noncontractible quality. Cost are always lower under private ownership but quality may be higher or lower under a private owner.

Hence the focus of the HSV model is on quality. Here quality has a broad interpretation. It can stand for how well prisons treat prisoners, how clean utilities keep the water, how well schools educate their pupils, how long it takes for a letter to reach a remote area or how innovative car makers are etc. The basic idea is that the provider of the service, whether it be the government or a private firm, can made an investment to increase the quality of the service or a investment to reduce the cost of the service. It is important to note that quality is reduced by any cost reductions. Neither of these two investments are ex ante contractible. But to implement either of the innovations requires the agreement of the owner of asset. The asset can be thought of as, say, a school or a hospital or a prison. If the owner of the asset is the government then the provider of the service, who will be a government employee, requires the approval of the government to invoke either investment since, in this case, the residual control rights reside with the government. As a result, the employee will receive just a fraction of the returns to either innovation, even if implemented.

If on the other hand the provider is a private sector contractor, then the contractor has the residual control rights and thus does not need the government's agreement for a cost reduction. However, if the contractor wishes to improve the quality of the service and receive a higher price for it, then they have to renegotiate with the government since the government is the purchaser of the service. Under the assumption that the contractor is successful in obtaining an increase in price they capture all such gains. Thus a private contractor will generally face stronger incentives, than a government employee, to improve quality and reduce costs but the incentive to reduce costs can be too strong since the contractor ignores the negative impact this has on quality.

HSV examined the conditions that determine the relative efficiency of in-house provision versus outside contracting of government services. Their theoretical arguments suggest that the case for in-house provision is generally stronger when noncontractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem. In contrast, the case for privatization is stronger when quality reducing cost reductions can be controlled through contract or competition, when quality innovations are important, and when patronage and powerful unions are a severe problem inside the government. They then apply this analysis to several government activities using the available evidence on the importance of various factors. They conclude that the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for privatization is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools.

For all this fancy technical modelling we do, however, have to ask, are really any further advanced on this issue than Adam Smith was.

The cappuccino policy on climate change

The Undercover Economist, Tim Harford, wants to deal with climate change ... one cappuccino at a time.

Mike Munger talks to EconTalk.

At EconTalk Mike Munger talks with host Russ Roberts about fair trade coffee and free trade agreements. Does the premium for fair trade coffee end up in the hands of the grower? What economic forces might stop that from happening? They discuss the business strategy of using higher wages as a marketing strategy to attract concerned consumers. They turn to the issue of free trade agreements. If the ideal situation is open borders to foreign products, is it still worthwhile to negotiate bilateral and multilateral agreements that requires delays, exemptions and a bureaucracy to enforce? What is the cost of including environmental and various labour market regulations in these agreements?

Cowen interview

Tyler Cowen is interviewed about his book "Discover Your Inner Economist: Use Incentives to Fall in Love, Survive Your Next Meeting, and Motivate Your Dentist" by Knowledge@Wharton. Cowen talks about Adam Smith's inner drive, why optimistic CEOs may be a bad bet, and blogging. Cowen is setting out, we are told, "to make economics more human."

For Gavin Kennedy's view on Cowen's comments on Adam Smith see the Adam Smith's Lost Legacy blog.

Laffer interview

From Justin Fox's (TIME's business and economics columnist) blog comes an interview with Arthur Laffer. On taxes and the Laffer Curve, Laffer says, "I've never said all tax cuts pay for themselves. I never even said Reagan's tax cuts would pay for themselves."

Incentives Matter: Danish Income Tax Edition

At the Division of Labo[u]r Blog, E. Frank Stephenson writes on the effects of Danish income tax, the marginal rate of which can reach 63 percent.

Books on economics

For the, very few, people who like to read about economics, 2007 was a great year. It produced a number of excellent books. Here are Arnold Kling's recommendations.

Repugnant markets

The Undercover Economist takes a look at what has come to be called "repugnant markets". His main example is Guatemala's baby trade. But there are others, prostitution, dwarf-tossing, terrorism futures and organ sales to name a few.

Three tales of a falling dollar

Tyler Cowen offers us Three tales of a falling dollar, one each from him, Brad DeLong and Don Boudreaux. Cowen notes that each "express different degrees of optimism about the current state of the dollar. Yet the approaches differ in both theory and rhetoric. "

Is comparative advantage obsolete?

This is the question that Grew Mankiw asks in light of recent comments on trade made in an interview with the FT by Hillary Clinton:

We have benefited through most of the 20th century from trade. It has helped to raise American standards of living, it has helped to create jobs. And I agree with Paul Samuelson, the very famous economist, who has recently spoken and written about how comparative advantage as it is classically understood may not be descriptive of the 21st century economy in which we find ourselves.

Mankiw notes that Clinton looks to be referring to Samuelson's paper in the Journal of Economic Perspectives. Mankiw then continues to point out some of the problems with many of the (mis)interpretations of the Samuelson's paper and to make the point that comparative advantage is far from obsolete.

Clive Crook offers this critique, while the view of the Adam Smith Institute is here.

Size does matter

In her book "Paradoxes of Prosperity" Diane Coyle notes that "Companies are getting bigger. Or smaller. In between is a bad place to be." The question is why? There seems to be at least two basic forces at work here.

One is globalisation which extends the market for good and services from the national level to the international level. Companies can now rearrange their production and marketing on a world-wide basis which favours huge companies. Some companies can take advantage of economies of scale due to high fixed costs in manufacturing or the marketing benefits of having a global brand like Coca-Cola.

The second force is the expansion of the knowledge economy. As knowledge is most often embedded in people, human capital is becoming more important as a factor of production. The development of ICTs has meant that the costs of moving information embedded in people as opposed to moving information itself have risen sharply. The costs involved in sending and receiving information have fallen thanks to technologies such as email and the Internet along with falls in the costs of long-distance phone calls and the expanding use of cellular networks. The costs of people moving have not fallen however. Commuting to work via congested city and suburban streets, for example, is at least as difficult as it was two decades ago. The increasing interest in congestion pricing in many cities around the world suggests that traffic problems are not lessening. The ever increasing relative cost of moving people would suggest that the size of the "unit of production" should be moving away from the large factory, so dominant for the last two centuries, towards more home based production, as in the period before the industrial revolution. Joel Mokyr does however add a cautionary note; "... it seems clear that the movement away from factory settings will eventually run into diminishing returns and that the locus of work will remain a mixture of work at home and work away from home". (Mokyr 2002: 155).

Brynjolfsson (1994) also sees advantages in firms being small when information is important in production. In his view " ... small firms are likely to have an advantage in providing incentives, not only because it is likely to be easier to separate out and contractually reward the individual contributions, but also because agents in smaller firms have stronger incentives to make uncontractible contributions as well. ... When it is important to provide incentives for the application of information in ways that cannot be easily foreseen and incorporated into a contract small firms have a relative advantage over large firms." (Brynjolfsson 1994: 1654).

There are of course other factors at work in determining firm size. Its now easier to set up new small companies: finance is more available, costs of equipment are lower and the burden of red tape has in many countries been reduced. But all of this seems to mean the mid-sized firm in on the way out.


Brynjolfsson, Erik (1994). 'Information Assets, Technology, and Organization', "Management Science", 40(12): 1645-62.

Mokyr, Joel (2002). "The Gifts of Athena: Historical Origins of the Knowledge Economy." Princeton: Princeton University Press.

DeLong reviews McCraw

In The Chronicle of Higher Education J. Bradford DeLong reviews Thomas K. McCraw's new book, Prophet of Innovation: Joseph Schumpeter and Creative Destruction (Belknap Press/Harvard University Press, 2007). DeLong concludes by saying,

Perhaps this next century will give Schumpeter's work its proper place as the power of innovation to transform, create, enrich, and destroy makes itself manifest globally. And while we marvel at how much he got right, we can hope Schumpeter was wrong in his political analysis. One great test of our era will be whether creative destruction can flourish alongside public order and political liberty. If not, we're in big trouble. But if so — and I'm an optimist on the point — the results could be a marvel.

Globalisation Not the Problem: Absence of Markets is the Problem

As normal Gavin Kennedy has interest things to say with regard to the thinking of Adam Smith. This time he is talking about the relationship between globalisation and markets. Kennedy writes "This local community interests idea is becoming quite popular, as if it is different now from what is was in Adam Smith's day." But he also points out that "In short, living standards [in Adam Smith's day], basic as they were, depended on distant markets. Globalisation is not that new. When markets were absolutely local living standards were dire."

Phillips curve

As the the 50th anniversary of the late Bill Phillip's most famous paper is coming up in 2008 and there is a conference to mark the occasion, this article from the San Francisco Fed is timely. It offers a nice summary of where things stand in "Fixing the New Keynesian Phillips Curve". Greg Mankiw points out that the Nobel Prize winner George Akerlof once said, "Probably the single most important macroeconomic relationship is the Phillips curve." But as Mankiw also points out, the problem is that "it is a relationship that we still don't fully understand".

Government and money

Over at Cato@Liberty Daniel J. Mitchell ask the very sensible question: Should the Government Have a Monopoly on Money?

Cowen on the falling dollar

In his latest column in the New York Times Tyler Cowen tells us that The Dollar Is Falling, and That’s Good News

Posner and Becker on Carbon Offsets

At the Becker-Posner blog they are discussing carbon offsets. Posner's comments are here while Becker's discussion is here. Posner concludes his comments with:

Against this it can be argued that the carbon-offset movement is increasing the public awareness of the global warming problem, which may lead to other voluntary efforts to reduce carbon emissions, such as switching from SUVs to more fuel-efficient vehicles, or may exert pressure on politicians to support the regulation of carbon emissions. I am skeptical. I think very few Americans are prepared to incur substantial costs to deal with a problem that is so afflicted by uncertainty about its imminence and magnitude as global warming. They will avoid cognitive dissonance by exaggerating the practical efficacy of largely symbolic gestures, such as purchasing carbon offsets.

Becker concludes in favour of a cap and trade system:

In our complicated and interdependent global economic system, opportunities to create carbon offsets can be readily produced by both companies and governments without any significant affect on the scale of emissions. Mainly for this reason, but also because of the reluctance of most individuals to voluntarily pay significant costs for acting "green", a cap and trade system, despite its many flaws, is a far preferable direction to develop in order to cut down on carbon emissions.

War Wine and Taxes

The economic historian John Nye has a new book, War, Wine, and Taxes: The Political Economy of Anglo-French Trade, 1689-1900. Nye argues that the conventional wisdom that Britain was devoted to free trade after the repeal of the Corn Laws in 1846 is wrong. He says that the British retained high tariffs on a number of goods including French wine which lead to large welfare losses among Britons. The book has been reviewed at EH.Net and the reviewer is not convinced Nye is right.

Easterly reviews Collier

Here is Bill Easterly's review of Paul Collier's book, The Bottom Billion. It was published in The Lancet.

The top 1%

The 'Top One Percent' of income earners in the US as seen by Thomas Sowell. Sowell points out that "At the highest income levels, people are especially likely to be transient at that level. Recent data from the Internal Revenue Service show that more than half the people who were in the top one percent in 1996 were no longer there in 2005."

Profs on Free Trade

Daniel B. Klein explains why why economists left, right, and center are in favour of free trade.

Human Capital and the Firm

One of the important aspects of the so-called "Knowledge Economy" is that changes in information technology has meant that the knowledge and information controlled by workers has become increasing important to the production process. That is, human capital has become increasingly important to the firm. This should affect the organisation of the firm. How?

Firms can be thought of as being made up of human and non-human capital. Changes in the importance of human capital can affect the organisational choices of the firm. Consider, for example, the case where you have, say, three workers each of whom have some (tacit) knowledge necessary to the production process and three bundles of non-human capital. The workers own their own human capital, and thus the question relevant for the organisation of firm is, who owns the non-human capital. In the case where the non-human assets are highly complementary then for any given worker to be productive he will need access to all three bundles of non-human assets. This suggests that keeping the assets together would maximise productive capacity. We would therefore expect to see these non-human assets owned together in one firm. On the other hand if a given worker's human capital needs access to only, say, one of the three bundles of non-human assets, and each worker needs a different bundle, then separate ownership of the non-human assets seems optimal. Such an argument tells us that where information is decentralised it opens up the possibility that non-human asset ownership should also be decentralised and thus we would expect to see an increased use of markets to coordinate economic activity.

The preceding also highlights the importance that asset specificity of the non-human asset can play in the integration/non-integration decision. If information technology makes assets more flexible so that they are less likely to be locked into other particular assets then this would facilitate a decentralised patten of non-human asset ownership. The alternative is that information technology may increase lock-in, via things like network externalities, proprietary standards or idiosyncratic hardware and software protocols. In this case centralised ownership becomes less costly and thus more likely.

An interesting question that this gives rise to, is to what extent is this just Hayek writ small? For Hayek the market is a mechanism for dealing with decentralised (tacit) knowledge. What we see above is, again, when information is decentralised markets become more likely to be used as a coordinating mechanism.

Does Increased Abortion Lead to Lower Crime?

Anindya Sen of the University of Waterloo has a new paper out, "Does Increased Abortion Lead to Lower Crime? Evaluating the Relationship between Crime, Abortion, and Fertility". The Abstract reads:

Donohue and Levitt (2001) attribute over half of the decline in U.S. crime rates during the 1990s to abortion legalization. This paper conducts similar research by exploiting cross-province time-series variation in Canadian data. The use of Canadian data allows me to separate the effects of teenage abortions from general abortion rates. This distinction is important, as more than a quarter of the drop in violent crime can be attributed to the increase in teenage abortions that occurred after legalization. These results suggest that lower crime rates from abortion legalization are due to better timing of births rather than lower cohort size. They are further substantiated by OLS estimates, which imply that the drop in teenage fertility rates during the 1960s and 1970s is responsible for more than half of the decline in violent crime rates witnessed during the 1990s.

Milton Friedman Interviews

Check out these two interviews with Milton Friedman at EconTalk. In the first Russ Roberts talks with Milton Friedman about his research and views on inflation, the Federal Reserve, Alan Greenspan and Ben Bernanke, and what the future holds - note the discussion of New Zealand; while in the second Roberts talks with Friedman about the radical ideas he put forward almost 50 years ago in Capitalism and Freedom (still well worth reading). You can listen to the most influential economist of the past 50 years discuss the principles of liberty, social responsibility of business, the inertia behind bad legislation and his career as economist and public intellectual. Well worth listening to.

Recent papers on the firm

There is an interesting new survey out on vertical integration. Francine Lafontaine and Margaret Slade's paper "Vertical Integration and Firm Boundaries: The Evidence" appears in a recent issue of the Journal of Economic Literature, Vol. XLV (September 2007), pp. 629–685. The abstract reads:

Since Ronald H. Coase's (1937) seminal paper, a rich set of theories has been developed that deal with firm boundaries in vertical or input–output structures. In the last twenty-five years, empirical evidence that can shed light on those theories also has been accumulating. We review the findings of empirical studies that have addressed two main interrelated questions: First, what types of transactions are best brought within the firm and, second, what are the consequences of vertical integration decisions for economic outcomes such as prices, quantities, investment, and profits. Throughout, we highlight areas of potential cross-fertilization and promising areas for future work.

Oliver Hart also has a new NBER working paper out, "Reference Points and the Theory of the Firm". It is based on Hart's inaugural Coase Lecture, presented at the London School of Economics in February, 2007. In it Hart argues that it has been hard to make much in the way of progress on the Coaseian theory of the firm because of the difficulty of formalizing "haggling costs". Hart puts forward an approach that tries to move things ahead using the idea of what he calls "aggrievement costs". He applies this approach to the question of whether a transaction should be placed inside a firm or in the market place.

Thinking about nonprofits

The discussion of nonprofit firms by Klein (noted previously) at Organizations and Markets should remind us that for-profit firms are not the only firms in the economy. Large sectors of the economy are dominated by nonprofit firms. Areas such as health, education and welfare are obvious examples. Private hospitals trend to be nonprofit, as do private universities - in countries lucky enough to have them - along with private welfare organisations such as IHC, Cancer Society, YWCA, RSPCA etc. A number of interesting questions are raised by nonprofit firms, why are they only in certain areas of the economy, why the nonprofit form, who owns them and how do these firms behave?

In their paper Not-For-Profit Entrepreneurs Edward Glaeser and Andrei Shleifer argue that entrepreneurs who start new firms may choose not-for-profit status as a means of committing to soft incentives. Such incentives protect donors, volunteers, consumers and employees from ex post expropriation of profits by the entrepreneur. Such protection is important in areas like health, education and welfare. When entrepreneurs have a taste for producing high quality products, argue Glaeser and Shleifer, the incentives are even softer, and, moreover, non-profit status can serve as a signal of that taste. Even in the absence of tax advantages, unrestricted donations would flow to non-profits rather than for-profit firms because donations have more significant influence on the decisions of the non-profits.

The paper by Jill Horwitz and Austin Nichols, What Do Nonprofits Maximize? Nonprofit Hospital Service Provision and Market Ownership Mix looks at the conflicting theories of the nonprofit firm have existed for several decades. The paper notes that empirical research has not resolved these debates, partly because the theories are not easily testable but also because empirical research generally considers organizations in isolation rather than in markets. Horwitz and Nichols examine three types of hospitals, namely, nonprofit, for-profit, and government. They look at the effect of for-profit ownership share within markets in two ways, on the provision of medical services and on operating margins at the three types of hospitals. Their findings indicate that nonprofit hospitals' medical service provision systematically varies by market mix. They find no significant effect of for-profit market share on the operating margins of nonprofit hospitals. These results fit best with theories in which hospitals maximise their own output.

Another paper by Glaeser, The Governance of Not-For-Profit Firms, looks at the implications of weak governance institutions on non-profit behaviour. A primary implication of Glaeser's results is that non-profits will often evolve into organisations that resemble workers' cooperatives. The primary check on this tendency is the need of the organisations to compete in outside markets. The paper considers four different sectors (hospitals, museums, universities and the church) and finds that all display significant signs of capture by elite workers, but all still perform their basic missions reasonably, probably because of market competition.

A further question about nonprofits is who owns them? Henry Hansmann (see "The Ownership of Enterprise", Cambridge, Mass.: The Belknap Press of Harvard University Press, 1996) argues that by definition they have no owners. This is because no one receives the residual earnings of a nonprofit firm. Jennifer Kuan, on the other hand, argues, in her paper "The Phantom Profits of the Opera: Nonprofit Ownership in the Arts as a Make-Buy Decision", that the nonprofits do have owners. In her model consumers make a "make or buy" decision with regard to a nonrival product. The result of the consumer decision to become the producer of the good, for their own consumption, is a nonprofit firm. These consumer/producers are the owners of the
organisation.

All in all nonprofits are important players in the economy who deserve more attention than they get from economists.

Car prices and pollution

Recent newspaper reports tell us that as from January 3, imported used cars made before 1998 will in effect be banned, unless they meet emissions standards to be toughened in 2009 and 2012. This is because of Government imposed limits on exhaust emissions introduced in a bid to cut pollution.

But will emissions be cut?

The ban on imported cars will reduce the supply of cars available on the New Zealand market. This will increase the price of used cars which will make it dearer for people to replace their old cars. Thus people will keep using their old, high emission, cars longer than they otherwise would have. It may turn out that keeping the old high polluter cars on the road longer may not lead to the reductions in pollution the government hopes for.

Why we trade

In Foreign Policy Russ Roberts attempts to explain, in around 1000 words, why we trade. He tries to explain the relative importance of imports and exports and the total unimportance of the trade deficit.

More on Kennedy on Smith on the Corporation

More on "Kennedy on Smith on the Corporation". Mark Hodak responds to Kennedy and Kennedy responds to Hodak. The debate between Gavin Kennedy and Mark Hodak about Adam Smith's view of joint-stock companies continues here and here.

Myth of the Invisible Hand, no 368

Gavin Kennedy continues to rightly find fault with peoples use of the Smith's invisible hand metaphor. But this time he writes "The elision of Adam Smith's metaphor in a theory of markets was a creation of modern neo-classical economists, centred on Chicago University, who found in the use of the metaphor some kind of justification of their mathematical theories of general equilibrium."

But I would not think of Chicago as the centre of "mathematical theories of general equilibrium". I would have seen Chicago as having more of an emphasis on basic price theory in its partial equilibrium form. General equilibrium followed from Walras's work and found its modern form in the works of McKenize, Arrow and Debreu etc. This is not, to my way of thinking, the Chicago tradition. Overtveldt (2007: 93-4) makes the point that "At the end of World War 11, the Cowles Commission for Research in Economics was installed at the University of Chicago. The fact that leading members of this Commission - such as Jacob Marschak, Trygve Haavelmo, Lawrence Klein, and Tjalling Koopmans - were heavily involved in the development of Walrasian general equilibrium economics and building sophisticated econometric models was a constant source of friction between them and the group around Friedman at the University of Chicago's department of economics." The Commission left and Friedman stayed.