Mankiw's Ten Principles of Economics

An unusual approach to Mankiw's Ten Principles of Economics. Very funny if you are lucky enough to have ever studied economics. You will never look at stage one the same again.

From Yoram Bauman, the Standup Economist

Public v. merit goods

In an article on the blog of the Adam Smith Institute, Madsen Pirie writes on the idea that A university or college education is a public good that society should pay for. He writes,

There's truth in the first part of this. Most of us prefer a society with educated people in it, and benefit from it. Educated people can provide services for us, and create the jobs and wealth for the future. They often also add a certain civility which enhances the lives of others.

I don't see the truth in the first part of the article's title. Even if the quoted text is true that doesn't make education a public good. A public good is a good which is non-rival and non-excludable. Put simply this means that the consumption of the good by one individual does not reduce the amount of the good available for consumption by others and no one can be effectively excluded from using the good. Clearly this definition fails for education, as it is easy to exclude people from receiving it, for example.

I'm guessing that what Pirie means is that education is a "merit good". The somewhat odd concept of a merit good was introduced by Richard Musgrave (1957, 1959). A merit good is a good or service which is judged that an individual or society should have on the basis of a norm other than respecting consumer preferences, ie the government forces you to have it. Or sometimes a merit good is thought of as a good which would be under-consumed (and under-produced) in the free market economy. There are, it is claimed, two major reasons for this: (1) When consumed, a merit good creates positive externalities. This means that the public benefit is greater than the private benefit but as consumers only take into account private benefits they will under-consume the good or service (and so it is under-produced). (2) Individuals are myopic, they are short-term utility maximisers and so do not take into account the long term benefits of consuming a merit good and so they, again, under-consume the good.

In the case of education, it can be argued that those lacking education are incapable of making an informed choice about the benefits of education, which would warrant compulsion (Musgrave, 1959, 14). In this case, the implementation of consumer sovereignty is the motivation, rather than rejection of consumer sovereignty (Musgrave, 1987, p. 452). Can't say I buy such an argument. After all, where would it end? Could an argument not be made that nearly any good has some merit/demerit aspect which means we should be force to consume it or forced not to consume it? And why can't people work out that education is good for them? In addition, what are these public benefits from education?

Most of the benefits of education are captured by the individual and not society. If so why should others pay for them? As Pirie puts it,

The main beneficiary of education is the recipient, directly and in measurable ways. The university or college graduate has access to a greater range of fulfilling career opportunities, and has access to much better paying jobs than their uneducated or untrained counterpart. Those who pay towards their education make one of life's very best investments – it repays them many times over in money as well as opportunity.

Pirie then makes the obvious point that education has to be paid for, but paying out of taxes means that those you don't get said education still have to pay for it.

Someone has to pay for tertiary education. Lecturers have to be paid, buildings and facilities maintained. If this is paid out of taxation, it means that taxpayers in general pay for it, rather than just the beneficiaries of it. It means that the person who leaves school to become a casual labourer is paying higher taxes so that someone who is already better intellectually endowed will have access to better jobs and a higher income for life.

At the very least someone should articulate what the taxpayer gets for their money. Or in other words, what exactly are these merit characteristics that education supposedly has which justify funding it out of general taxation?

• Richard A. Musgrave (1957). "A Multiple Theory of Budget Determination," FinanzArchiv, New Series 25(1), pp. 33-43.
• Richard A. Musgrave (1959). The Theory of Public Finance, pp. 13-15.
• Richard A. Musgrave (1987). 'Merit Goods' , in The New Palgrave: A Dictionary of Economics, v. 3, pp. 452-53.
  

Financial Globalisation: for and against

There is another interesting debate on financial globalisation taking place at the Wolf Forum. In a recent article in the Financial Times, We must curb international flows of capital, Dani Rodrik and Arvind Subramanian argue that

Financial globalisation has not generated increased investment or higher growth in emerging markets. Countries that have grown most rapidly have been those that rely least on capital inflows. Nor has financial globalisation led to better smoothing of consumption or reduced volatility. If you want to make an evidence-based case for financial globalisation today, you are forced to resort to indirect and speculative arguments.

It is time for a new model of financial globalisation, one that recognises that more is not necessarily better. As long as the world economy remains politically divided among different sovereign and regulatory authorities, global finance is condemned to suffer deformations far worse than those of domestic finance. Depending on context, the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them. Policymakers who view their challenges exclusively from the latter perspective will get it badly wrong.

William Easterly responds to this by noting,

To say that there are crises because of international capital flows is not very meaningful; it is like saying there are recessions because of GDP. Dani and Arvind do not adequately address two big issues on capital flows:
(1) what are the benefits of capital flows? Usually, a voluntary movement of capital signifies a reallocation from a low-return investment to a high-return investment. This raises the rate of return to investment overall, which is usually considered to be a good thing.
(2) To what extent are international capital flow crises the symptom or the disease? They are oftentimes the symptom, so trying to control them to treat macroeconomic imbalances is like treating fevers with ice-baths. Better to confront the underlying imbalances, as Dani and Arvind sensibly recommend in the second half of their column.

Martin Wolf states his view, in part, as

I am certainly closer to the Rodrik-Subramanian position now than five years ago. But I remain of the view that free capital flows have some desirable consequences, including a degree of autonomy vis a vis the overweening or predatory state and a stimulus to institutional development.

The big question, however, is: what is to be done? I do not agree with the idea of handing over exchange-rate issues to the World Trade Organisation. That would grossly overload it, so risking its destruction. Nor do I think the IMF can do much about "global imbalances" either. But it would be desirable if the IMF staff were at least allowed to declare openly and clearly that particular countries have grossly undervalued exchange rates or that their intervention policies are indefensible. This would be the power of moral suasion.

Apart from this I have three comments.

First, this is a matter for individual countries to decide. Capital account liberalisation should neither be forced on countries nor should they be prevented by others. Outside advisers, including official advisers, should analyse the pros and cons against the particular circumstance of the country concerned and offer advice on the feasibility of the set of policies proposed.

Second, capital inflows are not a substitute for an adequate level of domestic savings. Promoting the latter is an important policy priority (though not to the excessive levels now seen in China).

Third, countries should normally discourage domestic borrowing in foreign currency, unless they adopt the foreign currency for domestic monetary use. Otherwise, countries should restrict capital inflow to direct investment, portfolio equity and domestic-currency-denominated lending. The fact that the US borrows in dollars makes the consequences of the crisis smaller and the ease of dealing with it far greater.

(HT: Bayesian Heresy)

The protectionism of Barack Obama? (updated x2)

From outside the US the most worrying thing about the current nomination races is the protectionist positions the candidates are taking. Barack Obama looks the most likely Democratic presidential candidate and thus his policies are being closely looked at. In this column, The dangerous protectionism of Barack Obama by Willem Buiter and Anne Sibert, at VoxEU.org, his idea of tax breaks for US corporations that invest at home rather than abroad is studied. The title of the article gives the authors view.

The article summaries the Obama plan as:

The legislation would provide a tax credit equal to one percent of taxable income to employers who fulfill the following conditions:

· First, employers must not decrease their ratio of full-time workers in the United States to full-time workers outside the United States and they must maintain corporate headquarters in the United States if the company has ever been headquartered there.

· Second, they must pay a minimum hourly wage sufficient to keep a family of three out of poverty: at least $7.80 per hour.

· Third, they must provide a defined benefit retirement plan or a defined contribution retirement plan that fully matches at least five percent of each worker’s contribution.

· Fourth, they must pay at least sixty percent of each worker's health care premiums.

· Fifth, they must pay the difference between a worker’s regular salary and military salary and continue the health insurance for all National Guard and Reserve employees who are called for active duty.

· Sixth, they must maintain neutrality in employee organising campaigns.

Buiter and Sibert discuss each of the conditions is the following terms:

The first restriction is distortionary. Companies ought to decide the location of their headquarters and their domestic and foreign employment levels without being subjected to fiscal incentives. It is also unenforceable. Foreign branches of domestic companies, whose workers count as employees of the parent, would be changed to subsidiaries, whose workers no longer count as employees of the parent. Companies ever headquartered in the United States would be sold to shell companies or shut down and immediately reopened with a different name and legal identity, headquartered abroad. Let Commerce Department lawyers try to use corporate DNA fingerprinting to determine the ancestry of these new corporations! Unfortunately, idiotic legislation that is unenforceable is not harmless – it breeds contempt for laws and institutions.

While requirement two is less damaging than raising the Federal minimum hourly wage (currently $5.85) to $7.80, Sen. Obama ought to realise that the natural response of firms to higher wages is to hire less labour and, even with a tax credit equal to one percent of taxable income, not every employer in the United States can provide these subsidies and still make enough of a profit to stay in business. The least skilled workers -- those who would be hired at a wage of, say, $6.50 an hour and who would be out of work when the wage is $7.80 -- are likely to find the passage of this act to be just another example of a (possibly) well-intentioned Democratic proposal unintentionally benefiting those not too badly off at the expense of the truly badly off.

The employers’ contributions to employee retirement plans, mentioned in the third requirement, are a cost of employment as much as wages are and the above discussion applies. Moreover, requirement three does little to correct problems associated with retirement plans. Any real solution must make the investment and management of retirement plans independent of the employer. This ensures portability and stops employers from raiding them. A demise of the corporate defined-benefit pension fund would be a small loss. Companies do not have the expected life span or employee base to run proper defined benefit pension funds; the government is the natural agent to do this, through the (unfunded) Social Security retirement scheme. In addition, defined benefit plans are not always required to be fully funded at all times and part of these costs can be deferred. This has led to such pension fund liabilities being ‘forgotten’, hidden, or not viewed as debt at all: consider the plans of the US automobile industry or the remnants of the US steel industry.

Similarly, employers’ contributions to employee health care costs are also a cost of employment. However, tax incentives, current or proposed, that link health insurance with being employed rather than with being alive, are distortionary and unfair. It discourages labour mobility and transfers income away from the self employed, the unemployed and the inactive.

Requirement five is a wonderful example of a policy that would end up hurting those it is intended to protect. It would create a strong incentive for companies not to hire any new employees who are National Guard or Reserve employees, and to fire any they already employ! If society deems it desirable that serving in the National Guard or Reserve not involve any loss of salary or benefits for the Guard member and his or her family, then society should pay for it, with general tax revenues.

Over at the Free Exchange blog they take a different view of the Obama plan. They write:

In short, Mr Obama deserves a slap on the wrist. He does not, in my opinion, deserve the rhetorical pounding he receives. Why not?

This bill is much less bad than it could be, primarily because the restrictions it contains are optional. The things it asks of employers are steps that firms would have already taken if they were likely to boost productivity, so we can assume they entail certain costs. The more costly the restrictions are to a business, the less likely it is that the tax credit will make the changes worth the firm's while. In other words, optionality ensures that firms will only adopt these measures if it's relatively cheap (and minimally distortionary) to do so.

Mr Buiter and Ms Sibert are also right to point out that the retirement and health plan provisions of the bill won't increase worker compensation but merely shift it from wage payments to benefits. This, too, will help to minimise the cost of the legislation. Workers seeking the package of benefits prescribed by Mr Obama's bill will be drawn to compliant firms. Those who value wages more highly will work elsewhere. Some inefficiencies could obviously result from changes in labour distribution, but once again, if the inefficiencies grow large for any one firm, that firm will decide not to participate in the program.

There is a case to be made that Mr Obama is the most economist-friendly candidate out there. One would hope that he'd use his growing popularity as an excuse to defend good but unpopular economic policies. He hasn't done that with this Patriot Employer Act, and he deserves a dose of criticism.

The Free Exchange makes the point that while parts of the bill are bad, its not really dangerous. By comparison, when you look at some of the anti-trade proposals that have been seen elsewhere in the campaign, you are see the point. But still much of what is coming out of all the campaigns is protectionist and that can't be good for the rest of the world. See The Candidates and Trade for a look at the views of the presidential contenders on trade. And its not pretty. A free trading US is the best thing that a US President could give the world.

Update: Greg Mankiw comments here that he doubts Obama's economic advisors will support his anti-NAFTA rhetoric. Tyler Cowen comments here.

Update 2: Daniel Griswold comments on the Obama and Clinton debate over which of them is the strongest critic of the North American Free Trade Agreement.

Markets and the environment

Here is an interview, from Wired, with Fred Krupp, who "... isn't your typical tree hugger." Krupp is the president of the Environmental Defense Fund. In the early 1990s he worked on the problem of acid rain avoidance and after noting the success of markets in dealing with the issue he says the following about approaches to carbon avoidance and global warming:

...I know that capitalism works, that American entrepreneurialism works, and we can damn well expect that private capital — not government money — will actually solve this problem.

(HT: Alex Tabarrok at Marginal Revolution)

Marginal Revolution book forum on chapter 8

Sahar Akhtar continues the Marginal Revolution book forum on the Logic of Life with a discussion of chapter 8, Rational Revolutions.

Sowell on EconTalk

This week on EconTalk, Thomas Sowell of Stanford University's Hoover Institution talks with Russ Roberts about the ideas in his new book, Economic Facts and Fallacies. He discusses the misleading nature of measured income inequality, CEO pay, why nations grow or stay poor, the role of intellectuals and experts in designing public policy, and immigration.

Incentives matter: referee file

Social forces can change the incentives people face and thus affect their behaviour.

Analyzing the neutrality of referees during 12 German premier league (1. Bundesliga) soccer seasons, this paper documents evidence that social forces influence agents' decisions. Referees, who are appointed to be impartial, tend to favor the home team by systematically awarding more stoppage time in close matches in which the home team is behind. They also favor the home team in decisions to award goals and penalty kicks. Crowd composition affects the size and the direction of the bias, and the crowd's proximity to the field is related to the quality of refereeing. (Thomas J. Dohmen, The Influence of Social Forces: Evidence from the Behavior of Football Referees, Economic Inquiry (2008).)

(HT: Overcoming Bias via Matt)

Inflation and the RBNZ

Frederic Sautet has another provocative piece on New Zealand over at the Austrian Economists blog. This time he has a posting on inflation in New Zealand and the role of the Reserve Bank. Sautet opens by making the point some people argue that,

As the prices of some traded goods have gone up and house prices are relatively very high, the New Zealand economy is experiencing "inflationary pressures."

I argue that this kind of thinking can be a problem in that it seems to assume relative price changes are "inflation". If the (relative) price of traded goods or housing are changing why should we worry? Such changes may affect the CPI, but are they really "inflation"? Or at least are they "inflation" we want to worry about. If they are just relative prices changes then we don't want to suppress them. Relative prices are the signals that the economy needs to allocate resources efficiently. If in a mistaken effort to control "inflation" the RBNZ distorts these signals they will do the economy more harm than good. This does not mean we can just forget about inflation and stop worrying. It just means we should try to distinguish between "pure inflation" and relative price changes. An idea discussed here.

Sautet goes on to say

Originally, the government and the RBNZ signed policy agreements to specify the inflation target (something that the US Federal Reserve doesn't have). In 1990, the inflation target was 0-2%; it is now 1-3%.

The thing here is that the target is written in terms of changes in the CPI and so anything that increases the CPI endangers the RBNZ target and thus the bank must react to it. But as I argue above that reaction could do more harm than good, depending on the source of the CPI increase. I doubt the RBNZ can really tell the difference between "pure inflation" and relative price changes and thus may well act when it shouldn't or over react. An obvious counter to this would be, What is a better inflation measure? ... and I don't know.

I have to agree with Sautet over the bad effects that the addition of "broader economic goals" to the RBNZ's mission has had and with his assessment of Bollard's tenure as head of the RBNZ along with Brash's recent statements on using taxation as a means to control inflation.

My real issue here is what in practice does "price stability" mean, how do we measure it and what effects would different definitions and measures have? The Reserve Bank Act type approach to fighting inflation may be the best we can get, in the real world, but I would like to be a bit more convinced of that.

Incentives matter: legal file

As long ago as 1927, the Supreme Court of the United States decided Tumey v. Ohio, in which it recognized the truism that judges and other law enforcement officials were more likely to find a person guilty when the conviction would increase their salaries and budgets. (Andrew P. Napolitano, A Nation of Sheep, Nashville: Thomas Nelson, 2007, p.119.)

Speed of government

MMP appears to have done one good thing, its slows down government. According to an article in the National Business Review,

At the beginning of the 1993 National government, the executive took 20 sitting days on average to pass a bill. The 1996 National-New Zealand First government enacted new laws in an average of 34 days.

When Labour took power in a minority coalition with the Alliance in 1999, that time ballooned out to 66 days.

Bills also spend more time at select committee being scrutinised, despite time limits being put on the process to avoid bills being lost behind desks.

Consequently, the number of laws being made has dropped under MMP by about a third each year.

Governments can still pass important legislation as in the past and, similarly, screeds of unimportant legislation. The point is not that MMP governments cannot govern but they cannot govern by blitzkrieg.

This has to be a good thing. Our freedom is being taken away at a slower rate. But how can we stopped it being taken away completely?

While they maybe passing laws more slowly there is no obvious evidence that the quality of law has improved. Just think of the Electoral Finance Bill as an example. As Eric Crampton put it

... this is very bad legislation - so bad that, even after amendment,the New Zealand Law Society wants it scrapped. This is amazing. When law is badly drafted, it's the lawyers that profit by the resulting court battles. Lawyers from Chapman Tripp warn that the courts may well decide the next election - they expect court action. Legislation has to be shockingly bad before we'd expect lawyers to say it should be scrapped entirely, but that's what they've done. Even the Electoral Commission, who has to give advice on compliance with the legislation, is reported to have thrown up its hands: it can't make heads or tails of the legislation either, and so can't provide advice.

So progress, if unintended progress, has been made on the speed front, but there is still much to do on the quality of legislation front and more to do on the speed of passing front.

(HT: Not PC)

Incentives matter: but I will ignore them file

In their book, The Theory of Incentives: The Principal-Agent Model, Jean-Jacques Laffont and David Martimort explain that one of the few economists even aware of incentive problems in the 1950s was Jacob Marschak .... and he choose to ignore them! (p.26)

This raises the problem of incentives. Organization rules can be devised in such a way that, if every member pursues his own goal, the goal of the organization is served. This is exemplified in practice by bonuses to executives and promises of loot to besieging soldiers; and in theory, by the (idealized) model of the laisser-faire economy. And there exist, of course, also negative incentives (punishments). I shall have to leave the problem of incentives aside. (Marschak 1955, p.128)

The Leeson pirate organization paper is a good example of some of what Marschak is saying.

The media and economcis

According to this report High interest rates wipe benefits of lower house prices. The report states,

A fall in house prices helped improve home loan affordability overall in January, but higher interest rates wiped out most of the gains, according to the monthly Fairfax Media home loan affordability report.

Has the report got the causation right and is an inverse relationship between interest rates and house prices surprising?

The causation would run from high interest rates to lower house prices, so given that house affordability depends on both interest rates and house prices, and they are inversely related, you would expect one to counter the other.

As interest rates increase, demand for housing should drop and this lower demand should lead to lower house prices. On the other hand, should interest rates drop, housing demand would increase and hence house prices would increase. So this inverse relationship will mean that the gains in housing affordability from a reduction in interest rates will be countered by an increase in house prices.

Another report tells us Rising fuel prices force people to stay home. This article says

Rising fuel prices are forcing nearly a third of New Zealand drivers to drive their car less often, according to new research.

Research New Zealand director Emanuel Kalafatelis said the rising cost of petrol and diesel over the past year had resulted in 32 percent of those polled saying they were driving their car less often.

Why is this news? Demand curves, including those for fuel, slope downward.

I guess as an economist, the good news from these stories is that people, even in New Zealand, respond to prices, which affects both their patterns of consumption and the (efficient) allocation of resources. Prices appear to be doing what they should, giving people the incentives needed to change their behaviour. But why does the media print such stories without any apparent thought or analysis? Slow news day?

Medieval business schools

Just to show that business administration is old hat, here is a post by Peter Klein at Organization and Markets about medieval schools that included courses relevant to business.

Trade and civil war

One of the most pressing problems for many of the poorest countries in the world is civil war. Increased integration in the world economy has often been advocated as a way of promoting peace and prosperity in these countries. However, little is known on the impact of trade openness on the risk of civil conflicts. Philippe Martin, Thierry Mayer and Mathias Thoenig have a summary of their recent work on the relationship between international trade and civil war available at VoxEU.org. Their research finds that trade deters severe conflicts but fosters less severe ones.

In their paper, "Civil wars and International Trade", forthcoming, Journal of the European Economic Association Papers and Proceedings, Martin, Mayer and Thoenig argue that there are two possible mechanisms relating international trade and civil wars: deterrence and insurance. Their basic argument is:

The first effect is such that trade openness lowers the risk of civil wars, the second works in the opposite direction. Our hypothesis is the following: because civil wars destroy international trade, some of the economic gains generated by trade are put at risk for all groups (rebels and government), so that the opportunity cost of conflict increases with observed trade flows and all involved actors should have more incentive to make concessions and avoid a violent escalation. From this point of view, greater openness to international trade should act as a deterrent to escalation towards civil conflicts. However, international trade also provides a substitute to internal trade as it provides alternative sources of income and consumption. From this point of view, it can act as insurance and can reduce the opportunity cost of civil war. Another way to state the second argument is that international trade can weaken economic ties and dependencies between groups and regions inside a country. This reduced internal dependency decreases the opportunity cost of conflicts. This line of reasoning echoes the one made in our previous paper [This reference is to their paper, "Make Trade not war?", forthcoming, Review of Economic Studies. See their VoxEU.org column of 4 July 2007.] showing that multilateral trade (contrary to bilateral trade) openness increases the probability of a bilateral conflict between countries.

The authors summary contains a discussion of their empirical results. Their conclusion,

... is that trade openness has contrasting effects on the probability of civil wars. It deters severe conflicts but fosters less severe ones. Our work should be interpreted as a word of caution on the expectations that several commentators have put on globalisation as a means of reducing internal violence in poor countries. However, our results do point to the positive effect that trade openness has in deterring the most violent conflicts. This is no small achievement.

Governance without government

The corporate governance of for-profit and not-for-profit firms is a well studied area in economics, but the governance of criminal enterprises is not nearly so well understood. The obvious problem for any criminal organisation is that they cannot rely on state enforcement of their governance structures. So how do such organisations hold themselves together?

In a new paper, An-arrgh-chy: The Law and Economics of Pirate Organization, in the current issue (Volume 115, Number 6, December 2007) of the Journal of Political Economy, Peter Lesson looks at internal governance institutions for the case of seventeenth and eighteenth-century pirates.

The "golden age" of piracy extended from 1690 to 1730. The period between 1716 and 1722 marks the height of the golden era. Pirate crews were quite large. Based on figures from 37 pirate ships between 1716 and 1726, Leeson can tell us, that the average crew was around 80 men and crews in the range 150-200 were not uncommon. Leeson writes that

To effectively organize their banditry, pirates required mechanisms to prevent internal predation, minimize crew conflict, and maximize piratical profit. Pirates devised two institutions for this purpose. First, I analyze the system of piratical checks and balances crews used to constrain captain predation. Second, I examine how pirates used democratic constitutions to minimize conflict and create piratical law and order. Pirate governance created sufficient order and cooperation to make pirates one of the most sophisticated and successful criminal organizations in history.

One problem for the merchant ship organisation is owner-crew principal-agent problem. The owners had to devise a system whereby the ship's crew hopefully acted in the absentee owners interests. This was not a problem for pirates since,

On a pirate ship, the principals were the agents. As one historian described it, in this sense a pirate ship was like a "sea-going stock company" (Pringle 1953, 106). As a result, pirates did not require captains to align the crew’s interests with those of the ship’s absentee owners.

This does not mean however that pirates did not need captains. They did.

Many important piratical decisions, such as how to engage a potential target, how to pursue when "chasing" a target or being chased by authorities, and how to react if attacked, required snap decision making. There was no time for disagreement or debate in such cases, and conflicting voices would have made it impossible to undertake the most essential tasks. Furthermore, pirate ships, like all ships, needed some method of maintaining order, distributing victuals and payments, and administering discipline to unruly crew members.

This need for a captain, as Leeson points out, created a dilemma for pirates.

On the one hand, a captain who wielded unquestioned authority in certain decisions was critical for success. On the other hand, what was to prevent a captain with this power from behaving toward his pirate crew in the same manner that predatory merchant ship captains behaved toward their crews?

As pirates jointly owned the stolen ships they sailed on, the owners were also the agents. Thus pirates needed captains but not autocratic captains. The crews got what they wanted by democratically electing their captains.

Since the pirates sailing a particular ship were both the principals and the agents, democracy did not threaten to lead to captains who served the agents at the principals' expense. On the contrary, pirate democracy ensured that pirates got precisely the kind of captain they desired. Because pirates could popularly depose any captain who did not suit them and elect another in his place, pirate captains' ability to prey on crew members was greatly constrained compared to that of merchant ship captains.

Leeson also shows that another method pirates used to prevent the captain from abusing and cheating them was to divide the power on the ship. This was done by, in the main, by giving the power

... to allocate provisions, select and distribute loot (there was rarely room aboard pirate ships to take all they seized from a prize), and adjudicate crew member conflicts/administer discipline to the quartermaster, whom they democratically elected.

The fact that captains and quartermasters were elected, and could be deposed, created competition between the officers for the positions and helped encourage those elected to serve in the crews best interests.

But as documented by Leeson problems still remained. In particular how did they prevent the quartermasters from abusing their authority even if the captains didn't.

After all, not only were pirates afraid of captain predation; they opposed any situation that threatened to jeopardize their ability to cooperate for organized banditry, including the institution of the quartermaster. To solve this problem, pirate crews forged written constitutions that specified their laws and punishments for breaking these laws and more specifically limited the actions that quartermasters might take in carrying out their duties.

There were several important features of these constitutions.

First, they created a democratic form of governance and explicitly laid out the terms of pirate compensation. This was to clarify the status of property rights aboard pirate ships and to prevent officers, such as the captain or quartermaster, from preying on crew members. In particular, making the terms of compensation explicit helped to circumscribe the quartermaster’s authority in dividing booty.

If the booty was indivisible or its value in question, it could be sold or auctioned and the proceeds divided among the crew according to the rules. This prevented conflict among the crew and it constrained the powers of the quartermaster with regard to loot which was indivisible or of ambiguous value.

Second, some activities which may have generated negative externalities were prohibited. Activities such as drinking, fighting and gambling were often prohibited or controlled. Some ships also forbade the firing of one's gun or smoking around flammable goods.

Third, constitutions often provided incentives for crew productivity and to prevent shirking.

One manifestation of this was their creation of social insurance for pirates injured during battle. As in the examples from Exquemelin and Roberts above, articles specified in detail what a lost arm was worth, a lost leg, and so on. They even went as far as to assign different insurance values depending on whether it was, for instance, the right or left appendage that was mutilated or lost, according to the importance pirates assigned to these body parts.

Another manifestation of these incentive provisions was the use of bonuses for crew members who displayed particular courage in battle, were the first to spot potential targets, and so forth. Because pirate crews were large, quartermasters could not easily monitor individual pirates' effort.

The share system that was used that was used for payment did create incentives for free riding. One mans laziness will reduce all incomes but his own income will fall only by a little. To deal with this bonuses were used. If you behaved courageously or performed a deed of valour or captured a ship a bonus could be paid. Also the first person who sees a ship which provides a prize would receive a bonus.

Finally, rules regarding the punishments for breaking any rule were stipulated in the constitutions. In addition, should a situation arise for which there were no written rules, the crew would gather to act as a kind of judiciary to interpret or apply the ship's articles to this new situation.

Leeson argues that the historical record points to the effectiveness of these constitutions in controlling quartermaster abuse and when abuse did occur the evidence indicates that crews successfully removed the quartermaster.

Leeson also makes the point that

The fact that pirate crews unanimously consented to the articles that governed them, ex ante, also plays an important role in explaining their success. Pirates recognized that "it was every one's Interest to observe them, if they were minded to keep up so abominable a Combination"(Johnson 1726–28, 210). Since pirates agreed to these rules before sailing, rules were largely self-enforcing once in place.

Thus pirates are a case were rules of internal governance could be enforced without relying on the power of the state and that these rules of governance created sufficient order and cooperation to result in pirates being one of the most sophisticated and successful criminal organisations known.

The above summary covers only part of the 45 page Leeson article, all of which is worth reading. According to Chris Coyne at the Austrian Economists blog, this article is just part of a larger research project exploring the economics and governance of criminal organizations. Leeson is also working on a book, The The Invisible Hook: The Hidden Economics of Pirates, History’s Most Notorious Criminals, which is under contract with Princeton University Press and is scheduled to appear in 2009. If this article is anything to go by the book will be a must read.

The Age of Milton Friedman

Andrei Shleifer opens this latest paper with the passage,

The last quarter century has witnessed remarkable progress of mankind. The world's per capita inflation-adjusted income rose from $5400 in 1980 to $8500 in 2005. Schooling and life expectancy grew rapidly, while infant mortality and poverty fell just as fast. Compared to 1980, many more countries in the world are democratic today.

The last quarter century also saw wide acceptance of free market policies in both rich and poor countries: from private ownership, to free trade, to responsible budgets, to lower taxes. Three important events mark the beginning of this period. In 1979, Deng Xiao Ping started market reforms in China, which over the quarter century lifted hundreds of millions of people out of poverty. In the same year, Margaret Thatcher was elected Prime Minister in Britain, and initiated her radical reforms and a long period of growth. A year later, Ronald Reagan was elected President of the United States, and also embraced free market policies. All three of these leaders professed inspiration from the work of Milton Friedman. It is natural, then, to refer to the last quarter century as the Age of Milton Friedman.

The paper is a review of two books which have two very different views of the Age of Milton Friedman.

The first book is a collection of papers edited by Leszek Balcerowicz and Stanley Fischer which basically endorses free market policies, the second, a volume by Joseph Stiglitz, Jose Antonio Ocampo, Shari Spiegel, Richardo FFrench-Davis, and Deepak Nayyar which rejects them.

Shleifer begins his discussion by quickly summarizing the salient facts about the world economy and society over the last quarter century. He concludes that,

In the Age of Milton Friedman, the world economy expanded greatly, the quality of life improved sharply for billions of people, and dire poverty was substantially scaled back. All this while the world embraced free market reforms. Is this a coincidence? Two recent books disagree on the answer.

The Balcerowicz and Fischer edited book is a collection of articles presented at a conference devoted to convergence among economies which took place in Poland. The contributions to this volume are in the most part country studies of economic reforms and their consequences. These include studies of China, Chile, Spain, Portugal, Greece, Ireland, as well as the Former Soviet Union. Shleifer notes that the conclusion of the book is summarized by the editors as:

reliance on market forces within an open economy in a stable macroeconomic environment, with assured property rights, are the keys to rapid economic growth.

He then adds,

Milton Friedman would have put it better, but with the same idea.

Perhaps the best lesson for New Zealand comes from Shleifer's comment on the two chapters that deal with a another small open economy, Ireland.

The collection also includes a pair of essays – one by O’Connell and Smyth and one by Bradley -- on Ireland, the miracle of Western Europe. As much as any other country in the world, Ireland embraced the prescriptions of Milton Friedman: trade openness, low taxes, low regulations, and balanced budgets. "The main lesson from the Irish experience is that there are certain key prerequisites necessary to sustain high growth – namely, sound macroeconomic policies, a strong commitment to free trade, a lightly regulated competitive microeconomic environment, and a well-educated and flexible labor force (p. 285)." Starting as one of Western Europe’s laggards, Ireland became the richest country of the region in the span of one generation.

The current New Zealand government would do well to take note.

Shleifer goes on to note that

The world is a much gloomier place in the volume "Stability with Growth" by Stiglitz, Ocampo, Spiegel, FFrench-Davis, and Nayyar (hereafter Stiglitz et al.). The book is an extended critique of free-market policies and their advocates, and a proposal for alternative policies. This volume does not deal with all the policies Stiglitz has embraced, such as state ownership and extensive regulation. It merely emphasizes the virtues of inflation and capital controls.

Shleifer's veiw of this book is perhaps best captured by the following comment,

One way to give the readers of this review an overall sense of this book is with an example. On p. 70, Stiglitz et al. chastise conservatives for objecting to fiscal deficits by making "arguments based on the hard- to-verify notion of confidence." "Despite how frequently conservatives invoke the confidence argument, there is remarkably little empirical research on the matter (including research by the IMF which seems to rely on the confidence argument heavily)." Then, on p. 148, Stiglitz et al. attack George Bush's budget deficits, equally severely. "What will happen, not just to the United States, but to the stability of the global financial system if foreigners lose confidence (emphasis added) in the strength of the dollar, if they worry that it will depreciate in value in the current years?" A reader might lose confidence in the rest of the book.

Shleifer concludes his essay by pointing out,

On strategy, economics got the right answer: free market policies, supported but not encumbered by the government, deliver growth and prosperity. And while a lot has been accomplished in the last quarter century, a lot remains to be done. Most countries have embraced responsible fiscal policies, but it is far from clear that such policies can survive the volatility in the world's economy. World trade has a long way to go to become truly open. Many developing countries, especially in South Asia, Latin America, and Sub-Saharan Africa, urgently need government much less hostile to business. Many countries desperately need improvements in their legal systems, including bankruptcy systems, to secure property rights. Indeed, many Sub-Saharan African countries are rethinking their development strategies, after several state-centered false starts. It is far from a foregone conclusion that their governments will make good choices. We have a long haul ahead of us.

(HT: Greg Mankiw)

• Balcerowicz, Leszek and Stanley Fischer, eds., 2006, Living Standards and the Wealth of Nations: Successes and Failures in Real Convergence. Cambridge, MA: The MITPress.
• Stiglitz, Joseph E., Jose Antonio Ocampo, Shari Spiegel, Ricardo Ffrench-Davis, and Deepak Nayyar, 2006, Stability with Growth. Oxford: Oxford University Press.

Easterly on Gates and aid

On February 15 at Bloomberg Radio, "Bloomberg on the Economy," host Tom Keene spoke for an hour with Dr. William Easterly (look down the page and you will find the interview). Easterly is professor of economics at New York University, and author of The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good, and The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics. Keene and Easterly talk about Easterly's assessment of Bill Gates's poverty-fighting strategy and Gate's "blind spot" in helping the poor. Professor Easterly discussed the achievements and challenges of global aid programs and U.S. donations under President Bush.

Dan Ariely's new book "Predictably Irrational" (updated x2)

At Free Exchange they have a comment on the new book by Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions. The posting opens with,

I AM reading MIT behavioural economist Dan Ariely's new book "Predictably Irrational" and finding it very frustrating. The book is chock full of fascinating experiments that reveal how people make choices followed by stunning non-sequiturs and quaintly naive cultural and political commentary. The scientific quality seems high. The philosophical quality... not so high.

And that's the nice bit of the review.

Update: Tim Harford has a somewhat kinder review. Harford writes,

The book has a lot to recommend it. Ariely is a more than capable storyteller, and he sticks close to his own research so his writing is full of colour and detail. He also has a knack for conveying the rigour of the experiments without brandishing too many technicalities. And although he is pursuing a consistent theme throughout, there is a fresh insight in every chapter.

I could scarcely imagine a better introduction to “behavioural economics”, a discipline of growing influence that sits on the boundary between economics and psychology.

But adds,

But opinions differ among economists as to whether behavioural economics seriously challenges the long-held basic assumption of economics that we make rational choices, or whether it merely illuminates some fascinating but relatively minor human foibles.

Update 2: Tim Harford comments here on the difference between his review and that of the Economist.

"Public ownership" (updated)

Madsen Pirie at the Adam Smith Institute blog has a nice posting on the topic of public ownership being a misnomer. As Pirie puts it

The state sector may have the name of the public filled in on the dotted line, but the public do not own it in any meaningful sense of the word. All of the attributes of ownership, such as control, the right to determine what use is made of it and under what conditions, is determined by the bureaucracy in command of it.

This is an important point, without control you don't have ownership. As Oliver Wendell Holmes Jr. put it,

But what are the rights of ownership? They are substantially the same as those incident to possession. Within the limits prescribed by policy, the owner is allowed to exercise his natural powers over the subject-matter uninterfered with, and is more or less protected in excluding other people from such interference. The owner is allowed to exclude all, and is accountable to no one. (The Common Law, p193, (1963 edn.))

Clearly the "public" does not have the rights Holmes refers to. The government (or its bureaucracy) has these rights. Following Grossman and Hart ("The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration", 'Journal of Political Economy', 94:691-719) economist's tend to define the owner of an asset as the one who has residual rights of control over the asset; that is whoever can determine what is done with the asset, how it is used, by whom it is used, when they can use it etc - note that ownership is not defined in terms of income rights. Under "public" ownership it isn't the "public" who has the control rights, its the government. The "public" can not determine what use is made of a "public" asset, rather its use is determined by the politicians and managers in command of it.

Because the public has no choice over whether to pay for state services, or to choose what quality of service is appropriate for them, they have no power over them. In their absence it is the managers and workforce who increasingly direct the services to meet their needs and convenience instead of those of the public.

Just think of the "public" universities in New Zealand, there are no private ones, what control does the "public" have over them? Control rests with either the government or a complex system of academic and non-academic staff, executives, outside trustees and current and past students of the university. The university's "owners", the "public", have the least say of anyone in their running.

In fact as Pirie points out, paradoxically,

The public actually has more influence, via its choices and purchasing decisions, on private sector businesses than it can ever have over state industries and services.

So private is more public.

Update: At Not PC they ask, What does "the public" actually own?

Tax evasion and flat taxes

Tax evasion is an issue all round the world. Russia had for the years following the collapse of the Soviet Union large problems with tax evasion. In January 2001 it introduced a reformed personal income tax code. In fact it became the first large economy to adopt a flat tax. The new tax code replaced a conventional progressive rate structure with a flat tax rate of 13 percent. What were the effects of this?

A new NBER working paper looks at this question: Yuriy Gorodnichenko; Jorge Martinez-Vazquez; and Klara Sabirianova Peter, 2008. "Myth and Reality of Flat Tax Reform: Micro Estimates of Tax Evasion Response and Welfare Effects in Russia," NBER WP 13719.

In this paper it is argued that the flat tax reform was a major factor in decreasing tax evasion in Russia. It is also noted that greater fiscal revenues in 2001 and several years beyond can be linked to increased voluntary tax compliance and reporting. In addition it is found that there was a positive productivity effect on the real side of the economy albeit smaller than the tax evasion effect.

In a summary of their paper on VoxEU.org, Gorodnichenko, Martinez-Vazquez and Peter point out that

As income underreporting is not observable by definition, we use data on reported consumption and income to infer tax evasion. Under the permanent income hypothesis, current consumption should equal a share of permanent income. Assuming that consumption expenditures are fully reported, the discrepancy between consumption and income, which we call the consumption-income gap, indicates that households underreport a portion of their income.

The Russian tax reform decreased marginal tax rates for some groups of people only. Because of this it was possible to use the variation across time and taxpayers to identify and estimate the effects of the flat rate income tax reform.

The findings of the study indicate that, ceteris paribus, for the households who received the reduction in marginal tax rates the consumption-income gap decreased by 9 to 12% more than other households.

That is, the most significant reduction in tax evasion was for taxpayers that experienced a decrease in tax rates upon introduction of the flat tax.

The study also found that this decline in tax evasion was likely due to changes in voluntary compliance rather than being due to greater enforcement efforts by the tax authorities. The productivity effect which was measured by the relative increase in consumption for households that faced the lower tax rates post reform, was zero at the threshold and about 4% for those taxpayers that experienced the decrease in tax rates over a four-year period.

The research has a number of policy implications. If an economy is plagued by ubiquitous tax evasion, as was the case in Russia, then a flat rate income tax reform may lead to substantial revenue gains via increased voluntary compliance. But the strong evasion response suggests that the gains in efficiency from the Russian tax reform are perhaps smaller than it had been thought up to now.

Using observable responses of consumption and income to tax changes, we find that the tax-evasion-adjusted deadweight loss from the personal income tax is at least 30% smaller than the loss implied by the standard method based on the response of reported income to tax changes.

Thus, overall, it should be noted that while there are real efficiency gains from a flat tax, the most important result of reform appears to be the reduction of tax evasion.

Timothy Brook on EconTalk

This week on EconTalk, Timothy Brook, professor of history at the University of British Columbia and author of Vermeer's Hat: The Seventeenth Century and the Dawn of the Global World, talks with Russ Roberts about issues to do with the expansion of global trade between Europe and the rest of the world, and in particular, North American and China. He discusses the differences and similarities between Chinese and Western attitudes toward trade and exploration and the implications for innovation and knowledge.

Mankiw on non-textbooks

On his blog Greg Mankiw reports on a conversation he had recently with a student:

Student: Professor Mankiw, if you could recommend just one book, what book would it be?

Me: Am I allowed to recommend my favorite textbook?

Student: No. Textbooks are disallowed.

Me: In that case, I'll suggest Milton Friedman's Capitalism and Freedom.

Student: That's funny. That's the same answer I got when I asked this question of Professor Summers.

One wonders how often he would get that answer if he increased his sample size above two. Friedman was one of the great economists of all time and his book is an excellent read for economists and non-economists alike. More students need to read it.

But what other answers to the question could he get? What other readable, but serious, books could be recommended? The Road to Serfdom? Economic Sophisms? An Inquiry into the Nature and Causes of the Wealth of Nations? The Theory of Moral Sentiments? On Liberty?

CEOs as University Presidents

Peter Klein over at Organisations and Markets, raises an interesting question over who should head a university. He writes,

But I’m interested here in universities hiring former corporate CEOs, rather than career educators, as presidents.

This something many within a university would find totally unacceptable. But as Klein continues,

Gary Forsee, Sprint-Nextel CEO from 2005 to 2007, became my boss yesterday when he began his term as President of the University of Missouri System.

An issue with his appointment was that

... he holds only a bachelor’s degree and has no faculty or university administrator experience.

So how important is faculty experience to a university head? Is it really necessary that they have such experience? Isn't the head of a university just like the head of any other large corporation? The problems they face will be those that any business leader would face, so why is university experience considered so important?

As Klein notes,

Under the university-as-guild model, hiring a leader from outside the guild is unthinkable, akin to bringing in Richard Dawkins to head the Catholic Church, or hiring a guy who never played in the NBA to coach an NBA team.

Is it that universities are not just like any other large organisation. After all how many other organisations are run along the lines of a university? Are the rather odd rules for the head of a university just the result of the rather odd organisational form of the university in general? Universities are normally set up so that rights to residual income are suppressed entirely and control rights are apportioned in a complex system between academic and non-academic staff, executives, outside trustees and current and past students of the university. This is not the manner that most business are run (for good reasons). But does such a corporate governance structure mean that the head of the university must come from inside the organisation and from a subset of insiders, the academic staff?

Marginal Revolution book forum on chapter 7

Kevin Grier at Kids Prefer Cheese continues the Marginal Revolution book forum on the Logic of Life with a discussion of chapter 7, The World is Spiky.

Freedom v. being poor

Over at the blog of the Adam Smith Institute Madsen Pirie has a message which deals with the idea that "It's all very well to talk of freedom, but poor people are not free to buy Rolls Royces."

Pirie opens his message by pointing out that poor people are free to buy Rolls Royces, they just can't afford to do so. But they are not stopped from buying such things "by the whim or will of others".

If they had or could get money they could buy luxury goods, but there are some things people are not free to do, be they rich or poor. They cannot smoke with impunity in a public bar, or demonstrate within the vicinity of Parliament. Being banned from doing something is about curbs on freedom. Being able to afford something is about power over circumstance.

Pirie goes on to make the important point that there is a crucial difference between being unable to do something because of circumstance and being prevented from acting due to the superior power of others.

In the first case you have aspirations beyond your present abilities, but in the second case you are subject to the arbitrary dictates of an authority which makes you live as it sees fit, rather than as you want to do.

In a free society you are able to make your own decisions rather than suffer the whims of those in power.

There are things they cannot do, not because they are unfree, but because they are unable. People are free to jump unaided over the Eiffel Tower, but are not able to do so. The difference is that people can overcome a lack of means more readily than gravity. In a free society they can hope to prosper, and to do the things hitherto beyond them. In an unfree society they cannot.

Voting and economic policy (updated)

In his latest article in the New York Times, It's an Election, Not a Revolution, Tyler Cowen makes a nice point about voting and economic policy, one doesn't much effect the other:

To put it simply, the public this year will probably not vote itself into a much better or even much different economic policy. To be sure, the next president — whoever he or she may be — may well extend health care coverage to more Americans. But most of the country's economic problems won't be solved at the voting booth. It is already too late to stop an economic downturn. Health care costs will keep rising, no matter who becomes president or which party controls Congress. China is now a bigger carbon polluter than the United States, so don't expect a tax or cap-and-trade rules to solve global warming, even if American measures are very stringent — and they probably won't be, because higher home heating bills are not a vote winner. A Democratic president may propose more spending on social services, but most of the federal budget is on automatic pilot. Furthermore, even if a Republican president wanted to cut back on such mandates, the bulk of them are here to stay.

He goes on to make the point,

The reality is that democracy is a very blunt instrument, and in today's environment we are choosing between ways of muddling through. We may hear that the election is about different visions for America's future, but the pitches may be more akin to selling different brands of soap.

We hear so many superficial messages precisely because most American voters have neither the knowledge nor the commitment to evaluate the pronouncements of politicians on economic issues. It is no accident that the most influential political science book of the last year has been "The Myth of the Rational Voter," by Bryan Caplan. The book shows that many voters are ill-informed or even irrational; many economic issues are complex, and each voter knows that he or she will not determine the final outcome.

Cowen follows up with bit of advice,

Rather than being cynics, we should be realists. Democracy is reasonably good at some things: pushing scoundrels out of office, checking their worst excesses by requiring openness, and simply giving large numbers of people the feeling of having a voice. Democracy is not nearly as good at others: holding politicians accountable for their economic promises or translating the preferences of intellectuals into public policy.

Cowen is right in that economic policy does not in most cases change via the voting booth. For big economic changes to be implemented normally requires very special circumstances. In the US the New Deal brought about a revolution in economic policy, much of it for the worse. But at the time the US, and the world, was in a depression and economic planning was all the rage all over the world. For the US that period was exceptional. As Cowen writes,

That period is an exception; it does not reflect the general tendency of the American political system, which usually operates by checks and balances. Shifts in economic policy are usually quite moderate.

In New Zealand much change, mainly for the good, occurred post 1984. But again this an exceptional period for New Zealand. We had been driven into crisis and the Lange Labour government took advantage of that to make the needed changes. But that wasn't the norm and soon things when back to the politically normal. We got the famous Lange "breather and a cup of tea" of 1987 and it is still going on. We missed our big chance to move into the economic fast lane. And it appears we have a lack of political will, by all parties and voters, to try to get us back into it. Normal transmission has been resumed.

Update: Mark Thoma comments here. John at Swords Crossed comments here. Don Boudreaux comments here. Greg Mankiw comments here. Tyler comments here.

Technology and emerging markets

As far as technology getting into emerging markets is concerned, The Economist magazine argues that it is spreading faster than it ever has,

The upshot is that technology is spreading to emerging markets faster than it has ever done anywhere.

They make the case based on work done by the World Bank who looked at how much time elapsed between the invention of something and its widespread adoption. Widespread adoption they defined as when 80% of countries that use a technology first report it.

For 19th-century technologies the gap was long: 120 years for trains and open-hearth steel furnaces, 100 years for the telephone. For aviation and radio, invented in the early 20th century, the lag was 60 years. But for the PC and CAT scans the gap was around 20 years and for mobile phones just 16. In most countries, most technologies are available in some degree.

But the Economist also points out that

In almost all industrialised countries, once a technology is adopted it goes on to achieve mass-market scale, reaching 25% of the market for that particular device. Usually it hits 50%. In the World Bank's (admittedly incomplete) database, there are 28 examples of a new technology reaching 5% of the market in a rich country; of those, 23 went on to achieve over 50%. In other words, if something gets a foothold in a rich country, it usually spreads widely.

In emerging markets this is not necessarily so. The bank has 67 examples of a technology reaching 5% of the market in developing countries—but only six went on to capture half the national market. Where it did catch on, it usually spread as quickly as in the West. But the more striking finding is that the spread was so rare. Developing countries have been good at getting access to technology—and much less good at putting it to widespread use.

So its clear that absorption of technology is one thing, diffusion is another.

APEE Essay Contest Winners

The Association of Private Enterprise Education (APEE) Essay Contest winners for 2007 have been announced.

The winners are:

First Prize (US$2500): Brad Taylor (University of Canterbury, New Zealand), "Prosperity and the Freedom to Cooperate."

Congratulations Brad! Good to see that Canterbury isn't completely devoid of all sensible thought.

Second Prize (US$2000): Emily Rose, (Bethel College), "What Causes Prosperity: The Estonian Example."

Third Prize (US$1500): Gennady Stolyarov II (Hillsdale College), "Enabling Ethical Behavior Through Markets."

Top High-School Entry (US$500): Will Simpson (Homeschooled, Mountain View, Arizona ), "Ethical Ideas and Consequences."

Honorable Mentions (US$250): Ojo Adekunle B. (United States International University, Nairobi, Kenya), Chris Kuiper (Dordt College), Vrinda Maheshwari (National Law School of India University), Abigail Martin (Wheaton College), Josef Mladek (University of Economics, Prague, Czech Republic), Ryan Musser (Houghton College), Joel Runyon (Bethel College), Joseph W. Siler (The George Washington University), Neville Tirimba (Masinde Muliro University of Agriculture and Technology, Kakamega, Kenya), Raluca Mihaela Ursu (Wesleyan College).

(HT: Robert Lawson)

Voluntary tax

The Washington Times has a report on the success(?) of a voluntary taxation scheme in the US state of Virginia, and no its not a great success. The Washington Post writes,

State lawmakers can rule out Virginian's offering up more of their hard-earned money to fix the $1.4 billion budget shortfall Gov. Tim Kaine announced this week.

At least that is what a peek at the so-called "Tax Me More Fund" suggests.

Since its inception in 2002, the fund has collected a total of $10,217.04.

This is 0.00000005 percent of Virginia's budget since 2002. The best year so far was 2003 when the program collected $6,602. The low point was in 2006, when the state received $19.36.

I'm sure there is a message in this somewhere.

(HT: Megan McArdle via Arnold Kling)

Why governments pick losers ... or do they? (updated)

Earlier I blogged on Why do governments back losers? Two parts of an answer. I now learn that there is a NBER working paper from a few years ago in which Richard E. Baldwin and Frederic Robert-Nicoud argue its not so much that government policy picks losers, it is that losers pick government policy. The paper is Entry and Asymmetric Lobbying: Why Governments Pick Losers, NBER Working Paper No. 8756, January 2002.

Baldwin and Robert-Nicoud point out that governments that try to pick winners and losers usually choose the latter. They note that governments intervene to support many industries but a large proportion of such support goes to the ailing sectors of the economy.

In the US and Europe, the most protected sectors – agriculture, textiles, clothing, footwear, steel and shipbuilding –have all been in decline for decades. Counter examples are rare. Even when a growing sector gets protection, such as the US semiconductor industry, the protection tends to focus on market segments – like memory chips – in which the domestic industry is losing ground.

In their paper Baldwin and Robert-Nicoud try to explain this outcome via a lobbying model that allows for entry and sunk costs.

At the heart of the pressure-group approach is the presumption that special interest groups (SIGs) who spend the most on lobbying or other political activities are, other things equal, the ones that get the most government support. In this light, the success of sunset industries in winning a disproportionate share of government support is paradoxical. After all, lobbying dollars of expanding industries should be just as welcomed by politician as those of declining industries and an industry’s ability to finance lobbying expenditures and its interest in obtaining government support should be positively related to its size, employment and/or profitability; one would expect the highest levels of government support in the biggest and strongest sectors rather than in ailing sectors.

The basic story behind the Baldwin and Robert-Nicoud model is the notion that government policy is influenced by pressure groups and such lobbying is costly. But SIGs need to incur these costs in order to create rents that they hope to appropriate.

There is, however, a strong asymmetry in the ability of expanding and contracting industries to appropriate the benefits of lobbying. In an expanding industry, policy-created rents attract new entry that erodes the rents. In the extreme, free and instantaneous entry obviates all rents. This is not true in declining industries. Since sunk market-entry costs (e.g., unrecoverable investments in product development, training and brand name advertising) create quasi-rents, profits in declining industries can be raised without attracting entry as long as the level of quasi-rents does not rise above a normal rate of return on the sunk capital.

This asymmetry in the appropriability of rents creates an asymmetry in the incentive to lobby. The upshoot being that losers lobby more and harder. This, in turn, means that government policy is more influenced by losers, that is,

... government policy doesn’'t pick losers; losers pick governments policy.

Baldwin and Robert-Nicoud note that a corollary to this reasoning accounts for the tendency of SIGs to fight harder to avoid losses than they do to win new gains.

(HT: Tim Harford)

Update: Not PC gives an example of Losers picking losers

20 reasons it's okay to hate Valentine's Day

The Times has a list, 20 reasons it's okay to hate Valentine's Day. Number 14 is

It's such a rip-off. With flowers, dinner and cabs, you’re looking at a hundred quid minimum. Wouldn’t she just prefer the cash instead?

This has to be true, as any economist will tell you. Just giving her the cash must be pareto improving. With the cash she can either go out and buy what you would have bought, so she and you are no worse off, or she can buy what she really wants, and you would not have bought, so you will both be better off.

So next year, just give her the money guys.

Whats your class worth?

The Chronicle of Higher Education has a report on ways that universities allocate students to classes.

At the University of Chicago you aren't allowed to sell your place in a class but "... the University of Pennsylvania's Wharton business school actually encourages it."

Wharton auctions spots to its M.B.A. students, allowing them to bid for their classes. They don't use real money; instead, students are each given 5,000 points when they enroll and 1,000 more for every credit they earn. An average course might sell for a few hundred points while the most sought-after ones can top 10,000.

But they go even further at Wharton, they allow students to sell their courses (for points) to other students.

It's all done through a Web site. Buyers and sellers are anonymous, so buddies can't make deals. Wharton also uses a second-price auction in which the highest bidder wins, but he or she pays the amount of the second-highest bid. Economists like the second-price auction because they think it encourages more honest bidding

The Chronicle points out that

Because students can place a numerical value on a class, they're better able to express their preferences. If one student bids 500 points and another bids 2,000, then it's clear, in theory, who wants it more.

Student take it seriously. Students study data from the previous semesters and try to outsmart their classmates. In fact some students try to game their fellow students,

Students regularly buy classes they don't want to take in hopes of selling them, making a profit, and using those points to buy classes they really do want.

Not that such an approach is allowed everywhere. As noted above, administrators (who else?) at the University of Chicago won't let you sell your place in class. We know since a women tried to sell her place in an economics class taught by Steven D. Levitt on line, and the administrators stopped her. What did Levitt think? He reports that

I liked her approach, though, so we’ve now got her employed doing research assistance for the sequel to Freakonomics.

Marginal Revolution book forum on chapter 6

The latest Marginal Revolution book forum is on chapter six of Tim Harford's book The Logic of Life. Its by Bryan Caplan and on "rational racism".

Does Free Trade Favour Rich Countries?

The University of Cambridge economist Ha-Joon Chang discusses (audio) his new book, Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism, with Tyler Cowen, a professor of economics at George Mason University. To quote Tyler "I believe in that myth and I try to hold his feet to the fire." I'm with Tyler on this one.

Venezuela Plays the Oil Card

Arnold Kling comments on the reports that Petroleos de Venezuela SA, the state oil company in Venezuela, cut off sales of crude, gasoline and diesel to Exxon Mobil Corp. in retaliation for the freezing of $12 billion in assets in a legal dispute.

Likely outcome, little effect on Exxon Mobil much more harm to Venezuela.

A Tribute to Julian Simon

Don Boudreaux notes the 10th anniversary of the passing of the late great Julian Simon.

Smoking bans can kill (updated x2)

According to this report in the The Boston Globe smoking bans can kill. The Globe points to research soon to be published in the Journal of Public Economics. The paper, "Drunk driving after the passage of smoking bans in bars" by S. Adams and C. Cotti, shows that smoking bans increase drunken-driving fatalities. The Globe writes,

SMOKING BANS CAN be hazardous to some people's health. A rigorous statistical examination has found that smoking bans increase drunken-driving fatalities. One might expect that a ban on smoking in bars would deter some people from showing up, thereby reducing the number of people driving home drunk. But jurisdictions with smoking bans often border jurisdictions without bans, and some bars may skirt the ban, so that smokers can bypass the ban with extra driving. There is also a large overlap between the smoker and alcoholic populations, which would exacerbate the danger from extra driving. The authors estimate that smoking bans increase fatal drunken-driving accidents by about 13 percent, or about 2.5 such accidents per year for a typical county.

The Law of Unintended Consequences yet again. The interesting question is how will the health fascists react to such news. Ban drinking as well?

Update: Comments from Tyler Cowen at Marginal Revolution are here. Phil Miller at Market Power comments here.

Update 2: At Productivity Shock they point out that

If you have ScienceDirect access, the article is online already, and here is the abstract:

Using geographic variation in local and state smoke-free bar laws in the US, we observe an increase in fatal accidents involving alcohol following bans on smoking in bars that is not observed in places without bans. Although an increased accident risk might seem surprising at first, two strands of literature on consumer behavior suggest potential explanations — smokers driving longer distances to a bordering jurisdiction that allows smoking in bars and smokers driving longer distances within their jurisdiction to bars that still allow smoking, perhaps through non-compliance or outdoor seating. We find evidence consistent with both explanations. The increased miles driven by drivers wishing to smoke and drink offsets any reduction in driving from smokers choosing to stay home following a ban, resulting in increased alcohol-related accidents. This result proves durable, as we subject it to an extensive battery of robustness checks.

Marginal Revolution book forum 5

The latest Marginal Revolution book forum is on chapter five of Tim Harford's book The Logic of Life. Its by Tyler Cowen and on Schelling's segregation model.

Easterly at EconTalk

William Easterly is this weeks guest on EconTalk. He talks with Russ Roberts about Growth, Poverty, and Aid.

William Easterly of New York University and author of The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good, and The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics, talks about why some nations escape poverty while others do not, why aid almost always fails to create growth, and what can realistically be done to help the poorest people in the world. Easterly's view is in contrast with the optimism of Paul Collier.

Property rights without government (updated)

The importance of property rights to economic growth and development is increasingly being acknowledged by economists. Along with this normally comes an argument as to the necessity of government for the enforcement of those rights. Absent such a government, it is argued, investors simply do not invest, farmers do not farm (or at least not expand their activities), artisans do not innovate, and merchants do not trade. This is simply because without a government to secure property rights agents are unsure as to whether or not they will retain the rewards of their endeavours.

While the argument is correct with regard to the importance of secure property rights, it is less clear as to the necessity of government for rights enforcement. Medieval Japan (ca. 1100-1600) was a period of economic growth but growth took place without much of a central government to enforce claims to resources. A recent working paper Property Rights In Medieval Japan: The Role Of Buddhist Temples And Monasteries by Mikael Adolphson and J. Mark Ramseyer argues that with regard to government in medieval Japan,

Emperors it had, along with regents, courtiers, warriors, and eventually shōgun and shōgunal regents. Yet these men seldom offered citizens much stability. Certainly, they seldom offered the security that would have induced citizens to invest scarce resources in easily appropriable investments or to undertake long-distance trade. These were not years of stability or peace. They were centuries of intrigue, murder, predation, and war.

But they also point out that,

... the Japanese economy grew anyway. Despite the chaos, people cleared forests. They lent money. They built elaborate and expensive irrigation facilities. They constructed sake breweries. And they traded their goods over longer and longer distances.

How then were property rights protected? Adolphson and Ramseyer show that temples and monasteries undertook the role of rights enforcer.

To obtain a secure claim to real estate, for example, a local landholder might "commend" his land to a temple (or monastery). Through the process, the temple obtained an equity interest in the land (took a cut of the harvest), and the landholder obtained an exemption from tax. At least as important, the landholder obtained the ability to call upon the temple to (and the temple had an incentive to) protect his land from rival claimants. Artisans and merchants obtained analogous protection by joining temple-sponsored guilds. They paid their dues, and the temple enforced their contracts.

In addition to the tax exemption the temples and monasteries offered a landholder two other sets of valuable services. First, they would adjudicate disputes over trades and property between parties within their jurisdictions. So contracts could be enforced. Second, estates within a temple's or monastery's region of control would be protected against threats and intrusions from outside parties. While it is true that some private landowners has the ability to protect their own property, in many cases the temples and monasteries had under their control the resources necessary to more effectively protect property.

Not only that but the temples and monasteries competed with each other to such services to landholders.

The competition was intense -- sometimes to a temple's chagrin. In 1145, for example, one landholder in the Uchi district commended a field to Kōfukuji. He soon concluded that Kōfukuji charged too much, and commended it to another temple instead. Kōfukuji was not amused. When its clergy tried to arrest the commendor, he fled to the rival temple. Kōfukuji laid siege to the temple, but he escaped. That rival temple then chased him with over 500 warriors, but encountered the district administrator's warriors (himself a Fujiwara -- recall that Kōfukuji was the Fujiwara temple). Reported one account, "there were too many casualties to count".

What in effect occurred was that "government services" were provided not by central government but in a competition market by private suppliers. This private provision was effective enough to allow economic growth to take place.

In effect, the temples and monasteries competed with each other to provide landholders with what we usually consider basic government services. In effect, medieval Japan maintained a market in private governments. Imperfectly to be sure, the resulting arrangements gave landholders something close to the protection they needed to improve and maintain their land.

Update: Another case of private law enforcement is Medieval Iceland as discussed by David Friedman in Private Creation and Enforcement of Law: A Historical Case.

You Are What You Spend (updated x3)

In an article in the New York Times, Michael Cox and Richard Alm tell us You Are What You Spend. Why does this matter? We are always told about the growing gap between "rich" and "poor" but this gap depends on what you measure. As Cox and Alm point out,

It’s true that the share of national income going to the richest 20 percent of households rose from 43.6 percent in 1975 to 49.6 percent in 2006, the most recent year for which the Bureau of Labor Statistics has complete data. Meanwhile, families in the lowest fifth saw their piece of the pie fall from 4.3 percent to 3.3 percent.

But as they also point out,

Income statistics, however, don’t tell the whole story of Americans’ living standards. Looking at a far more direct measure of American families’ economic status — household consumption — indicates that the gap between rich and poor is far less than most assume, and that the abstract, income-based way in which we measure the so-called poverty rate no longer applies to our society.

If you take the ratio of the incomes of the top and bottom fifths of US income eaners, you see a ratio of 15 to 1. If you look at consumption however, the gap declines to around 4 to 1.

A similar narrowing takes place throughout all levels of income distribution. The middle 20 percent of families had incomes more than four times the bottom fifth. Yet their edge in consumption fell to about 2 to 1.

So what is measured really does matter. Why then should we look at consumption? To understand why it helps to consider how our lives have changed over time.

Nearly all American families now have refrigerators, stoves, color TVs, telephones and radios. Air-conditioners, cars, VCRs or DVD players, microwave ovens, washing machines, clothes dryers and cellphones have reached more than 80 percent of households.

Cox and Alm note that

The conveniences we take for granted today usually began as niche products only a few wealthy families could afford. In time, ownership spread through the levels of income distribution as rising wages and falling prices made them affordable in the currency that matters most — the amount of time one had to put in at work to gain the necessary purchasing power.

Look, for example, at the number of hours of work needed to purchase a VCR. At the average US wage to buy a VCR in 1972 took 365 hours of work, today it is just two hours.

A cellphone dropped from 456 hours in 1984 to four hours. A personal computer, jazzed up with thousands of times the computing power of the 1984 I.B.M., declined from 435 hours to 25 hours. Even cars are taking a smaller toll on our bank accounts: in the past decade, the work-time price of a mid-size Ford sedan declined by 6 percent.

Cox and Alm note that there are a number of reason for this increase in the well being of Americans,

... but perhaps the biggest is increased international trade. Imports lower prices directly. Cheaper inputs cut domestic companies’ costs. International competition forces producers everywhere to become more efficient and hold down prices. Nations do what they do best and trade for the rest.

This means that the costs of goods have dropped drastically, lower income families can buy more for their dollar, their well being has increased.

While foreign competition may have eroded some American workers’ incomes, looking at consumption broadens our perspective. Simply put, the poor are less poor. Globalization extends and deepens a capitalist system that has for generations been lifting American living standards — for high-income households, of course, but for low-income ones as well.

Bottom line. It's the command over goods and services that ultimately determines living standards and looking at consumption gives us a handle on peoples command over goods and services.

Update: Art Carden comments here, Don Boudreaux comments here, Greg Mankiw is here, Paul Krugman is here.

Update 2: Commets from the Free exchange blog are here.

Update 3: Tyler Cowen comments here. Mark Thoma is here.