Monday 31 August 2009

Interesting blog bits

  1. Dan Klein asks A Milton Friedman on the Horizon? I think not.
  2. Gary Becker points out that More Regulation of Mortgages would Likely Hurt Consumers.
  3. Brad Taylor on Minority Rights are Anti-Democratic. Robert Dahl knows his democratic theory, so we should take notice when he argues that the protection of minority interests conflicts with democratic ideals.
  4. Al Roth has a list of Misc. organ transplant links. All have something interesting to say about transplantation.
  5. Eric Crampton on Strategic incompetence. For the mafia, signalling incompetence at running a business credibly shows the subject of the protection racket that the mafia just wants to keep extracting money that way rather than take over the business fully. In academia, at least in Italy, something similar happens.
  6. Ann Harrison on International trade, offshoring, and US wages. This column revisits the heated debate over international trade, offshoring, and US wages using new data. It says that increased international exchange with low-income countries has depressed US wages. That effect only arose during the 1990s, suggesting a different conclusion about trade, offshoring, and income inequality than the previous round of debate.

The long-term impact of hurricanes

A version of the Broken Window Fallacy is that while natural disasters, such as hurricanes, create havoc and impose large costs in the short run, they also simulate economic activity and thus are good for the economy. From the Economic Logic blog comes this counter to such thinking:
Makena Coffman and Ilan Noy study the case of the Hawaiian island of Kauai that was affected by hurricane Iniki in 1992, while neighboring Maui was not. Comparing the two islands, it appears clearly that while externally there are few signs of the hurricane seventeen years ago, Kauai is still suffering, mostly because its labor market still has not recovered, despite massive transfers right after the storm. Population took a permanent hit, at least partly as a consequence of a sudden drop in the housing stock and a spike in unemployment, and never recovered compared to the neighboring island.
Yes people natural disasters really are bad.

Sunday 30 August 2009

Sautet on Kennedy

Over at the Austrian Economists blog Frederic Sautet writes on Senator Edward Kennedy. He says,
Instead of worshiping politicians, we should wake up to the current situation. Since the fall of the Roman Empire, nations and civilizations have fallen because of two things: fiscal recklessness and inflation. This is because bad policies are rarely reversed. Instead, politicians attempt to mitigate the consequences of their stupidity through fiscal expansion and inflation. The U.S. was born under the “Old Time Fiscal Religion,” as Richard Wagner and James Buchanan put it. For decades, fiscal prudence and low inflation were the mantra. Not anymore. So let’s be honest, while Senator Kennedy may have been well-intentioned (and I leave that to God to judge), he has promoted the expansion of government and the establishment of socialist policies in the United States. With others, he has pushed ideas that have made fiscal and individual irresponsibility acceptable. Is this what being a true American hero is about?
It may not be what a true American (or New Zealand) hero is about, but it is, sadly, what being a politician is all about.

The least surprising correlation of all time (updated)

One wonders what Marty G from the Standard would make of this graph.

The New York Times Economix blog offers us the above graph, showing that kids from higher income families get higher average SAT scores. Clearly it's another example of the unfair advantages that the wealthy get in our society. Just because their parents are wealthy kids get higher SAT scores. It is obvious that government intervention is needed to equalise incomes and SAT scores at the same time.

(HT: Greg Mankiw)

Update: For more on this issue see here and here.

The irony of it

Weather supercomputer used to predict climate change is one of Britain's worst polluters

Saturday 29 August 2009

Scale and scope of government

There are at least two ways of dealing with failing banks. 1. bail them out 2. let those banks go through the normal bankruptcy and reorganization process. To me the second option seems the best. In the world of the second best, it seems preferable to have a known, predictable process of bankruptcy rather than a new, uncertain, largely political, processes of the bailout. Steven Horwitz writes on this topic,
I think that's exactly right. One can make a Higgsian point here about regime uncertainty: we're always better off (in the world of the second best) by operating under the known and predictable set of government rules than adopting new ones that have never been used before, or giving purely discretionary power to government agencies.
But Horwitz goes further to make a second, Higgsian, point,
We also know from Higgs and public choice theory more generally that once powers are given to government during a crisis, they never totally disappear when the crisis is over. So even if one thinks there was something unique about the situation last fall, it's naive to think that the powers the Fed and other agencies grabbed to fight it would go away in the long run. From a libertarian perspective then, the bailouts look like a really bad idea in the longer view.
Now a possible response to this argument is to say "if you did all of this through the bankruptcy courts, wouldn't that be enlarging government's size as well?" Yes, but with a difference. As Horwitz puts it,
Giving more cases to bankruptcy courts would be an increase in the scale of government, but not in its scope. This scale vs. scope distinction is one Higgs makes at the beginning of Crisis and Leviathan but is often overlooked in quick discussions of its main arguments.
Here "scale" means that government grows not by adding new powers but by having to do more with the powers it already has. Such expansion may be due ot factors like growth in the population or the economy or in other things that would draw more heavily on existing processes. "Scope,"refers to the size of the set of powers governments have. Growth in scope means acquiring new powers. Horwitz notes,
In Higgs's theory of crises and government growth, the key point is that crises lead to expansions of the scope of government that do not ever completely disappear.
Returning to the issue of bailouts Horwitz writes,
[...] the bailouts gave government new powers it never had before, expanding its scope, but using the bankruptcy process would have only expanded the scale of powers it already had. Forced to make that choice, a libertarian perspective would see increasing the scale as the notably lesser of two evils.
The state will be involved in whatever process is used to resolve the problems of the banking system in the US. But it seems better to rely a known and predictable process that only expands government's scale rather than turn to an unknown, unpredictable process that expands the scope of government by granting to it powers it did not previously have. Horwitz concludes,
From a libertarian perspective neither is ideal, but I would argue growth in scale is much less damaging than growth in scope, in the short run and especially the long run.
This may be an unacknowledged benefit of New Zealand's more low key approach to the economic crisis, we have expanded the scope of government less than has been the case in other countries.

Friday 28 August 2009

Complexity and central planning

This from Philip Booth at the IEA blog:
The Pythagorean Theorem has 24 words. The ten commandments (English version) contain 138 words. US regulations about cabbages contain about 26,000.

Not to be outdone, the Department for Education in this country [UK] over a 12 month period sent to schools thousands of pages of “guidance” documents, containing almost 1.3 million words - one and a half times as many as in the King James Bible. Schools even received a 90-page document advising head teachers how to cut down on bureaucracy.
So it takes 90 pages to cut down on bureaucracy?!!! I hate to think what it would take if the wanted to increase it!

Competition builds trust

Patrick Francoi, Thomas Fujiwara and Tanguy van Ypersele have an article over at on Competition builds trust
Recent research argues that culture affects economic outcomes. Do markets instil cultural values that support good outcomes? This column provides evidence that more competitive markets raise employees’ trust levels. That suggests that competitive markets build the values that support them.
So competitive markets are economically and morally good.

Thursday 27 August 2009

EconTalk this week

David Brady of Stanford University talks with EconTalk host Russ Roberts about American public opinion on changing the health care system. Brady discusses the impact of taxation on public opinion toward health care reform--if the poll includes a measure of the likely increase in taxes necessary to pay for expanding coverage, support for expanding coverage drops dramatically compared to generic polls that ignore costs. He also discusses the role of the party system and partisanship for the health care issue and more generally, how partisanship has changed over time. The conversation concludes with Brady's views on how much science there is in political science.

Boettke v. Cowen (updated)

Over at Marginal Revolution Tyler Cowen asks Were the bailouts a good idea? Cowen argues that in hindsight, we should consider the bailout to have been successful in averting a financial meltdown of the US economy. Specifically he asks whether Peter Boettke, of the Austrian Economists blog, can bring myself to admit this. Boettke has now replied. Boettke writes,
The basic point I would like to make is that those long-run negative consequences that Tyler admits in his post might cause problems (perhaps even serious ones) are in fact problems. The cycle of deficits, debt, debasement doesn't just cause economic disturbances against a long-term growth trend, it has historically destroyed the economies of nations. If what the bailout and shift in both the traditional role of the Fed and Treasury perform have done is unleash this cycle of deficits, debt and debasement rather than constrain it (as it obviously has done!), then we have sent our national economic policies on a path of ruin that may well set us back for decades.

But there is more to my hesitation than just this issue of short-run and long-run consequences as can be gleaned by following the commentary I have made throughout the history of the debates over the financial crisis. I have been consistently against the bailout, and critical of Fed and Treasury behavior in general. Government activism isn't the cure for the crisis, it is the cause.
He ends by saying
But expediency tends to defeat principle in political discourse, because of the focus on direct and immediate effects whereas principle tends to focus on indirect and long-run effects. Was it expedient to pursue the bailout? Of course. But was it a policy move that followed a working principle of public policy? Of course not. And once we include those indirect and long-run negative consequences the assessment of the effectivenss of the bailout on averting disaster is not as easy as Tyler suggests.
In the comments to the Boettke post Steve Horwitz writes
[...] but I've never, ever suggested that "bailing out" the banks was even the right second-best policy. Banks should have been allowed to fail if they made bad investments. Adding reserves into the system to prevent the money supply from falling and leading to more, economically unjustified, bank failures is a different matter.

So I have no problem at all saying "banks shouldn't have been bailed out," but I think that's a different idea from "the Fed should have done nothing."
I feel Horwitz is right, there is a difference between saying the Fed should have done nothing and saying bank shouldn't have been bailed out. The bailouts were not a good idea, just think of the moral hazard problem this has created, while there may have been more justification for the Fed acting to prevent the money supply from falling.

Update: Matt Nolan writes on Bailouts, moral hazard, and the money supply.

Jeffrey Miron blogging again

Economist Jeffrey Miron is blogging again at Libertarianism, from A to Z : A Small Government Perspective from Jeffrey Miron. This will be a blog well worth adding to your blog list.

A Nobel for the theory of the firm?

Peter Klein at the Organizations and Markets blog argues,
Josh Wright makes a good case for an economics prize honoring the UCLA tradition in the theory of the firm, property rights, and transaction costs. Josh himself is an excellent representative of that tradition.
Williamson is still my favorite dark horse candidate, for obvious personal reasons, but I’d be delighted to see Klein, Alchian, Demsetz, or even Barzel and Cheung recognized for their contributions.
Personally my beat for a theory of the firm Nobel, if there is to be one, would be Willaimson, Holmstrom and Hart together. Which does leave the UCLA boys out in the cold. My view is, however, that there is so little interest in the theory of the firm these days that it is highly unlikely that the Nobel committee would award in this area.

Wednesday 26 August 2009

Why peak oil is wrong

In this New York Times Op-Ed, Michael Lynch explains,why the "peak oil" concept is so wrong.
Like many Malthusian beliefs, peak oil theory has been promoted by a motivated group of scientists and laymen who base their conclusions on poor analyses of data and misinterpretations of technical material. But because the news media and prominent figures like James Schlesinger, a former secretary of energy, and the oilman T. Boone Pickens have taken peak oil seriously, the public is understandably alarmed.

A careful examination of the facts shows that most arguments about peak oil are based on anecdotal information, vague references and ignorance of how the oil industry goes about finding fields and extracting petroleum.
Worth a read.

The Economist on predatory pricing (updated)

Most industrial organisation economists will agree that so-called "predatory pricing" is a rare phenomenon. This doesn't stop the courts from finding predatory pricing almost everywhere as the recent EU Intel case shows. The Economist magazine has a article in which it discusses predatory pricing in light of the Intel judgement. It says
Allegations of predatory pricing have a long history. The Sherman Antitrust Act of 1890, the foundation of America’s competition policy, was partly a response to complaints by small firms that larger rivals wanted to drive them out of business. Trustbusters need to be wary of such claims. Low prices are one of the fruits of competition: penalising business giants for price cuts would be perverse.
The Standard Oil case of 1911 is a landmark in the development of anti-trust law. But in his famous paper "Predatory Price Cutting: The Standard Oil (N. J.) Case", John S. McGee showed that the predatory pricing case against Standard Oil didn't make economic sense.

The Economist continues
Establishing that a firm is guilty of predation is difficult. If rivals stumble or fail, that may be down to their own inefficiency or poor products, and not because they were preyed upon. Proving that a firm is pricing below its costs is tricky in practice. Even where a reliable price-cost or profit-sacrifice test is feasible, failing it need not imply sinister intent. There are often pro-competitive reasons to forgo short-term profits. Firms with a new product, or a new version of an existing one, may wish to pick a lossmaking price to defray the cost to consumers of switching, or because they expect their own costs to fall as they perfect the production process (video-game consoles are a classic example). Losses would then be a licit investment in future profits.

Predation is even trickier to uncover when goods are sold together. A firm that enjoys fat profits on one good may “bundle” it with another on which margins are lower. If the discount on the bundle is hefty enough, other firms may struggle to offer as enticing a deal. In 2001 the EU blocked a proposed tie-up between GE and Honeywell for fear that the merged firm might use bundled discounts to squeeze rival suppliers. In 2007 a committee of antitrust experts appointed by the American government proposed a test for whether bundling is predatory. First, assume the discount applies solely to the low-margin good. So if each good sells for $10 separately and $16 as a bundle, allocate the $4 discount to the more “competitive” product. Next, apply a price-cost test: if the product costs over $6 to make, the bundle is predatory.

That check seems neat but sound business practices may still fall foul of it. It may be cheaper for a firm to sell the two goods together, because of cost savings on distribution. Firms also often use bundling as a way of charging high-demand users more. Thin margins on sales of printers, for example, can be made up by bundling in more profitable toners. This kind of “metering” is an efficient way of recovering fixed costs such as research.

Another ambiguous tactic is to offer rebates to customers that reach certain sales targets. Bulk buyers generally pay lower unit prices to reflect suppliers’ economies of scale. Rebates can also help align incentives. Suppliers want retailers to promote their products, offer in-store information and keep plentiful stocks. The trouble is, retailers bear all the costs of such sales efforts but reap only some of the benefits. Rebates provide incentives for retailers to drive sales, as profits are bigger once the target is met.
Louis Phlips suggests that the necessary conditions for predatory pricing are
To sum up, economic theory suggests that predatory pricing is a real possibility only when the following five conditions are simultaneously met:
1 The aggressor is a multimarket firm (possibly a multiproduct firm).
2 The predator attacks after entry has occurred in one of its markets.
3 The attack takes the form of a price cut in one of the predator's markets, which brings this price below a current non-cooperative Nash equilibrium price at which the entry value is positive for the entrant (possibly below a discriminatory current Nash equilibrium price with the same property).
4 The price cut makes the entry value negative (in present value terms) in the market in which predation occurs.
5 Yet the victim is not sure that the price cut is predatory. The price cut could be interpreted by the entrant as implying that its entry value is negative under normal competition. In other words, the victim entertains the possibility that there is no room for it in the market under competitive conditions.
It seems unlikely that such conditions are ever met in the real world and such conditions also mean that it is unlikely that competition agencies will find a robust and simple rule to use to detect predatory pricing. Most just seem to fall back on the old presumption that firms with market power are always suspect. William Landes tells the story about why Ronald Coase gave up antitrust,
“Ronald [Coase] said he had gotten tired of antitrust because when the prices went up the judges said it was monopoly, when the prices went down they said it was predatory pricing, and when they stayed the same they said it was tacit collusion.”

–William Landes, “The Fire of Truth: A Remembrance of Law and Econ at Chicago”, JLE (1981) p. 193.
A rule that says everything is illegal is at least simple.

Update: In the comments to this post John Lott makes the important point that
If predatory pricing is going to occur any place, it seems much more likely to be done by government enterprises.
For more on anticompetitive behaviour by public enterprises see John Lott Jr., "Predation by Public Enterprises", Journal of Public Economics 43 (2) November: 237-51 and "Competing with the Government: Anticompetitive Behavior and Public Enterprises", edited by R. Richard Geddes, Standford: Hoover Institution Press, 2004. For an empirical analysis of predatory pricing see Lott's book "Are Predatory Commitments Credible?: Who Should the Courts Believe?", Chicago: University Of Chicago Press, 1999.

Tuesday 25 August 2009

Asymmetric information: banking version (updated)

Peter Klein over at the Organization and Markets blog writes
At least one major US bank is advertising the fact that it refused TARP funds. Bernanke and Co. must be unhappy, as they insisted that all large banks take the money to avoid tainting those that actually needed it
In other words, markets are finding way to undo the government's attempt at preventing the truth about the financial conditions of banks from coming out.

If you are a strong bank, you can signal this to people by pointing out that you didn't need or take TARP funds. As Klein writes,
The irony in all this is that government intervention in financial markets is usually justified by claims about asymmetric information: consumers can’t distinguish reliable from unreliable banks, insurers can’t tell healthy from unhealthy people, and so on, leading to a rash of adverse-selection problems that market mechanisms cannot solve. Actually the reverse is true: low-quality but politically connected financial institutions rely on government intervention to enforce a pooling equilibrium, preventing the market signaling and screening that would otherwise take place.
The moral of the story, markets can deal with asymmetric information.

Update: At TVHE the Hand talks about Bank runs and TARP.

Risk taking and the menstrual cycle

From the Economic Logic blog comes this piece on Risk taking and the menstrual cycle:
Matthew Pearson and Burkhard Schipper asked an unusual question to the female participants in an otherwise standard auction experiment: what stage of your menstrual cycle are you in? It turns out the answer can explain bidding behavior: while otherwise indistinguishable from men, women in their menstrual and premenstrual phase bid significantly higher, thus exhibiting more risk taking.
If correct, there is an obvious question, Why such behaviour?
Pearson and Schipper argue this can be explained by biology and evolution. This is when women are most likely to be fertile and take risks to increase the probability to procreate.

An alternative Big Mac index

From the Economist magazine comes a new Big Mac index. The size of your pay packet may be important, but so is its purchasing power. Helpfully, a UBS report published this week offers a handy guide to how long it takes a worker on the average net wage to earn the price of a Big Mac in 73 cities.

It turns out that fast-food junkies are best off in Chicago, Toronto and Tokyo, where it takes a mere 12 minutes at work to afford a Big Mac. By contrast, employees must toil for over two hours to earn enough for a burger fix in Mexico City, Jakarta and Nairobi.

Monday 24 August 2009

Incentives matter: fires file

Incentives matter, but you have to get the incentives right. This from David Henderson at the EconLog blog:
This last winter, our house smelled like an ashtray much of the time. Our neighbors upwind insisted on burning. We told them of the discomfort we felt and, while the lady of the household was sympathetic, the adult sons were not and, at one point, one of them got quite nasty when I tried to press the point. I even offered to pay $50 a month for every month they didn't burn. The lady of the household returned the check uncashed. You might say that I didn't offer enough. I sensed, though, that that wasn't it.


One day, my wife made banana bread and took half of it next door. The lady of the house was delighted. Then we noticed something else: the frequency of the fires went from almost every day, which had been driving us wild, to about once a week or less. Shortly after, one of the sons, out mowing his lawn, waved and smiled at my wife as she was pulling out of the driveway. She was so shocked that she almost sideswiped our house. I thought we were on to something, so the next time I made my brownies full of chocolate chips, I took half of them over. A few days after that, one of the sons brought over some cantaloupes. Then about a month ago, I took over some brownies. Then Sunday evening, one of the sons brought over some home-grown tomatoes and onions. Summer in Pacific Grove, where I live, is almost as cold as winter. Yet they have hardly burned a fire at all.
Montary incentives aren't always the best incentives.

Robert Lucas argues in defence of the dismal science

Over at the Economist Robert Lucas argues In defence of the dismal science. One interesting point he makes is with regard to the efficient-market hypothesis (EMH). The EMH tells us that the price of a financial asset reflects all relevant, generally available information. Lucas explains,
If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier. (The term “efficient” as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.)
He continues,
Mr Fama arrived at the EMH through some simple theoretical examples. This simplicity was criticised in The Economist’s briefing, as though the EMH applied only to these hypothetical cases. But Mr Fama tested the predictions of the EMH on the behaviour of actual prices. These tests could have come out either way, but they came out very favourably. His empirical work was novel and carefully executed. It has been thoroughly challenged by a flood of criticism which has served mainly to confirm the accuracy of the hypothesis. Over the years exceptions and “anomalies” have been discovered (even tiny departures are interesting if you are managing enough money) but for the purposes of macroeconomic analysis and forecasting these departures are too small to matter. The main lesson we should take away from the EMH for policymaking purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them.
So for policy purposes, it is best to assume the EMH holds. You can't, over the long term, beat the market.

If you want to be a academic ..... (updated)

then read this. You really won't believe it.

As Greg Mankiw puts it,
If you are thinking about being a professor, read this (unless it is too late to turn back).
Actually I have had a couple of comments published without the problems this poor guy had.

Update: Eric Crampton suggests that Professor Trebino should Get a blog!

Sunday 23 August 2009

Bribes for Ph.D. degrees

If universities are short of money to pay faculty market pay rates, is this part of the answer. From Carpe Diem some this,
BERLIN (AP) – German prosecutors are investigating about 100 professors across the country on suspicion they took bribes to help students get their doctoral degrees, authorities said Saturday.

According to two publications, students paid between €4,000 to €20,000 ($5,700 to $28,500) to a company, which promised to help them get their doctorate degrees through its extensive contacts within university faculties.

The Neue Westfaelische newspaper reported that "hundreds" of students were involved, and that the company paid professors between €2,000 to €5,000 when their clients had successfully received their Ph.D.s. It was not clear whether the students knew that bribes were being paid.
Perhaps this is one for Al Roth's repugnant markets file.

Cash for clunkers: dumbest program ever?

Chris Edwards at Cato@Liberty argues it is. He writes,
Farm subsidies are unjust. Trade restrictions are counter-productive. Energy regulations have done great damage. Housing policies helped cause the financial crisis. But for pure dumbness, Cash for Clunkers takes the cake.
That's a big call given how many very dumb government programs there are out there, but Edwards asks us to think about what the program will have accomplished. Edwards writes,
  • A few billion dollars worth of wealth was destroyed. About 750,000 cars, many of which could have provided consumer value for many years, were thrown in the trash. Suppose each clunker was worth $3,000 at a guess, that would mean that the government destroyed $2.25 billion of value.
  • Low-income families, who tend to buy used cars, were harmed because the clunkers program will push up used car prices.
  • Taxpayers were ripped off $3 billion. The government took my money to give to people who will buy new cars that are much nicer than mine!
  • The federal bureaucracy has added 1,100 people to handle all the clunker administration. Again, taxpayers are the losers.
  • The environment was not helped. See here and here.
  • The auto industry received a short-term “sugar high” at the expense of lower future sales when the program is over. The program apparently boosted sales by about 750,000 cars this year, but that probably means that sales over the next few years will be about 750,000 lower. The program probably further damaged the longer-term prospects of auto dealers and automakers by diverting their attention from market fundamentals in the scramble for federal cash.
Now that's dumb, but the dumbest? I mean farm subsidies really do take some beating.

Saturday 22 August 2009

Why have copyright and patents?

My previous post on the protection of intellectual property does raise an interesting question, Why have things like copyright and patents at all? An answer may be found in terms of incomplete contracts. Jean Tirole writes,
Consider the patent system. It has long been recognized that patents are an inefficient method for providing incentives for innovation since they confer monopoly power on their holders. Information being a public good, it would be ex post socially optimal to award a prize to the innovator and to disseminate the innovation at a low fee. Yet the patent system has proved to be an unexpectedly robust institution. That no one has come up with a superior alternative is presumably due to the fact that, first, it is difficult to describe in advance the parameters that determine the social value of an innovation and therefore the prize to be paid to the inventor, and, second, that we do not trust a system in which a judge or arbitrator would determine ex post the social value of the innovation (perhaps because we are worried that the judge might be incompetent or would have low incentives to become informed, or else would collude with the inventor to overstate the value of the innovation or with the government to understate it). A patent system has the definite advantage of not relying on such ex ante or ex post descriptions (although the definition of the breadth of a patent does). (Jean Tirole, "Incomplete Contracts: Where Do We Stand?" Econometrica, Vol. 67, No. 4 (Jul., 1999), pp. 741-781.)

Protection of intellectual property should be decreasing, not increasing

It is obvious that the length and reach of intellectual protection keeps expanding. We see copyright periods lengthen, the scope of patentable "innovations" widens, and the enforcement of intellectual property become the topic of international trade negotiations. Is this to the good?

The Economic Logic blog points us to research that suggests not. They write,
Michele Boldrin and David Levine look at this using the age-old trade-off in intellectual property protection: long protection provides the innovator with monopoly rents and thus incentives to create more innovations, whereas should protection allows society to benefit earlier and more widely of these innovations. As you move the protection duration (or scope or enforcement), the question really is how many new innovations one gains or loses at the margin. The distribution of innovation thus matters a lot as the marginal idea (in terms of quality) will be pursued. Ultimately, you want to measure the elasticity of revenue with respect to the marginal idea.

Boldrin and Levine do this with various empirical strategies that all come to a similar conclusion: the elasticity mentioned above increases a lot with the quality of the marginal idea. Also, they find that the growth rate of ideas is lower that that of population, there are decreasing returns to scale. What this means is that protection for intellectual property should be decreasing with the scale of the market. And as globalization has dramatically increased that scale, protection should be decreasing rather than being reinforced.
The Boldrin and Levine paper is Market Size And Intellectual Property Protection. The abstract reads,
Intellectual property (IP) protection involves a trade-off between the undesirability of monopoly and the desirable encouragement of creation and innovation. Optimal policy depends on the relative strength of these two forces. We give a quantitative assessment of current IP policies. We focus particularly on the scale of the market, showing that as it increases, due either to growth or to the expansion of trade, IP protection should be reduced.

Paul Romer discusses charter cities

Economist Paul Romer discusses the idea of "charter cities": city-scale administrative zones governed by a coalition of nations. Could Guantánamo Bay become the next Hong Kong?

Friday 21 August 2009

Mechanism design and the free market

Having been reading up on mechanism design recently I was interested to come across this piece by Robert P. Murphy at the Ludwig von Mises Institute on the awarding of the 2007 Nobel Prize in economics to Leonid Hurwicz, Roger Myerson, and Eric Maskin for laying the foundations of "mechanism design theory". Murphy writes
The official press release made it quite clear that although the Invisible Hand works well in the simplistic world of Adam Smith, it doesn't always succeed in our complex real world, with its private information, transaction costs, and externalities. According to the official statement, mechanism design theory is essential to "distinguish situations in which markets work well from those in which they do not." The press largely followed this lead; the Washington Post's headline read, "3 U.S. Economists Share Nobel for Work on Flawed Markets."
Fortunately Murphy also points out that such doubts about the market economy are unfounded and mechanism design says little about the case for (or against) laissez-faire capitalism. Like most tools, it all depends on how it is used. Murphy goes on,
For those who equate "the free market" with "atomistic individuals who reduce everything to money," it is obvious why the insights of mechanism design appear to impugn pure capitalism, and to justify enlightened government tinkering with spontaneous outcomes. Yet this view relies on a false caricature of the market economy, and a naïve faith in political action.
Naive to say the least. The article continues,
First, the market economy is not characterized by the "rational fools" ridiculed by Amartya Sen. To oppose government intervention in private property is not to don a top hat and send the crippled to be quartered and sold on the market for body organs. For example, people living in a purely free-market society could quite consistently give to charities, make "investments" with no rate of return such as the X-Prize, and even feed and house their children without charging them the market rate for boarders. Those who think these are "exceptions" to capitalism don't understand what capitalism is; in their view, nobody should ever spend money on a sports car because cheaper modes of transportation are available and hence more "profitable."

When we reflect that the free market is far more nuanced than the mainstream model of perfect competition, it becomes clear that the insights of mechanism design are comparable to, say, Henry Ford's innovations with the assembly line, or Peter Drucker's recommendations for better corporate management. Successful entrepreneurship upsets the status quo; this is the market in action, not evidence of "market failure." To the extent that mechanism design in the past shed light on inadequacies in auction rules and other organizational proceedings, it merely showed the ability of a free society to constantly improve.

In the second place, even if we concede that Pareto-inefficient outcomes can occur in a free market, as demonstrated in certain mathematical models, it doesn't follow that therefore the government ought to "fix it." To rush to this judgment assumes away all of the problems of government failure. In particular, this conclusion only holds if we assume that (a) the politicians are smart enough to set up the model correctly, with all of the relevant information to plug into the parameters, and then derive the "optimal" policy, and (b) the politicians are noble enough to ignore their campaign donors and actually implement this ideal policy. I am personally not convinced on either account.
Murphy then discusses the mechanism design approach to the Socialist Calculation Debate. This I think is the weakest part of mechanism design since mechanism design misses much of thrust of the Austrian argument in the calculation debate. The design approach, put very simply, concludes that socialism does well from an adverse-selection viewpoint, but poorly from a moral-hazard viewpoint. But this approach, Murphy argues, misses the point the Austrian economists were trying to make in the first place.

Mechanism design has, however, been more successfully used in implementing efficient voting, trading, and regulatory schemes. An obvious example being the use of auctions and auction-like mechanisms. These are an important part of modern economic life, in which many different goods, from flowers to fish to radio spectrum, are sold this way.

All this said I would also agree with Murphy's conclusion,
Notwithstanding the official press release and subsequent media coverage, the goal of mechanism design is, generally speaking, to study how best to harness markets. As Hurwicz himself said in a famous passage, "[W]hat economists should be able to do is to figure out a system that works without shooting people." It's true that Hurwicz's definition of coercion is much narrower than the typical libertarian's, but, even so, Austrian economists should not dismiss this field simply because of a few misleading stories in the media. Mechanism design poses no threat to the free market.

Interesting blog bits

  1. Eric Crampron on Auckland Maori seats: good idea? But what about the loss of of Tiebout competition?
  2. Seamus Hogan on Electricity Technical Advisory Group Report. The ETAG was appointed in April this year to review the performance of the electricity markets (wholesale and retail) and make recommendations on improvements. And the report isn't as bad as you may think.
  3. Seamus Hogan on ETAG Report and Wholesale Competition
  4. Matt Nolan on NZ/Aussie Optimum currency area. Can't say I see the point myself, but Matt puts the case for and against.
  5. Elizabeth U. Cascio on Long-term effects of investments in universal early education: Evidence from the American kindergarten expansion. Proponents of universal early education hope that such investments will yield long-term socioeconomic benefits. This column presents evidence that state governments funding public kindergartens in the US actually widened socioeconomic disparities across adults, as whites made gains that blacks did not. That result highlights the sensitivity of policy interventions to their means of funding and the structure of existing alternatives.
  6. Robert Higgs on The Rise of Big Business and the Growth of Government. Just what is the relationship between the rise of big business and the growth of government?
  7. David Henderson on Cash for Clunky Ideas. Cash for clunkers destroys wealth

Economics v. politics

From Greg Mankiw's blog comes this quotation from congressman Barney Frank:
Not for the first time, as an elected official, I envy economists. Economists have available to them, in an analytical approach, the counterfactual. Economists can explain that a given decision was the best one that could be made, because they can show what would have happened in the counterfactual situation. They can contrast what happened to what would have happened. No one has ever gotten reelected where the bumper sticker said, "It would have been worse without me." You probably can get tenure with that. But you can't win office.

Thursday 20 August 2009

A good question

Somehow I don't see the benefits of such a law outweighing the costs. It just looks like more Wellington wowserism to me. I have to agree with Brad Taylor when he writes,
As it happens, I don’t think government should be concerned with reducing the social costs of alcohol: I think they are much smaller than the social costs of any policy intervention I can imagine. Even if we accept the need to Do Something, however, Palmer’s proposal worries me more than other (perhaps less efficient) means of alcohol control.

Since being drunk is arbitrary, the proposal would give police more arbitrary power. As someone who takes the rule of law seriously, this worries me more than the (very high) cost of excise taxes on innocent drinkers. Unless you think being drunk is itself wrong, in which case I don’t much value your opinion, this gives cops another legal weapon to brandish against innocent people they don’t quite like the look of.

Game theory has a host of practical applications

Or so says Robert Aumann ... and he should know, Aumann shared the 2005 Nobel prize for economics for his contributions to the field of game theory. Aumann has been in South Africa lecturing about game theory as the foundation of market design. The general area of market design is more often referred to as mechanism design or implementation theory. Aumann points out that using mechanism design is not new,
[...] the first written account of a game theoretic solution is in the Bible, when King Solomon faced two women, both claiming a baby as their own. Solomon decreed that the baby be cut in half, but as soon as he offered his verdict one of the women renounced her claim. Solomon promptly awarded her the baby, realising that only the true mother would value the child’s life enough to give it away.
But an important point to come from Aumman's lecture was,
Aumann thinks moving from game theory to game engineering will help us. Theory can be used to design practical interactive systems — the US auctions being a good example.
But Aumann cautions,
[...] governments in particular must understand the power of incentives to drive economic and political actors, and work towards creating systems that get the best from them. All too often, governments want to play the game instead of acting as referee, and find themselves subject to unexpected incentives they cannot control.
A very important point: referees should not be players, because when they are the refereeing decisions tend to favour one, obvious, team. But somehow governments all to often forgets this basic point.

The world's biggest employers

This list is from Steve Bettison at the Adam Smith Institute blog:
  1. Wal Mart 2.1m
  2. People's Army Liberation 1.6m
  3. China National Petroleum 1.6m
  4. State Grid 1.5m
  5. Indian Railways 1.4m (2007)
  6. NHS 1.3m

Wednesday 19 August 2009

Local nanny state

At least in the UK. The Adam Smith Institute blog points out that the
Liverpool Council would like to consult with organisations and members of the public upon a proposal to revise its licensing policy that would mean an "18" classification would be given to new release films exhibited in Liverpool if they depict images of tobacco smoking and do not already carry an "18" classification.
The ASI blog continues
The lunacy of this proposal is beyond argument, but is further evidenced in the details. Apparently smoking will be permitted if it shows “a real historical figure (not an historical era) who actually smoked” and/or shows “clearly and unambiguously, the dangers of smoking, tobacco use or second-hand smoke.” Imagine the jobsworths who will judge this; they would have had to make Saving Private Ryan an “18” . Under such circumstances this of course could have been avoided: Steven Spielberg could had also pointed out the dangers of smoking while telling the story of the Omaha beachhead assault of June 6, 1944.
Hasn't the council got something more important to be doing rather than just coming up with pointless, stupid, paternalistic, pc regulations? What will be next? Public burnings of books which mention smoking?

On the causes of slavery and serfdom

Over at the Oxonomics blog they are discussing the causes of slavery and serfdom. They write,
Daron Acemoglu and a co-author, Alexander Wolitzsky have a new paper on the economics of coerced labour. I've not worked through the model yet. From an economic historian's perspective, the paper looks important because it promises a resolution of the Brenner Problem.

The Brenner Problem concerns the decline of feudalism in western Europe. Historians had argued that the Malthusian crisis of the 14th century caused serfdom to collaspe because it increased the bargaining power of (the now scarce factor) labour. Brenner however pointed out that while that seems to describe western Europe, exactly the same forces caused the reimposition and strengthening of serfdom in Eastern Europe. More generally, labour scarcity suggests that landlords can ''capture' more rent by enslaving or enserfing workers, so it alone cannot explain why some economies have used free labour while others have used slave labour. Brenner argued that the coercive relationship between slave and master had to examined in detail. This is effectivley what the Acemoglu paper seeks to do (there is much more in the paper too).
Interesting stuff. The abstract of the paper reads,
The majority of labor transactions throughout much of history and a significant fraction of such transactions in many developing countries today are “coercive,” in the sense that force or the threat of force plays a central role in convincing workers to accept employment or its terms. We propose a tractable principal-agent model of coercion, based on the idea that coercive activities by employers, or “guns,” affect the participation constraint of workers. We show that coercion and effort are complements, so that coercion increases effort. Nevertheless, coercion is always “inefficient,” in the sense of reducing utilitarian social welfare. Better outside options for workers reduce coercion, because of the complementarity between coercion and effort: workers with better outside option exert lower effort in equilibrium and thus are coerced less. Greater demand for labor increases coercion because it increases equilibrium effort. We investigate the interaction between outside options, market prices, and other economic variables by embedding the (coercive) principal-agent relationship in a general equilibrium setup, and study when and how labor scarcity encourages coercion. We show that general equilibrium interactions working through prices lead to a positive relationship between labor scarcity and coercion along the lines of ideas suggested by Domar, while those working through outside options lead to a negative relationship similar to ideas advanced in neo-Malthusian historical analyses of the decline of feudalism. A third effect, which is present when investment in guns must be made before the realization of contracting opportunities, also leads to a negative relationship between labor scarcity and coercion. Our model also predicts that the slave trade makes slaves worse off, conditional on enslavement, and that coercion is more viable in industries that do not require relationship-specific investment by workers.

Rose Friedman, R.I.P.

Rose Director Friedman, who was partner and collaborator with her late husband Milton on many of his most important works of political thought and advocacy, passed away Tuesday, August 18, 2009, in her home in Davis, California, of heart failure. While the exact date of her birth is uncertain, she is believed to have been 98 years old.

Brian Doherty comments here. The Milton and Rose Friedman Foundation has a notice of her death here. Tyler Cowen comments here. Mark J. Perry comments here. Peter Boettke comments here. Mario Rizzo comments here. The New York Times looks back on her life here. The Chicago Tribune covers the story here. is here. Cato @ Liberty covers here. The National Review Online comments here. The Heritage Foundation comments here. The University of Chicago comments here. Greg Ransom comments here. David Henderson comments here. Steve Bettison comemnts here. JC Caldara comments here. Alex Chafuen comments here.

Tuesday 18 August 2009

Not all advertising is good advertising

(HT: Kids Prefer Cheese)

Interesting blog bits

  1. David Henderson on Market Failure or Market Success? Not all failure may be failure.
  2. Tom M on Meritocracy - Neither Descriptive nor Desirable. He wants you to reject meritocracy.
  3. BK Drinkwater asks Which Are You More Upset About? The ban on driving while using a cellphone, or the prospect of a pseudoephedrine ban?
  4. Eric Crampton on Gender pay gap: nonpecuniary benefits edition.
  5. MacDoctor on Sick Food. Orthorexia nervosa: Obsession with righteous eating.
  6. Peter Boettke on George Selgin on the Audit of the Fed, and Why We Could Even Do Without the Fed
  7. Matt Nolan on Social harm and drugs: Is something missing? All costs, no benefits again?

EconTalk this week

Christopher Hitchens talks with EconTalk host Russ Roberts about George Orwell. Drawing on his book Why Orwell Matters, Hitchens talks about Orwell's opposition to imperialism, fascism, and Stalinism, his moral courage, and his devotion to language. Along the way, Hitchens makes the case for why Orwell matters.

Monday 17 August 2009

Just for fun: the theory of the farm

An interesting question, at least for New Zealand, is Why are family-based firms still dominate in agriculture? The short answer given by Allen and Lueck (1998) and Allen and Lueck (2002) is "nature". They argue that farms operate in unique circumstances defined by nature, in particular seasonality. This is the main feature that distinguishes farm organisation from industrial organisation. For farmers a season is a distinct period of the year during which a given activity is optimally undertaken.

This is key to understanding the why the incentives generated within agriculture favour family farms. The two basic issues are opportunities for hired workers to shirk due to random production shocks from nature and the limits on the gains from specialisation and the timing problems caused by seasonality. The trade-off between effect work incentives and gains from specialisation help determine the costs and benefits of different farm organisational types.

The family farm model provides the best work incentives since the owner is the sole recipient of the benefits, but this model misses some benefits due to specialisation. This follows from the fact that the farmer must engage in numerous different tasks during each stage of production, and in addition, numerous production stages throughout the year.

On the other hand, large factory-style corporate farms gain from a specialised labour force and lower cost of capital, but suffer from bad worker incentives since hired workers, not being one of the owners, have an increased incentive to shirk.

To some degree all firms are governed by the trade-off between gains from specialisation and work incentives. For the case of farming it is the unique, large impact of nature that biases it towards family operations.

An obvious, but key, feature of agriculture is that it involves a living, growing product. In the case of livestock, for example, you have breeding, husbandry, feeding and slaughter. Such a cycle is largely governed by nature. In principle there is no reason that a different farmer could not own each stage. But timing difficulties between stages result in high costs of engaging in market transactions. Such timing issues are particularly severe in farming because the inventories of the intermediate goods cannot be held given the living nature of the product.

There are a number of factors, such as the number of crop cycles, the length of the production stages and the number of tasks within a stage, which also influence wage labour incentives. When cycles are few, stages are short, random shocks are large and the tasks are few, there is little to gain from specialisation and labour is especially costly to monitor. Thus family farms.

If these issues can be overcome, that is, if farmers can mitigate seasonality and random shocks to output, farm organisation starts to look much like that in the rest of the economy. Under such conditions farm organisation will gravitate towards factory process and develop the large-scale corporate forms of other sectors of the economy.

  • Allen, Douglas W. and Dean Lueck (1998). "The Nature of the Farm", Journal of Law and Economics, 41: 343-86.
  • Allen, Douglas W. and Dean Lueck (2002). The Nature of the Farm: Contracts, Risk, and Organization in Agriculture, Cambridge Mass.: The MIT Press.

Government v. private provision

Greg Mankiw explains,
Yesterday, I chartered a sailboat so my family and I could spend a couple of hours out on the waters off Nantucket. The captain of the boat met us at the town pier, loaded us onto a small skiff, and then took us to a mooring out in the harbor, where the boat was waiting.

He explained to us that he would prefer to keep his sailboat at the pier, which would make loading and unloading passengers much easier, but he could not get a space there. Every year, he told us, the town has a lottery to allocate the right to rent one of the scare docking slots. For quite a few years, the captain has been putting his name into the lottery, but he has never won. "There are just not enough spaces," he said.

Ever the economist, I replied, "It seems to me that the price isn't high enough."

"Well, actually," the captain said, "if you want to pay more, you can go down there." He pointed to the next dock over.

Apparently, next to the town pier is another pier that is privately owned and operated. The price for a docking space there is about five times as high as it is at the town pier. But there is never any significant shortage. Anyone can sign up for a slot, as long as you are willing and able to pay.
So "free markets" use the price system to allocate resources, and there are no shortages while governments prefer other mechanisms, in this case a lottery, which don't always direct resources to their highest value use. A lottery allocates resources on the basis of luck rather than economic logic. There is no guarantee that the luckiest person will also have the highest value use for the resource.

Business for Africa, not aid

Thanks to BK Drinkwater for pointing me to this article in Foreign Policy on Think Again: A Marshall Plan for Africa. Glenn Hubbard argues for a new Marshall plan, but this time for Africa. But that does mean what you think it means. Hubbard writes,
The Marshall Plan was fundamentally different from the aid that Africa has received over the past four decades. The Marshall Plan made loans to European businesses, which repaid them to their local governments, which in turn used that revenue for commercial infrastructure -- ports, roads, railways -- to serve those same businesses. Aid to Africa has instead funded government and NGO development projects, without any involvement of the local business sector. The Marshall Plan worked. Aid to Africa has not. An African Marshall Plan is long, long overdue.
Hubbard then goes on to discuss why
Aid groups will argue that such a plan, grounded in building up the local African economy, can never work. Here are the objections they'll make to an African Marshall Plan -- and why they're wrong.
The whole thing is worth a read.

Sunday 16 August 2009

Health care reform the Turkmenistan way

This from Annie Lowrey writing in Foreign Policy:
In 2003, "President for Life" Saparmurat Niyazov decided that poor, landlocked Turkmenistan's medical costs were too high and that its healthcare system urgently needed reform. The country had already suffered from a shortage of doctors, and the only qualified ones were in cities, Niyazov said on a public radio address.

So, in a frankly insane healthcare reform effort, he restricted the public's access to care by replacing up to 15,000 doctors and nurses with unqualified military conscripts. The next year, he ordered hospitals and clinics outside of the capital, Ashgabat, to close -- even though the vast proportion of Turkmenistan's population lives in rural areas. The BBC quoted him as saying, "Why do we need such hospitals? If people are ill, they can come to Ashgabat." He also implemented fees and created an "unofficial" ban on the diagnosis of certain communicable diseases, like hepatitis.

As a result, an epidemic of the bubonic plague reportedly broke out (Turkmenistan's highly secretive government does not allow in organizations like the WHO) and existing rashes of AIDS, hepatitis, and tuberculosis worsened.

Caldwell on Keynes and Hayek

Bruce Caldwell talks about Keynes and Hayek. The talk was delivered as part of roundtable discussion on John Maynard Keynes of Bloomsbury, the inaugural event of the Center for the History of Political Economy at Duke University, and were held in conjunction with Vision and Design: A Year of Bloomsbury, a campus-wide interdisciplinary program surrounding an exhibition of Bloomsbury art at Duke University's Nasher Museum.

Saturday 15 August 2009

Just for fun: the theory of the firm 7

A very brief, biased and incomplete history of the theory of the firm. While the theory of the firm has existed for only 70-80 years, in practice firms have existed for several thousand years. In fact Spulber (2008: 5, footnote 8) gives the origin of the word 'firm' as
"The word "firm" derives from the Latin word "firmare" referring to a signature that confirmed an agreement by designating the name of the business."
Silver (1995: 50) notes that
"[p]rivate firms [...] were prominent in late-third-millennium Akkad (the region south of Baghdad), in the Old Assyrian trade with Cappadocia [...] and, somewhat later, at Nippur. In the mid-second millennium the firm of Tehip-tilla played a major role in the real estate transactions and other business activities at Nuzi. A list of about the some time from Alalakh in northwest Syria refers to sixty-four firms participating in leatherworking, jewellery, and carpentry."
Sobel (1999: 21) points out that during the Roman Republic contracting out of economic activities to private firms was the norm:
"[t]he republican Senate left virtually all economic activities to private individuals and companies, known collectively as the publicani. Tax collection, supplying the army, providing for religious sacrifices and ceremonies, building construction and repair, mining, and so on were all contracted out. There was even a contract for summoning the assembly in session and one for feeding the sacred geese."
Micklethwait and Wooldridge (2003: 4) also note the private nature of tax collection in Rome, pointing out that companies were formed for this, and other, purposes:
"[t]he societates of Rome, particularly those organized by tax farming publicani, were slightly more ambitious affairs. To begin with, tax collecting was entrusted to individual Roman knights; but as the empire grew, the levies became more than any one noble could guarantee, and by the Second Punic War (218-202 b.c.), they began to form companies - societates - in which each partner had a share. These firms also found a role as the commercial arm of conquest, grinding out shields and swords for the legions. Lower down the social scale, craftsmen and merchants gathered together to form guilds (collegia or corpora) that elected their own managers and were supposed to be licensed."
The firm, it appears, is such an old and obvious feature of the economic landscape that it has tended to be overlooked by economic theory. The dichotomy between theory and practice could not be more stark. One reason for the firm to be overlooked is that for a long time economists saw the internal workings of the firm to be outside the competence of economists. Arthur Pigou wrote:
"[...] it is not the business of economists to teach woollen manufacturers to make and sell wool, or brewers how to make and sell beer, or any other business men how to do their job. If that was what we were out for, we should, I imagine, immediately quit our desks and get somebody - doubtless at a heavy premium, for we should be thoroughly inefficient - to take us into his woollen mill or his brewery." (Pigou 1922: 63-4).
Lord Robbins argued similarly that
"[t]he technical arts of production are simply to be grouped among the given factors influencing the relative scarcity of different economic goods. The technique of cotton manufacture [...] is no part of the subject matter of economics [...]" (Robbins 1932: 33).
Foss and Klein (2005: 6-7) argue that there is the possibility of an empirical reason for the neglect of the firm; the relative unimportance of the firm. Until relatively recently firms were simply not a large part of the economy. But they also point out that such an explanation is not wholly convincing. Large firms have existed since before the time of Adam Smith and the classical economists knew this. A more precise, and defendable, version of the argument would be that the large, vertically integrated and diversified firm was not empirically important until recently. Thus analysing anonymous "firms" may not have been a bad approximation to the empirical realities of the time.

It is only in more recent times that the firm has attracted attention as an important part of the economic system. As Foss, Lando and Thomsen (2000: 632) note:
"It is only relatively recently, in other words, that economists have felt the need for an economic theory addressing the reasons for the existence of the institution known as the (multi-person) business firm, its boundaries relative to the market, and its internal organization - to mention the issues that are generally seen as the main ones in the modern economics of organization [...] ".
Many would date the beginning of a serious theory of the firm as recently as Knight (1921) or Coase (1937), rather than to either the classical school or the neoclassical revolution. O'Brien (1984: 25) takes a contrary position:
"Serious discussion of the history of the theory of the firm has to start with Alfred Marshall." O'Brien's argument is based, in the main, on Marshall (1920). O'Brien also argues that developments subsequent to Marshall have resulted in many of Marshall's insights being lost to succeeding generations of economists. We would therefore argue that Marshall has left little in the way of a legacy in terms of the mainstream theory of the firm. In addition to his views on Marshall's work and later developments O'Brien also argues that any "attempt to construct a pre-Marshallian theory from the materials available is likely to be unsuccessful."
See, however, Williams (1978) for such an attempt. On the neglect of Marshall's 'Industry and Trade' (Marshall 1920) see also Liebhafsky (1955). The development of the "theory of the firm" from Marshall to Robinson and Chamberlin is also dealt with in Moss (1984).

Before the contributions of Knight and Coase, we had discussions of pin factories, but the discussion was about the importance of the division of labour rather than being an 'enquiry into the nature and causes of the firm'. McNulty (1984: 237-8) comments
"Having conceptualized division of labor in terms of the organization of work within the enterprise, however, Smith subsequently failed to develop or even pursue systematically that line of analysis. His ideas on the division of labor could, for example, have led him towards an analysis of task assignment, management, or organization". Such an approach would have foreshadowed the much later-indeed, quite recent-effects in this direction by Herbert Simon, Oliver Williamson, Harvey Leibenstein, and others, a body of work which Leibenstein calls "micro-micro economics". [...] But, instead, Smith quickly turned his attention away from the internal organization of the enterprise, and outward toward the market and the realm of exchange, perhaps because he found therein both the source of division of labour, in the "propensity in human nature [...] to truck, barter and exchange" and its effective limits."
As has been pointed out by Demsetz (1982, 1988 and 1995) before Knight and Coase - and it could be added for much of the period after them - the fundamental preoccupation of economists was with the price system and hence little, or no, attention was paid to either the firm or the consumer as separate, important, economic entities. Firms (and consumers) existed as handmaidens to the price system.

The interest in the price system, culminating in the "perfect competition" model, has its intellectual origins in the eighteenth-century debate between free traders and mercantilists. Butler (2007: 25-6) briefly sums up mercantilism in the following way:
"[...] it measured national wealth in terms of a country's stock of gold and silver. Importing goods from abroad was seen as damaging because it meant that this supposed wealth must be given up to pay for them; exporting goods was seen as good because these precious metals came back. Trade benefited only the seller, not the buyer; and one nation could get richer only if others got poorer. On the basis of this view, a vast edifice of controls was erected in order to prevent the nation's wealth draining away - taxes on imports, subsidies to exporters and protection for domestic industries. [...] Indeed, all commerce was looked upon with suspicion and the culture of protectionism pervaded the domestic economy too. Cities prevented artisans from other towns moving in to ply their trade; manufacturers and merchants petitioned the king for protective monopolies; labour saving devices such as the new stocking-frame were banned as a threat to existing producers."
The free trade versus mercantilism debate was, to a large degree, about the proper scope of government in the economy and the model it gave rise to reflects this. The question implicitly at the centre of the debate was, Is central planning necessary to avoid the problems of a chaotic economic system? Adam Smith famously answered "no". Smith
"[...] realised that social harmony would emerge naturally as human beings struggled to find ways to live and work with each other. Freedom and self-interest need not lead to chaos, but - as if guided by an 'invisible hand' - would produce order and concord. They would also bring about the most efficient possible use of resources. As free people struck bargains with others - solely in order to better their own condition - the nation's land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends and purposes that people valued most highly. Thus the maintenance of a prospering social order did not require the continued supervision of kings and ministers. It would grow organically as a product of human nature" (Butler 2007: 27-8).
For Smith, markets are the most prominent mechanism for solving the problems of coordination and motivation that arise with interdependencies of specialisation and the division of labour. Market institutions leave individuals free to pursue self-interested behaviour, but guide their choices by the prices they pay and receive. For economists, the 200 years following Smith involved a search for conditions under which the price system would not descend into chaos.

The formal (neoclassical) model that arose from this examination is one which abstracts completely from any form of centralised control in the economy. For Smith this would be an abstraction too far. Smith knew of the importance of institutions to the proper functioning of the market economy. Mark Blaug points out
"[...] Smith's faith in the benefits of 'the invisible hand' has absolutely nothing whatever to do with allocative efficiency in circumstances where competition is perfect \`{a} la Walras and Pareto; the effort in modern textbooks to enlist Adam Smith in support of what is now known as the 'fundamental theorems of welfare economics' is a historical travesty of major proportions. For one thing, Smith's conception of competition was, as we have seen, a process conception, not an end-state conception. For another society, a decentralised competitive price system was held to be desirable because of its dynamic effects in widening the scope of the market and extending the advantages of the division of labour - in short, because it was a powerful engine for promoting the accumulation of capital and the growth of income." (Blaug 1996: 60-1).
It is a model delineated by "perfect decentralisation". Authority, be it in the form of a government or a firm or a household, plays no role in coordinating resources. The only parameters guiding decision making are those given within the model - tastes and technologies - and those determined impersonally on markets - prices. All parameters are outside the control of any of the economic agents and this effectively deprives all forms of authority a role in allocation. This includes, of course, the firm. It doesn't matter whether it is the general equilibrium version of the neoclassical model, characterised by Walras's auctioneer, or the partial equilibrium version, characterised by Marshall's representative firm, there is no serious consideration given to the firm as a problem solving institution. The exact role of the theory of the firm in price theory has been the subject of some confusion. Fritz Machlup has argued:
"[m]y charge that there is widespread confusion regarding the purposes of the ``theory of the firm" as used in traditional price theory refers to this: The model of the firm in that theory is not, as so many writers believe, designed to serve to explain and predict the behavior of real firms; instead, it is designed to explain and predict changes in observed prices (quoted, paid, received) as effects of particular changes in conditions (wage rates, interest rates, import duties, excise taxes, technology, etc.). In this causal connection the firm is only a theoretical link, a mental construct helping to explain how one gets from the cause to the effect. This is altogether different from explaining the behavior of a firm. As the philosopher of science warns, we ought not to confuse the explanans with the explanandum." (Machlup 1967: 9).
Despite the pioneering efforts of Knight (1921) and Coase (1937), the neoclassical model held sway, in mainstream economics, up until the 1970s. It was only then that serious attention began to be payed to the firm. Work by Oliver Williamson (see, for example, Williamson (1971, 1973, 1975)), Alchian and Demsetz (1972) and Jensen and Meckling (1976) were among the main driving forces behind this upswing in interest.

Foss, Lando and Thomsen (2000: 634) classify the mainstream post-1970s economics literature on the theory of the firm into two general groups:
  1. Principal-agent type models where agents can write comprehensive contracts characterised by ex ante incentive alignment under the constraints imposed by the presence of asymmetric information.
  2. Incomplete contracts models which are based on the idea that it is costly to write contracts and thus contracts will have holes, and therefore there is a need for ex post governance.
This division can be seen as resulting from the breaking of two different assumptions embedded in the general equilibrium (Arrow-Debreu) version of the neoclassical model. Note that the Arrow-Debreu framework was not originally conceived as a theory of contracting per se, but rather it was seen as an analytical apparatus for modelling competitive equilibrium. But the efficiency properties associated with trade involving complete contingent claims contracts - that is, contracts specifying the price, date, location and physical characteristics of a commodity for every future state of nature - made such contracts the standard against which other, more realistic, contracts are compared. The first group corresponds to the breaking of the assumption that there are no asymmetries of information between parties and thus no principal-agent problems, of either the adverse selection or moral hazard kind. The second grouping results from breaking the assumption that agents can foresee all future contingencies and can costlessly contract on all such eventualities. We discuss each group in turn.

Within the principal-agent classification Foss, Lando and Thomsen (2000: 636-8) identify three sub-groups: 1) the nexus of contracts view, 2) the firm as a solution to moral hazard in teams approach and 3) the firms as an incentive system view.

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

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

Roberts (2004: 104) responds to this line of argument:
"While there are several objections to this argument, we focus on one. It is that, when a customer "fires" a butcher, the butcher keeps the inventory, tools, shop, and other customers she had previously. When an employee leaves a firm, in contrast, she is typically denied access to the firm's resources. The employee cannot conduct business using the firm's name; she cannot use its machines or patents; and she probably has limited access to the people and networks in the firm, certainly for commercial purposes and perhaps even socially."
The second grouping, the "firm as a solution to moral hazard in teams approach", was developed by Alchian and Demsetz (1972) and Holmstrom (1982). Alchian and Demsetz (1972) extend their discussion by noting that the firm is more than just a special legal arrangement, it is also characterised by team production. The problem that arises here is that with team production, the marginal products of the individual members of the team are hard to measure. This means that free-rider behaviour is now possible since team production can act as a cover for shirking. The Alchian and Demsetz solution is to give the right to hire and fire the members of the team to a monitor who observes the employees and their marginal products. To ensure that the efficient amount of monitoring takes place, the monitor is given the rights to the residual income of the team.

Holmstrom (1982) looks at the incentive problems to do with monitoring and identifies possible solutions. Holmstrom assumes that the members of the team each take actions which are unobservable to the monitor but the overall result of the combined actions is observable. What Holmstrom shows is that it is only under very restrictive assumptions that the monitor can ensure that efficient effort levels will be provided by each team member. The way the monitor would ensure this is to design a sophisticated incentive scheme. But Holmstrom shows that given unobservable effort levels, the requirements of the incentive scheme being a Nash equilibrium, budget balancing and Pareto optimality, can not be met. More specifically, a budget-balancing incentive scheme can not reconcile Nash equilibrium and Pareto optimality. This is because each team member will equalise the costs and benefits of extra effort: that is, if the team revenue is increased by the efforts of a single member, that member should receive that revenue to ensure that they are properly motivated. But as the monitor only knows that team revenue has increased and not the effort levels of each individual member, all members of the team would have to each receive the extra revenue to ensure that the hard working member is rewarded for his efforts. But this will, obviously, violate the balanced budget condition. This suggest that there is an advantage, in terms of incentives, in the team not having to balance their budget.

Clearly the role of the "monitor" in the Alchian and Demsetz model is very different to their role in the Holmstrom model. For Alchian and Demsetz, the monitor oversees the behaviour of the team members, in the Holmstrom model, the monitor injects the capital needed so that the team members do not have to balance their budget.

The third subgroup is the "firms as an incentive system view". Early contributors to this approach where Holmstrom and Milgrom (1991, 1994). In Holmstrom and Milgrom (1994) it is stressed that the firm should be viewed as 'a system', that it is a set of contractual relationships which endeavour to mitigate incentive problems. In their view the firm is characterised by a number of factors: 1) the employees do not own the non-human assets of the firm; 2) the employees are subject to a 'low-powered incentive scheme' (see below); and 3) the employer has authority over the employee.

Holmstrom and Milgrom (1991) makes two observations. First, they note that there are a number of ways that an employee can spend their time, many of which can be of value to an employer. But if these multiple activities compete for the worker's attention then the incentives offered for each of the activities must be comparable. Otherwise, the employee will put most effort into those things that are most well compensated and put less effort into the others activities. The second observation relates to the provision of strong incentives to a risk-averse employee. Providing strong financial incentives is costly because it loads extra risk into the worker's pay. In addition, the cost is greater the more difficult it is to measure performance. This means that, other things being equal, tasks where performance is hard to measure should not be given as intense incentives as ones that are more accurately observed. But having low-powered incentives means that the employer needs to be able to exercise authority over the use of the employee's time, since the employee will not have the proper incentives to be productive.

This logic suggest that, conversely, an independent contractor should face the opposite combination of instruments. The choice between the having an employee or using an independent contractor depends on the ability of the principal to measure each dimension of the agent's contribution. Thus, in the Holmstrom and Milgrom approach, measurability of performance is one important determinant of the boundaries of the firm. In addition their approach incorporates the importance of the allocation of property rights to the physical assets in determining incentives via determination of bargaining positions as is the case with the Williamson and Grossman-Hart-Moore approaches.

In the incomplete contracting theories group Foss, Lando and Thomsen (2000: 638-43) identify five subgroups: 1) the authority view, 2) the firm as a governance mechanism, 3) the firm as an ownership unit, 4) implicit contracts and 5) the firm as a communication-hierarchy.

In the authority view, the firm is seen as being defined as an employment relation. This view is most closely associated with Coase (1937) and Simon (1951). For Coase a firm will arise when it is cheaper to carry out a transaction in a firm than it is to do so over the market. Given it costs something to enter into a market contract, that is, there are transaction costs, firms will emerge to carry out what would otherwise be a market transaction when it is cheaper for the firm to handle that transaction. The size of the firm (the boundaries of the firm) will be determined when the cost of organising a transaction within the firm equals the cost of using the market. Coase notes that within the firm contracts are not eliminated but are greatly reduced and the nature of the contract changes. When a factor of production is employed within the firm the contract controlling it is incomplete. The factor (or its owner) agrees, for remuneration, to obey the directions of the manager of the firm, within certain limits. In the last section of Coase (1937), it is noted that the relationship that constitute the firm corresponds closely to the legal concept of the relationship between the employer and employee. Coase explains that direction is the essence of the legal concept of the employment relationship, just as it is for the concept of the firm that he developed.

For Simon (1951) the issue is a comparison of an employment contract against a contract between two autonomous agents. A contract between autonomous agents specifies an action to be taken in the future along with its price while an employment contract specifies a set of acceptable instructions that the employee has to accept if asked to carry them out by the employer. The advantage of the employment contract is its flexibility, the employer does not have to pre-commit to an action and can adapt the choice of action to the state of the world that occurs.

A more modern approach to these issues is Wernerfeld (1997). He compares three alternative governance structures (game forms) for situations where a buyer needs a sequence of human asset services: 1) the hierarchy game form, 2) the price list game form and 3) the negotiation-as-needed game form. Wernerfeld (1997: 490) introduces the game forms with three simple examples:
1. As a typical day unfolds, you learn that you will need several services from your secretary. In principle, the two of you could contract over the provision of each service as its nature becomes clear. However, under such an arrangement you would spend a lot of time negotiating. We therefore have the institution normally called the employment relationship under which the secretary has agreed to supply ex ante unspecified services for a certain number of hours.

2. Consider what happens if a general contractor remodels your house. You may change your mind during construction, but because these adaptations are infrequent they are typically handled through negotiation on an as-needed basis.

3 . Suppose next that you are at H & R Block getting help with your tax return. While at the store, you may realize that you need additional services: there may be more schedules to file or you may want to prepay part of next year's taxes. In this case you know the price of each adaptation ex ante and no new negotiation is needed. Since the number of possible adjustments is small, the price list governs adaptation cheaply.
An employee is defined as someone who sells his services in a specific game form characterised by the absence of bargaining over adaptations to changing circumstances. The firm is seen as consisting of the buyer of human asset services, along with a set of sellers, provided that the human services are traded in the "employment relationship" or "hierarchy" game form. The hierarchy game form is defined as the situation in which the parties engage in once-and-forall wage negotiation, the manager describes desired services sequentially, and either party may terminate the relationship at will. In this model, the boundaries of the firm are given by the set of agents employed by the buyer. Whether one uses the employment relationship or an alternative game form depends on the nature of the expected adaptations. If many diverse and frequent adjustments are needed, the employment relationship involves lower adjustment costs than any of the other governance structures. The price list game form is better when the list of possible adjustments is small and the negotiation-as-needed game form is better when adjustments are needed infrequently.

The second subgroup "the firm as a governance mechanism" is based round the work of Oliver Williamson which I will discuss in more detail in a later posting and so will delay discussion until then. The third subgroup "the firm as an ownership unit" is the Grossman/Hart/Moore approach which I outlined here. That leaves subgroups 4) implicit contracts and 5) the firm as a communication-hierarchy. These I will briefly discuss below.

Implicit contracts: There are many cases where it is difficult, if not impossible, to write complete state-contingent contracts. This is the case when, for example, certain variables are either ex-ante unspecifiable or ex-post unverifiable. In these cases we often see that people often rely on 'unwritten codes of conduct', that is, on implicit contracts. Foss, Lando and Thomsen (2000: 642) explain
The basic idea in the implicit-contract theory of the firm is that implicit contracts may function differently within firms than between firms; a person is hired as an employee rather than as an independent contractor when coordinating with him requires an implicit contract that is easier to implement within the firm than in the market place.

In a recent paper, Baker, Gibbons and Murphy (1997) emphasize that implicit contracts occur both within firms (in the employment relationship) and between firms (‘relational contracting’). The difference lies in the options which are open to the parties if the implicit contract breaks down. Contrary to an independent contractor, an employee cannot leave the relationship with the assets belonging to it. Specifically, in their model, independent contracting is defined by the feature that the supplier has the possibility to sell the finished product elsewhere, while firm-contracting is defined by the supplier (the employee) not owning the finished product and hence not having the option of leaving with the asset or the product. The strength of the threat to leave the relationship determines the implementability of implicit contracts. For example, if the market for the good is volatile, relational contracts are vulnerable since the supplier is tempted to break out from the implicit contract when the market price is high. If the supplier is a division within the firm, this option does not exist and the implicit contract which holds the (internal transfer) price constant may therefore be self-enforcing. The implicit-contract theory is linked with Williamson’s idea that dispute resolution is easier to carry out within a firm than between firms: Mechanisms for dispute resolution can be seen as part of the system of self-enforcing implicit contracting within a firm.
The Firm as a Communication-Hierarchy: An obvious and important requirement for any firm is to adapt to and process new information. The world is ever changing and firms have to adapt or die. Marschak and Radner (1972), is a classic contribution on team-theory which pointed to a completely different approach to economic organization, one in which incentive conflicts were disregarded, or at least assumed to have been solved, and where coordination and communication were highlighted instead. Writers within this approach view the firm as a communication network that is designed to minimize both the cost of processing new information and the costs of communicating this information among agents.

A simple but important point is that communication is costly given that it takes time for people to absorb new information sent to them. But this time usage can be reduced by specializing in the processing of particular types of information.
In Bolton and Dewatripont’s (1994) model, for example, each agent handles a particular type of information, and the different types of information are aggregated through the communication network. When the benefits to specializing outweigh the costs of communication, teams (firm like organizations) arise. (Foss, Lando and Thomsen 2000: 643)
There is a problem here in that the theory of the firm as a communication hierarchy has difficulty explaining the boundary of the firm. An open question is why communication hierarchies cannot exist between firms. However, if this can be given an explanation, that explanation together with the theory of the firm as a communication hierarchy may constitute a theory of the firm.

This potted history has centred on what would be considered the mainstream approaches to the theory of the firm and thus has overlooked a number of non-mainstream contributions. In the pioneers category the work by Malmgren should be mentioned. Malmgren's paper draws on many influences, such as the work of Keynes, Hayek, Penrose and Richardson, As Foss (2000: xxi) puts it
[...] Malmgren (1961) is the first contribution to 1) "operationalize" the Coasian approach to the theory of the firm, 2) suggest that ideas on firm capabilities may be combined with ideas from the contractual approach to the firm, and 3) to treat in economic terms a number of concepts (such as "business culture") the economic analysis of which has begun only recently. Assuredly, addressing each one of these three points would have been a remarkable contribution from somebody writing in 1961; to address all three, and do so in a way that still inspires, is extraordinary.
Penrose (1955/1959) and Richardson (1972), and the knowledge based perspective on the firm that they helped found, are also deserving of mention. There is also the contributions from business history and firm strategy to consider. Alfred D. Chandler's work is a must read. Then there is the Austrian view of the firm, the managerial theories of the firm and the behavioural. All of this tells us there in no generally accepted theory of the firm and that one is unlikely to appear in the near future. Which, at least, means it is unlikely that those working on the theory of the firm are about to become redundant.

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