Interesting times

Lindsay Perigo writes at the Solo blog,

Perigo! followers will also have noted the empathy between Don Brash and me, even though I'm a 1000% libertarian and he's about a 65% one. In our present crisis, 65% will do me. Quite simply, I believe his becoming Act leader has brought a glimmer of hope to New Zealand's economic and political landscape, which otherwise was unfailingly bleak. I believe that, in these parlous, debt-ridden, Political Correctness-infested circumstances, everyone—including members of Libertarianz—concerned about stopping the rot and initiating a meaningful restart toward freedom and prosperity, should get in behind—on a suck-it-and-see basis, letting Don know that if he doesn't really try to deliver, or becomes captive to those notorious forces within Act alien to freedom and prosperity, then we'll all be out of there before you can say "Epsom." I say this as someone who has fought the conservatives and compulsionists within Act tooth and nail since its inception and delivered Libz, as leader, its highest party vote (by a factor of 600%) since its inception.

Well I never thought I would see the day, Lindsay Perigo a member of Act! I can't help thinking this will do more good for Act than it will do for Perigo. Perigo is being pragmatic by accepting that he has a better chance of achieving, at least part of, what he wants with Act than he has under the Libz banner. There will be battles between Perigo (and Brash) and the conservative elements of Act. Having Perigo around could help Brash in these battles. I guess the good thing to come from this is that it will strengthen the Liberal (in the classical meaning) faction of Act, which is all to the good. Returning Act to a truly Liberal party would be a good first move towards rejuvenating politics in New Zealand. A powerful Liberal voice has been missing from political discourse for far too long. I wish Perigo luck, he will surely need it.

Bad thinking on privatisation

In a recent posting on privatisation at his blog Roger Kerr writes

Thus in a recent letter to the Dominion Post, investment analyst Garth Ireland wrote:

Labour leader Phil Goff says that, under Labour, there will be no asset sales (May 2). He says: “It is economic madness. The power companies return $700 million in dividends every year – that is lost forever”. But is it?

Surely the sale price received today is equivalent to the future expected dividends? Nothing is lost. Dividends of $700m a year at a rate of return of, say, 10 per cent are equivalent to $7 billion today.

Mr Goff claims that the dividends “pay for 10,300 teachers, 12,600 new police officers or 33,000 hip replacements”. He can still spend the $7b sale proceeds or the $700m each year forever. They are equivalent.

This drew the following comment on the Dominion Post website:

“Surely the sale price received today is equivalent to the future expected dividends?” I think you sir may in fact not get it. “The future expected dividend” is infinite. Inflation happens, and so does increasing dividend.

If we sell it for 7 billion, that is ALL we ever get and it will end up like kiwi rail, run down by the owners to maximise profit. The 7 Billion will become worth less and less. And we will become asset poor.

If we keep it, the value will increase, dividends will increase as electricity becomes our primary fuel source (Oil crisis), and because we (the NZ government, and by default the NZ people) will invest in it, it will not become run down.

Would you sell your kidney for short term profit? I think you would. Think long term, thinking short term led to the current problems.

Kerr then makes the point that we need to think in terms of the discounted value of the future (infinite?) dividend stream. A dollar tomorrow is not worth the same as a dollar today.

The future expected dividend may indeed be infinite (if the SOE performs well). But what Garth Ireland was pointing out is that to compare the value of the asset to the Crown if it remained in public ownership with the value to the Crown of a sale, you have to discount the future (infinite) dividend stream to express it in net present value terms. People value a dollar today more than they value a dollar in 100 years’ time.

On that basis, the Crown’s financial position is no worse as a result of the sale.

Kerr also notes that the government could gain from a sale,

because the new private owners of the business are likely, on average, to operate it more efficiently, the Crown is likely to be better off financially (relative to keeping the asset) because in a competitive sale process it will capture some of the likely efficiency gains.

But there seems to be other problems with the quote from the Dominion’s website. First, obviously the future income stream is not infinite as this would require the firm to exist forever. Firms tend not to be around for that length of time. So we can't get the $700 million forever. Secondly the $7 billion is not all that we get if an SOE is sold as taxes on the private firm’s profits will be taken by the government. Thirdly there seems to be confusion as to the relationship between the dividends of $700 million per year and profit maximisation. The writer of the Dominion posting says “If we sell it for 7 billion, that is ALL we ever get and it will end up like kiwi rail, run down by the owners to maximise profit” which seems to indicate that the writer thinks maximising profits is a bad thing. But if the firm doesn’t maximise profits where does the writer think the dividends are going to come from? We only get the $700 million each year because the SOE sets out to maximise profits. So even if we have public ownership we still have to have profit maximisation to get the $700 million in dividends. So if it is bad for the private firm to maximise profits it must also be bad for the SOE to maximise profits, so we can have either profit maximisation by the SOE and the $700 million in dividends or non-profit maximisation by the SOE and miss out on the dividends. The actions of a profit maximising SOE will be the same as the actions of a profit maximising private firm. Both will do whatever they need to to maximise profits.

There are good reasons for not liking partial privatisation but those given in the comment on the Dominion Post website are not some of them. Kerr is right when he says,

One of the difficulties of debunking myths about privatisation is that some people do not get basic factual or economic points even when they are clearly explained.

Incentives matter: alarm clock file

The perfect gift for the economist who has everything:

Its one way I guess of finding out someone's willingness to pay for sleep.

(HT: Marginal Revolution)

Questions and more questions

Bryan Caplan asks

1. If the minimum wage is a good idea, shouldn't unpaid internships be illegal as well? If not, why not?

2. Name the main arguments in favor of the legality of unpaid internships. Aren't all of them equally good arguments for allowing people to work for wages greater than zero and less than the minimum wage?

While Mark Perry asks

1. If ticket scalping laws that make it illegal to sell a ticket to a concert or sporting event above face value are a good idea, shouldn't selling a coin, bond, car, or house above face value, sticker price or list price also be illegal as well? If not, why not?

2. Name the main arguments in favor of selling a coin, bond, car or house above face value/list price. Aren't all of them equally good arguments for allowing people to selling tickets above face value?

Not I think that anyone will bother to answer them.

EconTalk this week

William Easterly of New York University talks with EconTalk host Russ Roberts about the oft-heard claim that poor countries led by autocrats grow faster than poor countries that are democratic. Drawing on a recent paper, "Benevolent Autocrats," Easterly argues that while some autocracies do indeed grow very quickly, a much greater number do not. Yet, the idea that the messiness of democracy is inferior to a dictatorship remains seductive. Easterly gives a number of arguments for the perennial appeal of autocracy as a growth strategy. The conversation closes with a discussion of the limitations of our knowledge about growth and where that leaves policymakers.

The GM nationalisation in review

In this Cato Daily Podcast Dan Ikenson reviews the nationalisation of G.M. by the U.S. government.

Entrepreneurs and university

What is the opportunity cost of university for entrepreneurs? John Tayor writes at the Economcis One blog:

On PBS NewsHour yesterday Peter Thiel argued that the opportunity cost of college may be surprisingly high for many students, and indeed, as widely reported this past week, he raised the opportunity cost for some impressive 20 Under 20 prize-winning entrepreneurs. Economist Richard Vedder was on Peter's side of the argument, and not so surprisingly Wesleyan University President Michael Roth was not.

But the opportunity cost argument is worth taking seriously, and the entrepreneurship example is certainly a good one for the introductory economics course. Ever since Tiger Woods took my Stanford Economics 1 course in 1996, I’ve started my text book and first lecture with the story about how he dropped out of Stanford and joined the pro tour after learning about opportunity cost from me. But in the 7th Edition (out this fall) we are using examples closer to Peter Thiel's (who also was a Stanford student).

It should be noted that along with Tiger Woods entrepreneurs like Mark Zuckerberg, Steve Jobs and Larry Ellison dropped out of university, to work on business opportunities. So not everyone needs to go to university, something that the government should think about, given its seeming obsession with having everyone at university.

New York University lands Paul Romer

A big catch for NYU. David Leonhardt writes at Economix:

New York University has landed a star economist: Paul Romer, a leading expert on economic growth, who has been at Stanford for the last 15 years. Mr. Romer has been a visiting professor at N.Y.U. this year.

Perhaps most interesting, Mr. Romer will run a new project — the Urban System Project, based at N.Y.U.’s Stern School of Business. As Mr. Romer recently wrote:

In the last 10,000 years, humans built cities to house 3 billion people. In this century, we will make room for another 3 to 6 billion. Because both the worldwide and urban population will stabilize this century, humans will never again have this chance to remake our system of cities.

Many of the people who will shape this process — national policy makers, mayors, corporate strategists, and managers of sovereign and private wealth — now see the city as a fundamental unit of social analysis. To use an analogy from software, cities are the modules of the modern world. Externally, they connect via such standardized interfaces as the shipping container, the airplane, the Internet. Internally, they can be diverse, experimental, and innovative. As they respond to technological and environmental change, new and restructured cities will be our most important source of social progress.

Romer is best known for this work on "endogenous growth" or the “new growth theory,” which emphasizes the role of technology in economic growth. His most recent work has been on what is called "charter cities". This is where in poor country would turn over a piece of land to be managed by a more affluent country or countries. One such model is Hong Kong. Sebastian Mallaby summarised the idea as:

Rather than betting that aid dollars can beat poverty, Romer is peddling a radical vision: that dysfunctional nations can kick-start their own development by creating new cities with new rules… By building urban oases of technocratic sanity, struggling nations could attract investment and jobs; private capital would flood in and foreign aid would not be needed.

Given some of the recent hires by NYU one wonders how much money they have to throw around on getting the best people.

World trade and the Doha Round: A deficit of political leadership

In this audio from VoxEU.org Peter Sutherland talks to Viv Davies about the final report of the high-level trade experts group, published this week, on 'World Trade and the Doha Round'. The report traces the imminent failure of the Doha Round back to what the authors consider to be "a deficit of political leadership"; they also make the case for why the WTO matters.

Entrepreneurship, compensation, and the corporation

Henry Manne has a new paper in the Quarterly Journal of Austrian Economics (Vol. 14, No. 1, p.3–24, Spring 2011) on the above topic. The abstract is given below, note that use of insider trading as a method of compensation and for the encouragement of innovation.

This paper revisits the concept of entrepreneurship, which is frequently neglected in mainstream economics, and discusses the importance of defining and isolating this concept in the context of large, publicly held companies. Compensating for entrepreneurial services in such companies, ex ante or ex post, is problematic—almost by definition—despite the availability of devices such as stock and stock options. It is argued that insider trading can serve as a unique compensation device and encourage a culture of innovation.

Does management matter?

A question asked by Claire Brunel in the latest NBER Digest. She writes,

Do differences in management practices cause differences in firm performance? Although economists typically have believed that competition will simply drive badly managed firms out of the market, co-authors Nicholas Bloom, Benn Eifert, Aprajit Mahajan, David McKenzie, and John Roberts find that that is not the case, at least in the Indian textile industry.

In "Does Management Matter: Evidence from India" (NBER Working Paper No. 16658), the researchers analyze the results of an experiment conducted among large multi-plant textile firms in India. A randomly chosen set of plants received free consulting on modern management practices, while other plants in the industry did not. When the authors compare the performance of the plants that received management advice with those that did not, they find that adopting the recommended management practices had three main positive effects. First, it raised average productivity by 11 percent, through improved quality and efficiency and reduced inventory. The evidence suggests that firms spread the "good management" practices from their plants that received the advice to other plants that they owned.

Second, it increased decentralization of decision making: owners delegated more power over hiring, investment, and pay to their plant managers. This happened in large part because the improved collection and dissemination of information that was part of the change in management process enabled owners to monitor their plant managers better, making them feel more comfortable with delegating.

Third, it increased the use of computers, which were necessitated by the data collection and analysis that are involved in modern management. Increased computerization, in turn, raised the demand for educated employees.

Because these practices were profitable, the authors ponder why firms had not adopted them before. They find that informational barriers were a primary factor in explaining this lack of adoption. Firms were often not aware of the existence of many modern management practices, such as inventory norms and standard operating procedures, nor did they appreciate how these could improve performance.

Moreover, it appears that firms that are poorly managed are not rapidly driven from the Indian textile market. Indeed, competition is limited by constraints on firm entry and growth. Tariff protectionism prevents entry of foreign competition which would force domestic firms to adopt more efficient practices. And, trust issues prevent delegating, thereby limiting how much additional productivity better management technology can generate from a single manager.

A couple of things seem interesting here: one being that the reason for non-adoption of profitable management practices was asymmetric information. Firms were not aware of modern management practices. What then is the standard of management training in India? Surely any decent management programme would teach the "best practice" methods of management. The second point is the effects of tariff protection which keeps out foreign competition which would force the local companies to upgrade their management thinking. This is something not normally thought about when considering the downside of trade barriers.

Tyler Cowen, America's hottest economist

Or so says Bloomberg Business Week, they have an article on Cowen here.

While a business magazine may reflect the public perception as to who's "hot" in economics, you may wonder who other economists would pick as the "hottest economist". According to this survey the top 3 economists under the age of 60 are: Paul Krugman, Greg Mankiw and Daron Acemoglu. Cowen comes in 16th on this list.

Technology and the academic world

Yes technology effects even the academic world. An announcement from the American Economic Association:

On April 15, 2011, the Executive Committee voted to drop “double-blind” refereeing for the Association’s journals. The change to “single-blind” refereeing (the referees’ identity remains undisclosed) is effective July 1, 2011. Easy access to search engines increasingly limits the effectiveness of the double-blind process in maintaining author anonymity. Double-blind refereeing also increases administrative costs of the journals and makes it harder for referees to identify an author’s potential conflicts of interest arising, for example, from consulting.

It will be interesting to see if there are any changes to the papers accepted by the AEA's journals from now on and thus it will allow a test of the effectiveness of double-bind refereeing.

When is insider trading legal?

For the U.S. at least, it appears it is when you're a politician. Valerie Richardson writes in The Washington Times:

An extensive study released Wednesday in the journal Business and Politics found that the investments of members of the House of Representatives outperformed those of the average investor by 55 basis points per month, or 6 percent annually, suggesting that lawmakers are taking advantage of inside information to fatten their stock portfolios.

“We find strong evidence that members of the House have some type of non-public information which they use for personal gain,” according to four academics who authored the study, “Abnormal Returns From the Common Stock Investments of Members of the U.S. House of Representatives.”

To the frustration of open-government advocates, lawmakers and their staff members largely have immunity from laws barring trading on insider knowledge that have sent many a private corporate chieftain to prison.

The obvious way to deal with this is make insider trading legal for everyone, not just a small select group.

But Richardson as notes,

Strict laws ban corporate executives from trading on their insider knowledge, but no restrictions exist for members of Congress. Lawmakers are permitted to keep their holdings and trade shares on the market, as well as vote on legislation that could affect their portfolio values.

One law for them and another for us.

What is the economic value of the internet?

Is a question asked by Tyler Cowen at Marginal Revolution. He is commenting on a new study of the value of the interest by McKinsey. He writes,

The study shows a few things:

1. Most of the economic benefits of the internet are in fact captured in current economic statistics, which I’ve already argued do not look so fabulous. The point is not to blame the internet, as without it things would have been worse. The point is that the internet gains, in absolute terms, haven’t been large enough to produce a rosy picture overall.

2. The direct and indirect economic effects of the internet account for 3.8% of U.S. gdp, as currently measured (p.15). That’s less than many people think and that value is already incorporated in the current gdp measure. The good news — and it is good news — is that there is lots of room for future growth from internet impact. We’ve yet to really organize our economy around the internet, as we someday will, and then the gains will be enormous. In the meantime we are waiting.

3. What about the unpriced consumer surplus gains from the internet? The study considers that too:

In general, this surplus is generated from the exceptional value users place on Internet services such as e-mail, social networks, search facilities, and online reservation services, among many others. This value far outweighs the costs, both actual costs such as access and subscription fees and annoyances such as spam, excessive advertising, and the need to disclose personal data for some services. In the United States, for example, research conducted with the Interactive Advertising Board found that consumers placed a value of almost €61 billion on the services they got from the Internet, while they would pay about €15 billion to get rid of the annoyances, suggesting a net consumer surplus of about €46 billion.

There are so many problems with the measurement of all aspects of the knowledge economy, not just the internet, - see Section 5 of this paper for a discussion of some of them - that I'm not sure what you can make of any such measurement exercise.

Interesting blog bits

1. N. Stephan Kinsella on How Intellectual Property Hampers the Free Market

   Advocates of free-market capitalism commonly believe in the legitimacy of intellectual property (IP) because IP rights are thought to be important to a system of private property. But are they?

2. Don Boudreaux says Beware of Celebrating Decreases in the Current-Account Deficit

   Keynesians – or, more generally, economists obsessed with aggregate demand – are fond of exports because foreigners’ expenditures on exports are demand for ‘our’ country’s goods and services. Aggregate-demand-obsessed economists also dislike imports because ‘our’ consumers’ expenditures on imports is demand, not for output produced at home but, rather, for output produced abroad. Unless that ‘demand’ returns to the home economy in the form of foreigners’ demand for ‘our’ exports, then aggregate-demand-obsessed economists are unhappy because the sum of C+I+G+[Xports-Mports] goes down. But .....

3. Nico Voigtländer and Hans-Joachim Voth on The geography of hate: How anti-Semitism in interwar Germany was influenced by the medieval mass murder of Jews

   Is violence a cultural trait passed from one generation to the next? This column examines an extreme case – anti-Semitism in Germany. It shows that towns that murdered their Jews during the Black Death (1348-1350) were also much more likely to commit violence or engage in anti-Semitic acts in interwar Germany, nearly 600 years later. This suggests racial hatred can persist over centuries.

4. Kevin K. Tsui on More oil, less democracy: Evidence from worldwide crude oil discoveries

   It has been widely argued that natural-resource wealth is a curse that leads to corrupt politicians, closed and illiberal societies, and defunct economies. This column presents new evidence on the political impacts of oil wealth. It argues that the effects depend on geology and history, shedding light on the recent uprisings in the Middle East and North Africa.

5. Nicola Lacetera, Devin Pope and Justin Sydnor on Limited attention costs: Sometimes driving a mile costs $200

   People like to take shortcuts and this affects how we make decisions. Looking at auctions of more than 22 million used cars in the US, this column finds that buyers will often only pay attention to the first few digits of mileage. So if you have driven your car 30,000 miles, you might have to sell it for $200 less than if you had driven in 29,999 miles.

6. Gary Becker on Subsidies to Oil and Other Energy Sources

   President Obama and members of Congress are calling for a sharp reduction in the substantial direct subsidies to American oil companies. Many countries also give an indirect subsidy to oil producers and refiners by subsidizing the purchase of gasoline. In Saudi Arabia, for example, subsidies have reduced the price of a liter of gasoline (1 gallon equals about 3 ¾ liters) to 12 cents, which had made gasoline there cheaper than bottled water. The largest subsidies to gasoline are usually found in oil producing countries: Saudi Arabia, Iran (although the Iranian government greatly reduced gasoline subsidies in 2010), Russia, Venezuela, Indonesia, and the UAE. Yet, the economic case for either direct or indirect subsidies to the production and refining of oil is quite weak.

7. Justin Wolfers on Google's New Correlation Mining Tool: It Works!

   You may have heard of Google Trends. It’s a cool tool which will show you the ups-and-downs of the public’s interest in a particular topic—at least as revealed in how often we search for it.

8. David Friedman on Learning from Evidence: Not

   This morning I listened to a commencement address by a former judge. It struck me as an interesting example of the failure to modify beliefs on the basis of evidence.

9. Mark Perry notes that Global Sticks Moves from China to Thunder Bay

   Why has Global Sticks, a manufacturer of wooden ice cream sticks, moving from Dalian, China to Thunder Bay, Ontario? It’s the kind of low margin manufacturing that is never supposed to come back after it leaves North America for cheaper labour abroad.

Needed: plain talk about the dollar

Or so says Christina Romer who seems to have gone back to being an economist rather than an economic advisor. In an article in the New York Times she says,

Our exchange rate is just a price — the price of the dollar in terms of other currencies. It is not controlled by anyone. And a high price for the dollar, which is what we mean by a strong dollar, is not always desirable.

She continues,

Such discussions would start with some basic economics. The desire to trade with other countries or invest in them is what gives rise to the market for foreign exchange. You need euros to travel in Spain or to buy a German government bond, so you need a way to exchange currencies.

The supply of dollars to the foreign exchange market comes from Americans who want to buy goods, services or assets from abroad. The demand for dollars comes from foreigners who want to buy from the United States.

Anything that increases the demand for dollars or reduces the supply drives up the dollar’s price. Anything that lowers the demand for dollars or raises the supply causes the dollar to weaken.

Consider two examples. Suppose American entrepreneurs create many products that foreigners want to buy, and start many companies they want to invest in. That will increase the demand for dollars and so cause the dollar’s price to rise. Such innovation will also make Americans want to buy more goods and assets in the United States — and fewer abroad. The supply of dollars to the foreign exchange market will fall, further strengthening the dollar. This example describes very well the conditions of the late 1990s — when the dollar was indeed strong.

Now suppose the United States runs a large budget deficit that causes domestic interest rates to rise. Higher American interest rates make both foreigners and Americans want to buy more American bonds and fewer foreign bonds. Thus the demand for dollars increases and the supply decreases. The price of the dollar will again rise.

[ ... ]

Both developments — brilliant American innovation and troublesome American budget deficits — caused the dollar to strengthen. Yet one is clearly a positive for the American economy, the other a negative. The point is that there is no universal good or bad direction for the dollar to move. The desirability of any shift in the exchange rate depends on why the dollar is moving.

And this is the point, the exchange rate like any price just tells what the relative demand for the dollar is, but it doesn't tell us anything about whether this is a good or bad thing. The question that must be asked is, Why is the dollar "strong" or "weak"? The answer to this question will tell us if we should be worried about the state of the economy. The exchange rate is just a price, at best a signal of the underlying condition of the economy.

The minimum wage, again

The effects of the minimum wage are not the same across all groups in society. The effects of labour market wage mandates fall disproportionally on minority groups. In the case of the U.S. this means the effects are felt mainly by blacks. Getting good estimates of this effect is difficult due to the lack of sufficiently comprehensive data.

A new study from the Employment Policies Institute, by economists William Even (Miami University) and David Macpherson (Trinity University), overcomes this problem by amassing a dataset from the years 1994 to 2010 that includes over 600,000 data observations —including a robust sample of minority young adults.

There was in the U.S. something of a “natural experiment” created by the substantial interstate variation in the minimum wage between 1994 and 2010. The focus of the study was on 16-to-24 year-old males without a high school diploma, a group that previous studies suggest are particularly susceptible to wage mandates. The authors control for labour market and demographic differences when estimating the effects of wage mandates on minority groups.

The finding of the study suggest that among white males in this group, each 10 percent increase in a federal or state minimum wage decreased employment by 2.5 percent; for Hispanic males, the figure is 1.2 percent. But among black males in this group, each 10 percent increase in the minimum wage decreased employment by 6.5 percent. So employment for all groups falls with the fall being greatest for blacks and least for Hispanics. Looking at the p-values for the estimated elasticities of employment with respect to changes in the minimum wage you will see that the elasticities for men are significantly different from 0 for whites and blacks, but not for Hispanics. So the effect on Hispanic males could be zero.

The substantial disemployment effects that emerge from the data raise an obvious question: Why do black males suffer more harm from wage mandates than their white or Hispanic counterparts? The study argues that blacks are more likely to be employed in eating and drinking places–nearly one out of three black young adults without a high school diploma works in the industry. Businesses in this industry generally have narrow profit margins and are more likely to be adversely impacted by a wage mandate. There’s also substantial variation in regional location, as black young adults are overwhelmingly located in the South and in urban areas. It's also likely that unobserved differences in skill level and job experience play a role. To the extent that these differences are concentrated among young men of a particular race or ethnicity, this group would have the greatest risk of losing jobs when the minimum wage is increased.

Property rights are?

Yesterday's blog on copyright raised interesting questions about the very nature of property itself. Many convinced free-marketeers and libertarians seem to believe that 'property rights' are undeniable, permanent and immutable, and endow them with an almost mystical quality. I see the crucial importance of property rights as well: you can't expect people to work hard and build up capital if it can simply be stolen by others, including politicians. Property is one of the foundations of a liberal social order.

But as Milton Friedman (no leftie, he) pointed out in Capitalism and Freedom, defining what constitutes property is problematic, and often controversial. Should my ownership of a piece of land, he asks, deny others the right to fly over it in an aircraft? Precisely what rights should the shareholders of a company have? And, indeed, what should be the rules on patents or copyright? Terence Kealey, another robust liberal, argues that there should be no patents (most inventions are hard to replicate and the financial reward tends to come early), but that there should be copyright (since words are almost costless for others to replicate).

Plainly, these things are matters of judgement. They are decided in a social context. It might be a kind of natural evolution, as Hayek suggests, in which particular property rules come to be adopted, almost without thinking, because they work and support the smooth functioning of a society. It may be that the rules evolve through the common law process. (The most wonderful examples here are those regarding property disputes between neighbours, which have left us with rules such as, yes, you can cut down the branches of a neighbour's tree that spreads over your garden, but you have to offer them back the wood!). Sometimes the rights are defined in statute, as with shareholders' rights – thought that can be more hit and miss in terms of getting the balances just right.

This is Eamonn Butler writing at the Adam Smith Institute blog. An important point about property rights is that they be known and certain. Freedom from being expropriated by some political majority is important if people are to act to maximise the value of such rights. And if transaction costs are low and the rights tradeable Coase tells us that people will trade such rights until the highest valuer of those right has them. But we are still left with the problem of what exactly property rights should be and how we decide on that.

Inefficient railways

At the IEA blog Richard Wellings has been looking at the reasons for the state of Britain's railways. He notes that for many people the recent history of Britain's railways has brought the whole concept of privatisation into disrepute. But he argues that this is unfair as rail privatisation was a pastiche of genuine privatisation – in many ways it actually increased the level of state control. He writes,

Last week’s McNulty Review estimated that costs are about 40% higher on Britain’s railways than comparable European networks. Taxpayer subsidies, adjusted for inflation, have probably more than tripled since the British Rail era – reaching around £7 billion per annum. As McNulty explained, higher costs are to a large extent the result of the fragmentation of the industry. A vertically integrated industry was split up, with different firms managing the infrastructure, running the trains and leasing the rolling stock. As a result, transaction costs mushroomed.

It is a myth, however, that fragmentation was the result of privatisation per se. The government imposed an artificial structure on the industry from above. Indeed, when train operators subsequently approached the government with a view to taking ownership of the track, they were rebuffed. Moreover, the regulations imposed on the ‘private’ rail industry made it virtually impossible to close loss-making lines, while franchise agreements with train operators effectively forced them to continue running uneconomic services.

By contrast, the structure of a rail industry under genuine private control would be determined by market forces. Historical experience suggests that vertical integration would predominate. This may be explained both by the desire to minimise transaction costs and the relatively high degree of asset specificity on the railways (for example, rolling stock is often designed for use on particular routes). Moreover, genuine private owners would be free to close uneconomic lines and cancel loss-making services. Freed from government price controls, they could set fares to address overcrowding. Expensive new capacity would be funded by fares and land development rather than taxpayers (many of whom never use the railways).

Much of this argument would apply with as much force to the situation with rail privatisation in New Zealand. Here as in the U.K. the government tired to undo vertical integration which history suggests occurs for good efficiency enhancing reasons. Also it was also difficult for private owners of rail in New Zealand to close loss-making lines. The result in New Zealand, as in the U.K., showed that privatisation done badly gives bad results.

On the relevance of freedom and entitlement in development

Reviewing the economic performance—good and bad—of more than 100 countries over the past 30 years, this paper finds new empirical evidence supporting the idea that economic freedom and civil and political liberties are the root causes of why some countries achieve and sustain better economic outcomes. For instance, a one unit change in the initial level of economic freedom between two countries (on a scale of 1 to 10) is associated with an almost 1 percentage point differential in their average long-run economic growth rates. In the case of civil and political liberties, the long-term effect is also positive and significant with a differential of 0.3 percentage point. In addition to the initial conditions, the expansion of freedom conditions over time (economic, civil, and political) also positively influences long-run economic growth. In contrast, no evidence was found that the initial level of entitlement rights or their change over time had any significant effects on long-term per capita income, except for a negative effect in some specifications of the model. These results tend to support earlier findings that beyond core functions of government responsibility—including the protection of liberty itself—the expansion of the state to provide for various entitlements, including so-called economic, social, and cultural rights, may not make people richer in the long run and may even make them poorer.

Or so says the World Bank's Jean-Pierre Chauffour in a new working paper. The paper looks at economic performance of a group of countries over time: it considers the last 30 years of data for more than 100 countries. The paper sets out to (1) re-examine the long-term relationship between freedom and economic growth; and (2) disentangle the respective role of economic freedom, civil and political liberties, and the pursuit of economic, social and cultural rights on economic growth.

In line with the analytical framework of the rights-based approach to development, the paper conjectures that development is fundamentally rooted in the protection of some fundamental rights. It however further conjectures that all so-called “rights” are not necessarily equal and that the individual rights at the root of sound institutions and sustainable economic growth may not necessarily coincide with the rights embedded in the instruments of international human rights law. In particular, the pursuit of freedom rights (i.e., economic freedom, and civil and political liberties) and entitlement “rights” (i.e., right to food, housing, education, health, etc) may lead to different institutions and development outcomes over the long run.

When thinking about economic development freedom and entitlement are two different paradigms can be utilised. Depending on the balance between free choices and more coerced decisions, individual opportunities to learn, own, work, save, invest, trade, protect, and so forth could vary greatly across countries and over time. The results of this paper demonstrate empirically the important point that fundamental freedoms are paramount in explaining long term economic growth. It argues that for a given set of exogenous conditions, countries that develop institutions that favour free choice — e.g. economic freedom and civil and political liberties — over entitlement rights tend to see greater growth and better achieve many of the proximate characteristics of success, e.g. leadership and governance; engagement with the global economy; high rates of investment and savings; mobile resources, especially labour; and inclusiveness to share the benefits of globalization, provide access to the underserved, and deal with issues of gender inclusiveness. In contrast, pursuing entitlement rights through greater state coercion may be deceptive and even self-defeating in the long run.

These findings, which tend to support earlier results from the empirical literature, provide potentially important policy lessons for all countries. For developed countries, they suggest that prioritizing economic freedom over social entitlements could be an effective way to reform the welfare state and make it more sustainable and equitable in the long run. For middle income countries, such as countries in the midst of the Arab Spring but also countries in Asia and Latin America, they indicate that the quest for civil and political rights but also economic freedom implies the reduction of existing privileges and entitlements to create new social contracts. For low-income countries (as well as the international community), they provide an opportunity to reflect upon the achievement under the MDGs and the potential role of economic freedom, along with other fundamental freedoms, in a post-2015 MDG development agenda.

Why oh why can't we have a better press corps?

An extremely good question asked by Seamus Hogan over at the Offsetting Behaviour blog. With regard to the press coverage of the budget Hogan writes,

So instead I am going to put in a plea for better media coverage of future budgets. Here are some suggestions:

1. Don't publish any press releases from interest groups; instead, interview the spokespeople and ask each one two questions: First, "please comment on those parts of the budget that did not relate to your sector"; and second, if you had to put the same total resources into your sector as in this budget, how would you have allocated it differently?".
2. Don't publish any press releases from opposition parties; instead, interview the leaders or finance spokespeople and ask each one, "please state the areas in which you would have spent less money".
3. In a one-marshmellow-now, two-marshmellows-later exercise, promise to give twice as much coverage to anyone whose response is "I haven't had time to fully digest the information yet, let me get back to you tomorrow with a more considered response".
4. Simply refuse to quote any statement with the words "bold", "imaginative" or "Titanic" in it. (To be fair, on the last of these, I didn't see a deckchairs cliché this year, but it will be back.)

All excellent suggestions but I would argue the problem with journalists is more basic: they don't understand economics. So my suggestion is that before any journalist is allowed to write on economic topics they have to sensibly answer one question:

As a journalist your job is to explain economic issues to the general public. So tell me one fundamental and important economic idea that the public don't seem to understand and tell me how you would explain it to them.

Obvious candidates as an answer would be a good discussion of comparative advantage, the importance of incentives, the fact that there are no solutions only trade-offs etc.

Also all would be economic journalists should be made to read Henry Hazlitt's Economics in One Lesson.

Time and work at the Bank of England

A topic that historian Anne Murphy discusses in a new column at VoxEU.org. She writes,

In 1783 the Bank of England appointed a Committee of Inspection to examine working practices within its departments and identify any failings in procedures. The committee spent a year interviewing the clerks and observing them at work. Their final report offers a comprehensive record of the bank’s operations at a time when it was the city’s chief financial institution and the centre of the edifice of public credit.

Much can be learned about the workings of the early modern financial system from this report. One aspect, however, that is particularly striking is the extent to which time mattered in the operation of this business. The majority of those who worked for the bank would have been constantly aware of the clock and conscious of their obligation to complete work by specific deadlines.

This is important because historians have long argued about when the clock began to shape the day of British workers and whether time-discipline improved productivity. The debate has been dominated by EP Thompson (1967), who argued that work discipline was transformed by the industrial revolution since the clock measured labour at machines and caused changes in the way individuals perceived time.

Thompson’s views have been questioned and refined in studies, such as those by Hans-Joachim Voth (1998) and Paul Glennie and Nigel Thrift (2009), but up until now the debate has focused chiefly on labouring and industrial work. My recent research (Murphy 2011) shows that at least some parts of Britain’s growing financial sector led the way in creating a working environment that was dominated by the clock and in encouraging their workforce to see long hours and commitment to career as a virtue.

During the eighteenth century the bank the hours of public business were typically Monday to Saturday from nine to five. Attendance books were kept to ensure workers did not arrive late to their desks. Murphy continues,

Clerks were allotted very specific tasks in a bank that was, by this time, organised into departments and employed over 300 people. Work was complex, time-consuming, and required coordination between individuals and offices. Work also had to fit into the broader rhythms of City life. Thus, Mr Greenway, a junior cashier, noted that business always increased “towards evening when the bankers come in”.

The official working day finished at 5.00pm when the doors were locked to customers but the level of business, much heightened by the recent War of American Independence and the subsequent increase in public indebtedness, required some clerks to work late into the evening. Mr Southey of the accountant’s office estimated that on a moderate day he did not get away until 6.00 or 7.00pm. Mr Bentley said that he was “very seldom out of the office before 8 at night, if the business is heavy much later, & on a Saturday generally ‘till 10 or 11 o’clock”.

Clerks were allowed an hour and a half for lunch but when business was brisk they worked through and had lunch sent in. In some offices, if it was quiet, a small number of staff could choose to forgo lunch and leave early. The more senior men also had shortened working days. They left when business grew quiet at three or three-thirty in the afternoon. This meant that the senior men generally worked 7 or 7.5 hours a day while their more junior colleagues worked 10 or 11 hours. The junior men also often lost their public holidays as the Bank kept some offices open for the convenience of its customers. The Bank of England’s junior clerks, therefore, were just as hard-working as their artisanal or labouring fellow Londoners.

Time provided a discipline which controlled the clerks day.

Aside from offering an insight into the working day at the bank and in the city, the committee’s report demonstrates the extent to which clerks themselves were measuring their time at work by the clock. Indeed, the importance of time emerges very clearly from the way clerks talk about not just their working day, which they invariably describe in terms of hours worked, but also the specifics of their labour.

As such, speed of working was highlighted. Clerks sometimes explained their work either with apparent pride in its speed of completion or to emphasise the length of time taken to complete certain tasks. Hence Mr Lander, on being asked how many notes he could sign in a specified time, answered “about 100 Notes in 20 Minutes if not interrupted”. The clerks in the drawing office who were responsible for making out warrants and notes on discounted bills frequently found that warrants were not completed before 3.00pm and then there still remained 500-600 bills to make out. They reckoned it took an hour to make out 80 bills and thus they very often remained in the Bank until late in the evening.

The public were also concerned with the speediness of service provision at the bank. The committee was informed that “many persons refuse to wait at the bank the time necessary to have their Notes changed & made out afresh, & go away to bankers to have their business done with less delay”. It was also noted, with some dissatisfaction, the “very frequent complaints, in regard to delays and inconveniences experienc’d by the publick in receiving their dividends”.

Clerks often told the committee of the strains of having to rush to meet deadlines. Frequent mention was also made of the increase of business that accompanied the rise in public indebtedness during the War of American Independence.

The committee were informed that, since the war, the work of compiling lists of unpaid dividends for the exchequer was so time-consuming that it could take up to 5 or 6 months to complete. Making up the general exchequer account had grown so complex that it could take nine months.

The Americans were causing trouble in banking even back then!

The conclusion Murphy reaches is,

The Bank of England clerks’ working day at the end of the eighteenth century was characterised by regular hours of work and sometimes very long working days. Their labour was time-oriented rather than task-oriented and controlled by the need to coordinate work and deadlines both within and between offices. Customers, public creditors, brokers, and notaries also demanded a prompt service. The capitalist working day, therefore, was firmly entrenched at the bank. Yet, there is very little evidence that clerks overtly resisted this type of time-discipline, perhaps because the financial rewards of working in the Bank could be great. Moreover, we can suggest that some clerks even judged their own performances against the clock. And it is clear that some were adept at using the length of the working day and the need to provide timely service to negotiate better conditions.

On the other hand, late evening work, while never explicitly complained of, does seem to have been described in terms that suggested the disagreeability of working at such times. Moreover, the notion that seniority brought with it a much shorter working day was perhaps reflective of a desire for additional leisure time. Like some of their modern counterparts, therefore, eighteenth-century bank clerks were concerned, especially in later life, with achieving a good work-life balance.

The 18th century sounds a lot like the 21st.

Are the seeds of bad governance sown in good times?

There is a new NBER Working Paper on this question out. The abstract of the paper, which is by Antoinette Schoar and Ebonya L. Washington - NBER Working Paper No. 1706, reads,

This paper examines the extent to which the corporate governance structure of a firm arises endogenously in response to its performance. We demonstrate that following periods of abnormally good performance managers are more likely to call special meetings and to propose and pass governance measures that are contrary to shareholder interests (based on IRRC classification). These results are driven primarily by firms that are characterized as having poor governance according to either the GIM Index or the proportion of activist shareholders. Following these special meeting we find that next quarter performance of the firm is negative. Our results are consistent with an interpretation of shareholder inattention to governance following good firm performance or a desire to reward management for good past performance. Overall our evidence seems more consistent with the former interpretation.

A period of good performance, which may have nothing to do with the firm's management, leads to investors trusting management the when they shouldn't, and they pay the price with lower returns in the future. There is a lesson in here somewhere.

EconTalk this week

Tim Harford, author and journalist and speaker at the upcoming NZAE meetings, talks with EconTalk host Russ Roberts about Adapt, Harford's book on the virtues of failure and the trial and error process. Harford argues that success is more likely when there is experimentation and trial and error followed by adapting, rather than following a top-down, ex ante plan driven by expertise. The conversation looks at the what war can teach us about information, knowledge, and planning, the challenge of admitting mistakes, and the implications of trial and error for our daily lives.

The next best thing to pet salvation in a Post Rapture World

There really are markets in everything. This just has to be a winner:

You've committed your life to Jesus. You know you're saved. But when the Rapture comes what's to become of your loving pets who are left behind? Eternal Earth-Bound Pets takes that burden off your mind.

We are a group of dedicated animal lovers, and atheists. Each Eternal Earth-Bound Pet representative is a confirmed atheist, and as such will still be here on Earth after you've received your reward. Our network of animal activists are committed to step in when you step up to Jesus.

We are currently active in 26 states, employing 40 pet rescuers. Our representatives have been screened to ensure that they are atheists, animal lovers, are moral / ethical with no criminal background, have the ability and desire to rescue your pet and the means to retrieve them and ensure their care for your pet's natural life.

[ ...]

Our service is plain and simple; our fee structure is reasonable.
For $135.00 we will guarantee that should the Rapture occur within ten (10) years of receipt of payment, one pet per residence will be saved. Each additional pet at your residence will be saved for an additional $20.00 fee. A small price to pay for your peace of mind and the health and safety of your four legged and feathered friends.

Only in America!!

Who should own human-capital based firms?

At the Freakonomics blog the question is asked Why Can’t Law Firms Go Public? They writes,

The personal injury law firm Jacoby & Meyers (known for its TV commercials) is suing to overturn state laws in New York, New Jersey and Connecticut that prohibit non-attorneys from owning stakes in law firms. From The Wall Street Journal:

The firm, which has more than 60 lawyers and specializes in personal-injury cases, claims that the restrictions have hurt its ability to raise capital to cover technology and expansion costs, and have hampered it in providing affordable legal services to its working-class clients.

U.S. law firms typically are owned by their senior-most lawyers, called partners. The structure was designed to ensure that all the principals of the business were accountable for the firm’s work and that of their fellow partners.

The ban on law firms accepting nonlawyer investors is nationwide, with the exception of Washington, D.C., under ethics rules established largely by state supreme courts. Violations of the rules can lead to disbarment.

The restriction on investors is decades old and stems from even older strictures against lawyers sharing fees with nonlawyers, for fear that might compromise their professional independence.

Firms like lawyers and doctors and accountants are by and large partnerships and, obvious, the major asset of these firms is the human capital of the partners and the others who work at these firms. The question that arises is, Is ownership by the human capital optimal for such firms?

The answer offered by this paper is, it depends. In particular it depends on the heterogeneity of the human capital involved in the firm. For firms with a homogeneous set of human capital, ownership by the human capital can be optimal. The more heterogeneous the human capital becomes the more likely is ownership by outside investors.

The argument as to why this is so is based on the "reference point" approach to the theory of the firm. The argument therefore is based on the ideas of aggrievement and shading. Think of a firm which involve both human and physical capital but where, like a law firm, the human capital is the most important. Giving ownership to the human capital make sense since the these workers can cause much grater efficiency losses for the firm should they become aggrieved than the owner of the physical capital could. Remember the physical capital is unimportant to the production of the firm.

But as the relative importance of physical capital increases the efficiency losses the owner of this capital can cause also increases and at some point they will become so large as to make giving him ownership of the firm optimal.

If you think of the owner of the physical capital as a second type of human capital then ownership of the firm should go to whichever human capital can cause the greatest efficiency loses. But as Oliver Hart has argued human capital only firms are inherently unstable. Some non-human capital is needed to "glue" the firm together.

Thus heterogeneous human capital only firms are unlikely to remain intact and so either firms must have significant non-human capital involved, the owner of which may be the owner of the firm, or they consist of only homogeneous human capital.

So we see why law firms which expand to involve human capital other than just lawyer may wish to seek investors. Labour-ownership may no longer be optimal when the firms human capital becomes heterogeneous.

Capitalists who fear free markets

There are reasons why we want a separation of business and state. Businessmen want to use the government (taxpayers) to cover their loses. Floyd Norris writes in the New York Times about Capitalists Who Fear Free Markets.

Capitalism is supposed to produce losses on bad investments.

But all too often it has not.

In Tokyo this week, corporate executives were outraged when a Japanese government official suggested that banks might have to take losses on loans to the company that produced a nuclear catastrophe.

Yukio Edano, the chief cabinet secretary, had the temerity to say “the public will not support” the injection of government money into Tokyo Electric Power, also known as Tepco, unless banks share in the pain. Tepco says it would like to pay compensation to victims, but needs government cash to do so.

The president of Japan’s largest bank, Mitsubishi UFJ Financial, was shocked by the very idea that a bank should lose money if it lent to a company that could not meet its obligations. Mr. Edano’s remarks “came out of the blue,” said the executive, Katsunori Nagayasu. “I felt there was something wrong about them.”

To Yasuchika Hasgawa, the chief executive of the Takeda Pharmaceutical Company and chairman of the Japanese Association of Corporate Executives, the idea violated basic tenets of society. Mr. Hasgawa said he “cannot help but question how this country’s democracy can be made to work with free-market-based capitalism.”

His definition of “free-market-based capitalism” seems to assume that lenders should escape without pain, at least if they are lending to major institutions.

Reality check for these statist-businessmen. Capitalism involves profits and loses. If you make a bad investment you suffer the consequences. This is, in part, how you get the incentives for businesses right.

Just for fun: the implementation criticism and the theory of the firm

As I have noted in a number of previous posts the incomplete contracts (or property rights) approach to the theory of the firm has become a workhorse in the literature. However it has been argued that there is a problem with the foundations of the theory of incomplete contracts that makes their use for the theory of the firm problematic. The standard property rights approach assumes there is symmetric but unverifiable information. That is, there is information that the contracting parties observe but a third party, e.g. the courts, cannot verify. Such information leads to incompleteness of contract since the inability of the courts to verify such information means it cannot be contracted on. What Aghion and Holden (2011) call the “implementation criticism” basically says that observable information can be made verifiable by the use of cleverly designed revelation mechanisms.

Aghion and Holden (2011) give a very nice toy example of how such mechanisms work:

Here, we begin with an example of a revelation mechanism that is drawn from Aghion, Fudenberg, Holden, Kunimoto, and Tercieux (2010). There are two parties, a buyer B and a seller S of a single unit of an indivisible good. If trade occurs, then B’s payoff is V_B = theta – p; where theta is the value of the good to the buyer and p is the price. S’s payoff is just V_S = p. The good can be of either high or low quality. If it is of high quality, then B values it at 14; if it is of low quality, then B values it at 10, thus theta is in {10, 14}.

Suppose that the quality theta representing the true value of the good to the buyer is observable and common knowledge to both parties. Even though theta is not verifiable by a court, and therefore no initial contract between the two parties can be made credibly contingent upon theta, truthful revelation of theta by the buyer B can still be achieved through the following mechanism:

1. B announces theta to be either “high” or “low.” If he announces “high,” then B pays S a price equal to 14 and the game then stops.
2. If B announces “low” and S does not “challenge” B’s announcement, then B pays a price equal to 10 and the game stops.
3. If S challenges B’s announcement then:
a) B pays a fine F to T (a third party), and
b) B is offered the good for 6.
c) If B accepts the good, then S receives F from T (and also the 6 from B) and we stop.
d) If B rejects at stage 3b, then S pays F to T, and
e) B and S Nash bargain 50:50 over the good.

When the true value of the good is common knowledge between B and S, this mechanism yields truth telling as the unique (subgame perfect) equilibrium. To see this, let the true valuation be 14; and let F = 9: If B announces “high,” then B pays 14 and we stop. If, however, B announces “low,” then S will challenge because, at stage 3a, B pays 9 to T and, this cost being sunk, B will still accept the good for 6 at stage 3b (because it is worth 14 and 14 – 6 = 8 is greater than 14/2 = 7, which is what B gets if it rejects the offer of 6). Anticipating this, S knows that by challenging B, S receives 9 + 6 = 15, which is greater than the 10 that S would receive if S did not challenge.

Moving back to stage 1, if B lies and announces theta = 10 when the true state is theta = 14, B gets 14 – 9 – 6 = –1, whereas B gets 14 – 14 = 0 if B tells the truth.

One obvious question this gives rise to is, If such mechanisms can get around incompleteness of contract, why are contracts still incomplete? Or, Why don’t we see such mechanisms being used?

One reason may well be that these mechanisms are not robust to even small deviations from common knowledge. Strict common knowledge is a very strong assumption which is very unlikely to hold in the real world. What it requires is that if party A knows something, party B knows it, party A knows that party B knows it, and so on ad infinitum, all with perfect certainty. The problem with this is that it has been shown that the type of mechanism used above may not work if there is only "close to common knowledge": that is, party A knows something, party B knows it, party A knows that party B knows it, and so on ad infinitum, but in each case only with almost perfect certainty. What has been shown is that if any mechanism can achieve truthful revelation as an equilibrium under common knowledge, then under approximate common knowledge, there must also exist an equilibrium with nontruthful revelation. Or in other words, the mechanisms discussed above turn out to be fragile in the sense that they depend crucially on delicate assumptions about higher-order beliefs.

Another possible reason for not seeing the above type of mechanism in the real world is the effects of asymmetric information. An assumption in the mechanism outlined above is that there is symmetric information between the contracting parties. That is, the both B and S know theta. It is the third party, the courts, who do not know what value theta takes. The above mechanism breaks down with the introduction of only small amounts of private information. For example, if S does not know the quality of the good then he cannot challenge B’s announcement of the quality.

Aghion and Holden make the point that

[ ... ] an interesting direction for future research is to explore how an incomplete contracts/property rights model is affected by aspects of common knowledge, revelation mechanisms, and bargaining under asymmetric information. It seems plausible that these issues could lead to other reasons for inefficiency in investment, and property rights in the form of asset ownership may help to alleviate these inefficiencies.

• Aghion, Philippe, Drew Fudenberg, Richard, Holden, Takashi Kunimoto, and Olivier Tercieux (2010). 'Subgame-Perfect Implementation under Value Perturbations and the Hold-Up Problem', Unpublished working paper.
• Aghion, Philippe and Richard Holden (2011). 'Incomplete Contracts and the Theory of the Firm: What Have We Learned over the Past 25 Years?', Journal of Economic Perspectives, 25(2) Spring: 181-97.

Aid and growth in the least developed countries

Foreign aid has a significant positive effect on real per capita GDP growth in the least developed countries if account is taken of the quantitatively large and negative reverse effect of GDP growth on foreign aid. That is the conclusion of research by Markus Bruckner of the University of Adelaide, which he discussed with Romesh Vaitilingam in this audio of an interview from VoxEU.org.

Interesting blog bits

1. Philippe Aghion and Richard Holden on Incomplete Contracts and the Theory of the Firm: What Have We Learned over the Past 25 Years? (pdf)

   Cool and readable paper discussing the incomplete contracts approach to the theory of the firm. Sanford Grossman and Oliver Hart used the theory of incomplete contracts to develop answers to the question "What is a firm, and what determines its boundaries?" in their path-breaking paper on "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration". Perhaps the central issue is that economic actors are only boundedly rational and cannot anticipate all possible contingencies. It might well be that certain states of nature or actions cannot be verified by third parties after they arise, like certain qualities of a good to be traded in the future, and thus cannot be written into an enforceable contract. When contracts are incomplete, and consequently not all uses of an asset can be specified in advance, any contract negotiated in advance must leave some discretion over the use of the assets; and the "owner" of the firm is the party to whom the residual rights of control have been allocated at the contracting stage. The optimal allocation of property rights—or governance structure—is one that minimizes efficiency losses. This produces a theory of ownership and vertical integration as well as a theory of the firm. First we spell out Grossman and Hart's argument using a simple numerical example. Then we show how the incomplete contracts approach can be used to analyze the firms' internal organization; the firms' financial decisions; the costs and benefits from privatization; and the organization of international trade between inter- and intrafirm trade. We discuss several criticisms of the incomplete contracts/property rights methodology and review recent developments of the incomplete contracts approach.

2. Seamus Hogan on Electricity "Overcharging" Again

   Is there over charging in New Zealand's electricity markets or not?

3. Roger Kerr on Budget-2011: the vision thing

   As background to today’s budget, this is an interesting analysis of the New Zealand economy by London-based investment advisory firm Independent Strategy.

4. Eric Crampton on Budget 2011

   Assorted first impressions on the budget

5. Mario Rizzo asks Is Economics a Public Good? How Would We Know?

   What is the economic justification for using tax money to subsidize the production of economic research? The standard answer is that academic economists produce a public good. In other words they produce knowledge for which they do not charge and for which it is not feasible to exclude non-payers.

6. Peter Boettke also asks Is Economics a Public Good?

   Just because a "good" might have publicness characteristics does not mean it is the responsibility of the public sector to finance it let alone produce it.

7. Ed Dolan asks Will Shifting Political Winds Finally Kill Ethanol Subsidies?

   We can only hope so.

8. John Taylor argues that Linking the Debt Limit Hike To Spending Cuts Is Good Economics

Recent arguments in the U.S. about debt and spending do not take account of important economic advantages of linking the debt limit to spending reductions. Such a link is good economics in theory and in practice. It is essential to a credible return to sound fiscal policy and an end to the ongoing debt explosion.

The effect of land tenure on investment

Yes institutions do matter. The role of land tenure, that is institutions governing land ownership, in investment in productivity-enhancing measures in developing countries has been widely documented.

There are three main theoretical arguments that have been put forward to explain a positive link between tenure security and investment. First, secured property rights are expected to provide a guarantee for farmers to undertake long-term investment in land-improving and conservation measures, since there would be no fear of expropriation. As has been noted, given that the result of land-improving investments is normally realized with a one period lag, if the tenant is evicted with some possibility during this period, he will be enjoying only a fraction of the benefit from the investment in expected terms. This may cause the tenant to supply a lower level of investment in effort for the same crop share, a reason why security of tenure is thought to be good for investment. This is a version of the standard argument for secure property rights. Second, it has been argued that secured land rights make it easier to use land as collateral to obtain loans to finance agricultural investments. The third effect operates through better possibilities for trade. If improved transfer rights enhance factor mobility by making it easier for farmers to sell or rent their land, investment in land-improving measures may be facilitated.

But what of the empirical literature? In a new paper, "Land tenure differences and investment in land improvement measures: Theoretical and empirical analyses" by Awudu Abdulai, Victor Owusu and Renan Goetz, in the Journal of Development Economics (vol. 96 (2011) p. 66–78) argue that the empirical findings on the land rights–investment relationship appear to be inconclusive. This is something they note to help change. Abdulai, Owusu and Goetz explain the contribution of their papers as,

The more recent studies appear to be showing positive impacts of tenure security on investment. Deininger and Ali (2008) show that full land ownership, compared to mere occupancy rights, exerts a statistically significant and economically large effect on investment and productivity of land-use in Uganda. Goldstein and Udry (2008) also find that insecure land tenure in Ghana is associated with greatly reduced investment in land fertility, while Jacoby and Mansuri (2008) find in their study on Pakistan that farmers invest less in their leased plots than they do in their owned plots.

This article contributes to the tenure-security-investment debate by developing a framework that captures the impact of different land tenure arrangements on investment decisions of farmers. The model embodies behavioral assumptions consistent with investment decisions that characterize investment in productivity-enhancing inputs in the agricultural sectors of most sub-Saharan African countries. First, we develop a model to examine the effects of 4 different land tenure arrangements on investment decisions of farmers on theoretical grounds. The investments include planting trees, mulching, and application of organic manure and mineral fertilizers. We then use variations in tenure arrangements between 560 plots obtained from a survey of 246 farmers from 6 villages in the Brong Ahafo region of Ghana to analyze the impact of land tenure arrangements on investment in soil-improving and conservation measures. The empirical part of the article also examines the relationship between land tenure arrangements and farm productivity.

The main contributions of the article reside in the fact that the results from the theoretical analysis hold for a wide range of situations and are as such independent of case specific data. The empirical analysis considers a) endogeneity between land rights and investment decisions and b) interdependence between the different investment decisions. Our empirical evidence shows that land tenure differences significantly influence farmers' decisions to invest in land-improving and conservation measures, and that tenure differences do affect farm productivity, even after accounting for household fixed effects.

The conclusions that Abdulai, Owusu and Goetz reach read,

In this article, we developed a framework to examine the relationship between different land tenure arrangements and households' investment in land-improving and conservation measures in the Brong Ahafo region of Ghana. The land tenure arrangements considered include owner-operated with full property rights, owner operated with restricted rights, fixed-rent and sharecropping contracts. We employed variations in tenure arrangements between different plots to estimate plot-level regressions relating tenure arrangement to investment in tree planting, mulch, manure as well as mineral fertilizer application. We also examined the relationship between land tenure arrangements and farm productivity.

The empirical results are consistent with our theoretical findings and show that secured land rights tend to facilitate investment in soil improving and natural resource management practices. In particular, farmers who owned land with secured tenure were more likely to invest in tree planting, mulch, manure, but not in mineral fertilizer. Farmers on fixed-rent and sharecropping contracts were found to be less likely to attract investments in soil-improving measures such as mulch and organic manure, although fixed-rent farmers were more likely to invest in yield increasing inputs such as mineral fertilizers. The positive impact of better land rights on investment remained unchanged when we introduced household fixed effects into the specification. As pointed out by Jacoby and Mansuri (2008), hold-up problems in the sense of lack of full commitment on the part of landlords could be driving the findings for fixed-rent farmers. The positive association of tenancy duration with investment in trees, mulch and organic manure also suggests that making temporary rights longer would go a long way to enhance investments in soil improving measures.

We also examined the impact of tenure arrangements on farm productivity, using an instrumental variable approach. The results showed a positive and significant effect of tenure security on farm productivity, a finding that reinforces the significance of tenure security in encouraging higher investment in soil-improving measures. Access to credit was also found to be positively related to crop productivity, suggesting that financial constraints may be a hindrance to investments in productivity-enhancing measures. The incorporation of household fixed effects did not change the positive and significant impact of secured land rights on farm productivity. The major policy implication of these findings is that, ensuring tenure arrangements that confer permanent or sufficiently long temporary rights to cultivators would enhance investment in both soil improving
and natural resource management practices. In addition, the results provide productivity-based arguments for enhancing farmers' access to capital.

In short institutions matter and getting them right helps development.

Now this could start a fight

There is a paper forthcoming in the American Economic Journal titled "Partisan Grading" by two economists Talia Bar and Asaf Zussman. The abstract reads:

We study grading outcomes associated with professors in an elite university in the United States who were identified - using voter registration records from the county where the university is located - as either Republicans or Democrats. The evidence suggests that student grades are linked to the political orientation of professors: relative to their Democratic colleagues, Republican professors are associated with a less egalitarian distribution of grades and with lower grades awarded to Black students relative to Whites.

One thing I noted taking a very quick look at the papers was:

We were able to match 511 out of 1,169 professors, i.e. about 44 percent of the total. Of these professors, 27 (5.3 percent) are Republicans and 370 (76.3 percent) are Democrats. The rest either registered to vote for smaller parties or were unaffiliated with any party.

Only 5.3% of the professors stated they were Republicans with three quarters of the sample being Democrats. And what do we make of results based on 27 people?

As to the second result noted in the abstract, that Republicans give lower grades to Black students, Bar and Zussman write,

An obvious question that arises regarding the second finding is whether and to what extent Democratic professors “discriminate” in favor of Black students or Republican professors “discriminate” against them. At this stage we only note that in the absence of an appropriate benchmark for comparison, this question cannot be credibly answered;

One thing I would like to know is what effects on this result does the ethnicity of professor have? That is, Do Black Republican/Democratic professors grade in the same way as White Republican/Democratic professors? Another point Bar and Zussman make is that

Our analysis finds practically no association between professor political orientation and the relative grading outcomes of Hispanic and female students.

So, Why only “discrimination” for/against Black students?

Bar and Zussman’s results on the grading question show

The variance of grades is higher in courses taught by Republicans than in courses taught by Democrats. Moreover, in additional analysis we find that relative to their Democratic colleagues, Republican professors tend to assign more very low and very high grades: the share of the lowest grades (F, D-, D, D+, and C-) out of the total is 6.2 percent in courses taught by Republican professors and only 4.0 percent in courses taught by Democratic professors; the share of the highest grade (A+) out the total is 8.0 percent in courses taught by Republican professors and only 3.5 percent in courses taught by Democratic professors. Both differences are highly statistically significant. These suggestive results are consistent with our grading egalitarianism hypothesis.

A different illustration of the relationship between political identification and grading egalitarianism is contained in the chart above. The figure displays mean grades by student SAT score ranges in courses taught by Republican and Democratic professors. The observed pattern is consistent with the hypothesis that Republican professors are associated with a steeper slope of the grade-ability profile, i.e. with higher returns to student ability. (Emphasis added.)

One wonders about selection issues here. As Mark J. Perry says,

One conclusion here might be that highly motivated, high-achieving students should prefer classes from Republican professors because it's more likely they'll be rewarded with a really high grade (A or A+), and less motivated, lower-achieving students should prefer classes from Democratic professors, because it's less likely that they'll receive a really low grade.

The conclusion of the paper states,

We studied grading outcomes associated with professors in an elite university in the United States who were identified - using voter registration records from the county where the university is located - as either Republicans or Democrats. Assuming that Republicans are conservative and Democrats are liberal [liberal in the American meaning, not the correct meaning], the paper tested two main hypotheses which are based on key differences between conservative and liberal political philosophies. The first concerns egalitarianism and the second concerns the treatment of traditionally disadvantaged racial and ethnic minorities. We found that relative to their Democratic colleagues, Republican professors are associated with a less egalitarian distribution of grades and with lower grades awarded to Black students relative to Whites.

Professors control the allocation of grades which serve as the primary currency of academia. Our results suggest that the allocation of grades is associated with the worldview or ideology of professors. This finding may inform the public debate on potential reforms to university grading practices. To the extent that the application of objective standards is an important university goal, policy makers should consider limiting the discretion professors enjoy when it comes to grading and making it more difficult for them to use student characteristics as factors in the grading process.

Such results and conclusions will, no doubt, be controversial and we will see much heat, if little light, generated in the discussion that is sure to follow publication of the paper.

Oh no!

Sadly there is a posting at the Aid Watch blog saying that the blog is no more. William Easterly and Laura Freschi write

The simple reason for ending the blog is that we want to free up our own time for writing longer and more substantive pieces, both academic and non-academic, on development.

The blog is a hungry mouth that always wants to be fed, and the longer projects we’d like to take on don’t fit in with those constraints.

Economists are professionally trained to be wary of diminishing returns to any one activity, and to be entrepreneurial about starting new activities. Although we’ll still write about aid, we plan to move away from aid criticism as our main focus, and put more emphasis on the high-stakes development debates going on now. We still believe that more aid will reach the poor the more people are watching aid, but, as we’ve always known, there’s a lot more to development than aid.

While I can fully understand the time issue, blogs do take a lot of your time, it's sad to see Aid Watch go. It was always a good and useful read.

Good news on free trade agreements

Free trade agreements can be controversial. While they promote trade between the member countries, they may also divert trade away from non-member countries, potentially reducing welfare. A new column by James Anderson and Yoto V. Yotov at VoxEU.org provides evidence that, even when trade diversion is taken into account, the overall effects are still strongly positive.

Back in 1950 Jacob Viner put for ward the idea of trade diversion and since then it has been an issue of concern in the academic literature on free trade agreements (FTAs). Simply there has been a concern about the potential harm to outsiders from trade diversion away them towards the insiders of the trade agreement. But economists are still not clear on the magnitude of trade diversion.

• How large is the harm from trade diversion?
• Does the gain to current FTA partners from trade diversion create a stumbling block to further expansion because that gain would have to be given up?

Recent research sheds new light on these questions.

Anderson and Yotov look at the basic economic logic:

Free trade agreements divert trade from outsiders to insiders because the relative cost of insider business falls. Tariffs between partners disappear while remaining in place for non-partners. More important in the modern setting of already low tariffs are the non-tariff barriers that fall between partners as regulatory barriers are reduced and the greater security of trade relations stimulates potential traders to invest in deals with insider counter-parties.

To understand the effects of trade diversion through non-tariff barrier reductions, an empirical analysis of trade flows before and after implementation of FTAs is required. Enter Anderson and Yotov. Their recent work tackles these questions (Anderson and Yotov 2011) and their findings are reassuring:

• FTAs provide gains to partners, large for the smaller partners, while inflicting very small losses on outsiders.
• Regional trade agreements appear to be building blocks rather than stumbling blocks.
• Direct gains to new partners are big, while indirect effects on outsiders are small.

An upshot of this is that an expansion of FTAs appears in the future is unlikely to be hampered by insiders having to give up important previous gains at the expense of outsiders. The Anderson and Yotov findings of very small terms-of-trade losses to outsiders, less than 0.2%, suggest that such potential stumbling blocks would be too small to notice while the size of the direct benefits to partners that join suggest much larger building blocks.

Anderson and Yotov provide further evidence of this overall effect in a counterfactual analysis by removing Mexico from NAFTA, reverting to the previous Canada-US FTA. In that scenario, all parties lose, while Mexico’s loss is larger by far, wiping out over 80% of its 7.6% terms-of-trade gain from its 1990s FTA implementations.

• Anderson, James E and Yoto V. Yotov (2011), "Terms of Trade and Global Efficiency Effects of Free Trade Agreements, 1990-2002", NBER Working Paper 17003.

Missing posts

The posts missing from last Friday have now turned up, two were posted yesterday while the remain two have been posted today. Who knows what was going on at Blogger last week?! But at least it looks to have been sorted out now.

What scientific concept would improve everybody’s cognitive toolkit?

This is the Edge Question 2011. There are 159 responses in all.

The last two paragraphs from Matt Ridley read:

Human achievement is based on collective intelligence — the nodes in the human neural network are people themselves. By each doing one thing and getting good at it, then sharing and combining the results through exchange, people become capable of doing things they do not even understand. As the economist Leonard Read observed in his essay "I, Pencil' (which I'd like everybody to read), no single person knows how to make even a pencil — the knowledge is distributed in society among many thousands of graphite miners, lumberjacks, designers and factory workers.

That's why, as Friedrich Hayek observed, central planning never worked: the cleverest person is no match for the collective brain at working out how to distribute consumer goods. The idea of bottom-up collective intelligence, which Adam Smith understood and Charles Darwin echoed, and which Hayek expounded in his remarkable essay "The use of knowledge in society", is one idea I wish everybody had in their cognitive toolkit.

The opening two paragraphs from Daniel Kahneman read:

Education is an important determinant of income — one of the most important — but it is less important than most people think. If everyone had the same education, the inequality of income would be reduced by less than 10%. When you focus on education you neglect the myriad other factors that determine income. The differences of income among people who have the same education are huge.

Income is an important determinant of people's satisfaction with their lives, but it is far less important than most people think. If everyone had the same income, the differences among people in life satisfaction would be reduced by less than 5%.

And there are lots of other interesting ideas, go read!

James Otteson interview

James Otteson is Professor of Philosophy and Economics at Yeshiva University and Senior Fellow at the Fund for American Studies in Washington, DC. He is the author of the books Adam Smith, Adam Smith’s Marketplace of Life, and Actual Ethics and the editor of several other works including Adam Smith: Selected Philosophical Writings. Otteson is interviewed by Jack Russell Weinstein discussing "On Liberty and Libertarianism".

See here for an audio of the interview.

Political freedom lies at the core of any democracy. Yet some people claim that even countries like America and England aren’t free enough. What does a free society look like and how much liberty is necessary for the moral life? What is the role of government, how big should it be, and what happens when individual interests clash? Join WHY?’s guest James Otteson as he examines these questions, talks about Adam Smith, the father of free-market theory, and discusses his own account of political morality with its roots in the “classical liberal tradition” (the political tradition that has led to everything from the American Tea Party to libertarians who argue for gun rights and drug legalization).

Are financial markets ‘short-termist’?

A common attack made by critics of financial markets is that suffer from 'short-termism'. They failure to take into account the long-term effects of what they are doing. This claim was made for the U.K. by Andrew Haldane, one of the most-well-regarded managers at the Bank of England in a recent paper. But at the blog of the Institute of Economic Affairs Philip Booth notes a basic error in Haldane's argument.

Haldane came to that conclusion that financial markets and companies were short-termist by assuming that the time preferences of savers were such that the interest rates that savers require on their investments were the same over all time periods. In other words, Haldane assumed that, if a saver wanted a return of 4% per annum over a one-year period, he would want a return of 4% per annum if his saving was for a 20-year period. If this were the case, we would expect the cash flows from investment projects to be discounted at the same rate of interest however far in the future they stretched.

This is a fundamental error. There may be many reasons why savers demand higher rates of return over longer time periods: if they do so, financial markets – and managers acting on behalf of company shareholders – should reflect this by demanding higher returns from longer-term projects. The market is then working well if it reflects the time preferences of savers.

Assuming a constant rate of time preference does seem a bit odd, if nothing else a longer term investment is riskier than a short term one and thus demanding a higher rate of return makes sense.