Thursday 29 November 2012

Just for fun: the theory of privatisation

Having been working on a survey of the theory of the firm I noted that an often neglected topic in the literature is that of state owned firms and their privatisation. Thus I added a short section on the literature on privatisation.

There is a surprising overlap between the theory of the firm and the theory of privatisation. Hart (2003: C69) makes this clear when he writes,
"Let me begin by discussing the very close parallel between the theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms, A and B. A might be a car manufacturer and B might supply car-body parts. Suppose that there is some reason for A and B to have a long-term relationship (e.g., A or B must make a relationship-specific investment). Then there are two principal ways in which this relationship can be conducted. A and B can have an arms-length contract, but remain as independent firms; or A and B can merge and carry out the transaction within a single firm. The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents a firm supplying the government or society with some service. B could be an electricity company (supplying consumers) or a prison (incarcerating criminals). Then again, there are two principal ways in which this relationship can be conducted. A and B can have a contract, with B remaining as a private firm, or the government can buy (nationalise) B".
"[ ... ] the issues of vertical integration and privatisation have much more in common than not. Both are concerned with whether it is better to regulate a relationship via an arms-length contract or via a transfer of ownership". Hart (2003: C70)

The incomplete contracting framework discussed in the previous subsection gives an approach which can be utilised to study the difference between public and private ownership. In fact incomplete contracts are a necessary condition to explain the differences between the two forms of ownership. In a world of complete or comprehensive contracts there is no difference between private and state owned firms. In both cases the government can write a contract with the firm that will anticipate all future contingencies - it will detail the managers' compensation, the pricing policy of the firm, how changes in technology will the change the firm's products etc - and thus the outcome under both forms of ownership will be the same.

This intuition has been formalised into a series of Neutrality Theorems. These theorems establish the conditions under which private or public ownership of productive assets is irrelevant for the final allocation of resources. Consider first the `fundamental privatisation theorem' due to Sappington and Stiglitz (1987). Assume the government's aim is to simultaneously achieve three objectives: (i) economic efficiency; (ii) equity; (iii) rent extraction. What Sappington and Stiglitz show is that the government can design an auction scheme that will result in these three objectives being achieved and where both public and private production give the same outcome. The government has a `social' valuation of the level of output. This valuation embodies the government's concerns with regard to equity issue such as the consumption levels of the good among different classes of citizens. It is assumed that the costs of production are such that production by a single firm is optimal but there are at least two risk-neutral firms, who have symmetric beliefs about the least-cost production technology, willing to bid to be the supplier. The government auctions off right to the supplier of the good with the understanding that the supplier receives a payment which equals the social evaluation. The most efficient firm will win the contract with the highest bid, which will equal the firm's (expected) profits, and will set the production level most preferred by the government. Rent extraction is achieved since the wining bit equals the firm's profits and economic efficiency is achieved since the most efficient firm is selected as the producer and the firm produces the government's preferred (social welfare maximising) level of output.

A simple example of this mechanism is given by Bos (1991: 20). Let the payment received by the firm equal the government's social valuation which equals the sum of consumer surplus plus revenue. (This is the total area under the demand curve for a given quantity.) This induces a profit maximising firm to maximise the sum of consumer and producer surplus. This implies technological and allocative efficiency. Since the highest offer in the competitive auction is identical to the expected profit of the firm, the expected monopoly profit goes to the government.

Shapiro and Willig (1990) obtain a similar result for a setting in which a public-spirited social planner or framer decides on the nationalisation/privaitisation outcome and sets up the governance structure for the enterprise chosen. The framer's decision is driven by the informational differences between private and public ownership. The important pieces of information are: (i) information about external social benefits generated by the firm; (ii) information concerning the difference between the ``public interest" and the private agenda of the regulator; (iii) information about the firm's profit level (cost and demand information).

First consider the case where the firm is state owned. Here the firm is run by a public official that Shapiro and Willig refer to as a Minister. By virtue of his role in managing the enterprise, the minister receives the private information about the profitability of the enterprise. By virtue of his position in the public sector, the minister also observes information that bears on the external social benefits generated by the enterprise's operations. Given this information the minister makes decision as to the level of investment in the firm and the level of output for firm. The overall social welfare function that the framer seeks to maximise is the sum of external benefits plus enterprise profits where there is a magnification factor added to the profit term which equals the unit cost of raising public funds, including any distortions caused by the taxes required to finance public sector operations. The minister's objective function is that of the framer plus a term related to the private agenda of the minister where there is a weighting parameter attached to private agenda term which measures how easily the minister can extract these benefits. This parameter can be interpreted as being a proxy for how well the political system works. The better the system the greater the limits on what the minister can extract.

If the firm is a private company then it is managed by a professional manager and is overseen by a regulator. The manager observes the profitability of the firm while the regulator learns the nature of the externality variable and the private agenda variable. The regulator designs a regulatory scheme that offers the expectation of a competitive rate of return on the private firm's sunk capital. The firm then maximises profit subject to the regulatory scheme while the regulator has the same objective function as the minister under state ownership. The framer's objective is to maximise the sum of the external benefits plus profits net of the cost of rasing any public funds needed to make the transfers to the private company required under the regulatory scheme.

The important difference between the two ownership forms is who receives the information about cost and demand conditions. The manager is the informed party under private ownership while under public ownership the minister is informed. This means that an informational barrier is created between the firm and the government by privatisation. The advantage of this barrier is that it reduces the discretion the minister has to interfere with the working of the firm. The disadvantage is that it makes it more difficult for the regulator to motivate the firm to purse social welfare objectives.

When considering neutrality results first consider the operation of an enterprise in an environment in which there is no private information whatsoever. Suppose all information about the external benefits of the enterprise and all information about its profitability is contractible. In such circumstances, the regulator could put in place a set of taxes or subsidies, contingent on what will become commonly known realisations of the public costs and benefits of the enterprise's operations. These taxes and subsidies could be designed to induce the owners to operate the enterprise to serve precisely the regulator's objectives in every contingency.

Perhaps it is not surprising that one can obtain a neutrality result in the complete absence of noncontractible private information, for in such a case there is no truly active role for the managers of the enterprise. They need only carry out the detailed instructions left by the minister or the regulator, and the manager cannot claim that there will ever be any new information or extenuating circumstances that can justify departures from that mechanical mandate.

The more interesting neutrality results arise in situations where there is private information. First assume that the private information about the firm's profitability is known only after the investment is made but the private information concerning public impacts and private agenda is known to the regulator when he must commit himself to the regulatory mechanism, before the time of the investment decision. Under these conditions, the regulator can exert sufficient indirect control over the private firm to obtain the same outcome and payoff as under public ownership, so the framer is indifferent between public and private enterprise. The regulator's control is secured by paying the firm according a the schedule which takes into account the sum of external benefits generated plus the private agenda of the regulator plus the smallest possible payment that will induce the firm to invest. With this schedule, the regulator induces the same actions and achieves the same payoffs as does the minister under public enterprise. The mechanism operates by forcing the firm to internalise the objectives of the regulator.

The second distinct case occurs when private information concerning both costs and public impacts is revealed only after the investment commitment must be made. Only the prior probability distributions of the private information of the regulator and the profitability of the firm are known at the time the investment decision must be effected. After the investment has been made, but before the activity level must be chosen, the private information of the regulator will become know to him and the nature of the firm's profitability will be revealed to the manager of the enterprise. Again, the regulator's optimal payment scheme results in the same choices of activity levels and the same expected drain on the treasury that would be the result of public enterprise. The logic behind this result is a straightforward extension of the analysis of the first case. Here the regulator commits himself to the menu of payment schedules, with the understanding that he will choose a particular schedule from this menu after investment is made and his private information is revealed to him, but still before the activity level must be chosen by the firm. The firm is indifferent, ex ante, about which particular schedule will be chosen from the menu by the regulator, because each of them offers the same zero level of expected profits, that is just enough to induce the firm to make the investment. Once the regulator learns his private information, he will be motivated to select the payment schedule corresponding to that information because that schedule is optimal for his objective function. Given this payment schedule, the firm will be motivated to choose the same activity level as in the first case above, and here too that is the optimum from the perspective of either the regulator or the public minister.

In the third case of neutrality the private firm has private information about its costs before the investment decision must be made. It is assumed that there are no costs to raising public funds and thus any transfers from the treasury are not a matter for concern to the framer, the regulator or the public minister. Because the firm knows information about its profitability and the regulator is aware of that fact but does not know this information himself, the regulator, to assure that investment will be made, must commit to a payment schedule or to a menu of schedules that provides non-negative profit for all demand/cost cases. Here, because of the stipulation that public funds can be raised at zero cost, this requirement poses no problem for the regulator: he is perfectly willing to add enough funds to any payment schedule to assure its profitability in the light of his indifference to transfers from the treasury. Consequently, it is optimal for the regulator to offer the firm internalisation schedules, each with different levels of investment funds, such that these funds are sufficiently large to guarantee the firm non-negative profit even if its profitability level is the worst possible. In the end, the regulated firm chooses the same activity levels that the public enterprise would choose, but the drain on the treasury caused by regulation is greater than that caused by public enterprise. Since, in this case, however, that drain is not a matter of concern, the framer would find no difference between the performance of public and private forms of organisation.

The third neutrality result is that of Shleifer and Vishny (1994). Their starting point is the idea that politicians control SOEs in order to achieve political objectives, such as excess employment and/or high wages. In this model the politician derives benefits from this inefficient allocation of resources, as they create political support for him. If the firm is privatised then the politician must bargain with the manger of the firm to get the outcome he wants. Clearly the manager, who aims to maximise profits, and the politician, who wants political support, have conflicting objectives. The firm will not want to expand employment above the profit maximising level as the politician wishes to do. The politician must make a transfer, from the treasury, to the firm to induce the takeing on of the extra workers. This is a problem to the politician since the transfer is costly to him as taxes need to be raised to finance the subsidy.

The Shleifer and Vishny model allows for a complete separation of income rights and control rights. There is no clear-cut dichotomy between state-owned and private firms in the model as it allows for four corparate forms: (i) a SOE, the Treasury has income rights and the politician has control rights; (ii) a regulated firm, the private owners have income rights, but the politician has control rights and can interfere in the operating activity of the firm; (iii) a 'corporatised' firm, when the government has income rights, but the control rights are in the hand of the firm's management; (iv) a purely private firm, when the manager/owner has both income and control rights.

As the model has the two parties bargaining, disagreement points have to be identified. These point are were the politician and the manager control the firm. When the politician controls the firm he has control over the manager and is able to the firm down to zero profits. He can use the firm's cash flow to hire extra labour up to the point where the marginal benefits of the excess employment equals the marginal cost of raising public funds. Under control by the manager, the manager has power over the politician, and the firm produces at the efficient level (with zero excess labour) but does not receive any transfer from the Treasury.

As far as the manager and the politician are concerned, the efficient point is reached when the level of excess employment reaches the point where the marginal political benefits equals the wage, which is the marginal cost of labour. At this point the amount of excess labour employed is lower than that under politician control and the subsidy paid to the firm is higher than under private control.

The neutrality result that Shleifer and Vishny present is basically an application of the Coase Theorem to privatisation. As side payments are allowed - or more correctly in this case, when the manager and politician can freely bribe each other - then the manager and the politician will reach the jointly efficient solution no matter what the initial allocation of income and control rights.

The importance of the above theorems is that they outline the conditions under which ownership of the firm does not matter. Of all the assumptions on which the irrelevance results hinge the most important requirement is that complete contingent long-term contracts can be written and enforced. But writing complete contracts is only possible in a world of zero transaction costs. In a positive transaction costs world only incomplete contracts can be written but contractual incompleteness creates a role for ownership - making decisions under conditions not covered in the contract. It is only within such an environment that we can explain why privatisation matters, that is, why the behaviour of state owned and private companies differ. This reliance on incomplete contracts means that the theory of privatisation can be seen as forming a part of the incomplete contracts framework explained in the subsection directly above.

These results also shows why the previous theoretical privatisation literature was largely unsuccessful. That literature took a `complete' or `comprehensive' contracting perspective, in which any imperfections present in contracts arose solely because of moral hazard or asymmetric information. But as Hart (2003: C70) notes
"[ ... ] if the only imperfections in are those arising from moral hazard or asymmetric information, organisational form - including ownership and firm boundaries - does not matter: an owner has no special power or rights since everything is specified in an initial contract (at least among the things that can ever be specified). In contrast, ownership does matter when contracts are incomplete: the owner of an asset or firm can then make all decisions concerning the asset or firm that are not included in an initial contract (the owner has 'residual control rights').

Applying this insight to the privatisation context yields the conclusion that in a complete contracting world the government does not need to own a firm to control its behaviour: any goals - economic or otherwise - can be achieved via a detailed initial contract. However, if contracts are incomplete, as they are in practice, there is a case for the government to own an electricity company or prison since ownership gives the government special powers in the form of residual control rights".

Thus privatisation matters only in an incomplete contracts world. In such an environment the allocation of residual control rights will differ and so the behaviour of publicly owned firms will differ from that of privately owned firms and thus ownership and therefore privatisation will become meaningful.

Schmidt (1996a) considers a monopolistic firm that producers a public good in a world of incomplete contracts. (Schmidt (1996a) is variant of Schmidt (1996b). 1996b considers the case of privatisation to an employee manager while 1996a applies to the case of privatisation to an owner-manager. While this second case is less realistic it is simpler and does not require the assumption that the manager is an empire builder that is utilised in 1996b.) His model is multiple period with the privatisation decision being made in the initial period. That is, the government must decide whether to sell the SOE to a private owner-manager or keep it in state hands and hire a professional manager to run it. Importantly knowledge concerning the firm's cost is private information known only by the firm's owner. Given this, privatisation amounts to a transfer of private information from the government to the private owner. In the next period the manager selects his effort level and the state of the world is then revealed. The importance of the manager's effort level is that it affects the probability of the state of the world. A high level of effort from the manager results in productive efficiency being enhanced and costs being lowered for any level of output. In the last period, the government selects the transfer scheme and payoffs are revealed.

When the firm is an SOE the government observes the firm's realised cost function and thus can implement the first-best allocation by choosing the ex post efficient level of production. But the manager's wage will be fixed, since contingent contracts can not be written, and thus independent of level of output. Given this the manager has no incentive to exert effort and the government knowing this will therefore offer him only his reservation wage.

On the other hand when the firm is in private hands the government does no know the exact cost structure of the firm. In an effort to get the private owner to produce the efficient level of output the government must provide an incentive via the payment of an informational rent.But if transfer are costly it will be impossible to implement the optimal allocation and therefore the cost to private ownership is an inefficiently low level of production. However given the rent payment provides an incentive to increase effort, productive efficiency is greater.

Schmidt's main conclusion is therefore that when the monopolistic firm produces a good or service which provides a social benefit, there is a trade-off between allocative and productive efficiency that needs to be considered when deciding if a firm is to be privatised. The equilibrium production level is socially suboptimal but the incentive for better management results in cost savings. Considered overall the welfare effect of privatisation should be positive for cases where the social benefits are small, but social welfare will be greater under public ownership for those cases where production exhibits large social benefits.

An important implication of this is that a case can be made for privatisation even when the government is a fully benevolent dictator who wishes to maximise social welfare. Even if all the deficiencies of the political system could be remedied it is still possible for privatisation to be superior to state ownership.

In the Laffont and Tirole (1991) model a firm is assumed to be producing a public good with a technology that requires investment by the firm's manager. In the case of a public firm this investment can be diverted by the government to serve social ends. For example, the return on investment in a network could be reduced by the government if it were to allow ex post access to the general population. Such an action may be socially optimal but would expropriate part of the firm's investment. A rational expectation of such an expropriation would reduce the incentives of a public firm's manager to make the required investment. For a private firm, the manager's incentives to invest are better given that both the firm's owners and the manager are interested in profit maximisation. The cost of private ownership is that the firm must deal with two masters who have conflicting objectives: shareholders wish to maximise profits while the government purses economic efficiency. Both groups have incomplete knowledge about the firm's cost structure and have to offer incentive schemes to induce the manager to act in accordance with their interests. Obviously the game here is a multi-principal game which dilutes the incentives and yields low-powered managerial incentive schemes and low managerial rents. Each principal fails internalise the effects of contracting on the other principal and provides socially too few incentives to the firm's management. The added incentive for the managers of a private firm to invest is countered by the low powered managerial incentive schemes that the private firm's managers face. The net effect of these two insights is ambiguous with regard to the relative cost efficiency of the public and private firms. Laffont and Tirole can not identify conditions under which privatisation is better than state ownership.

In the Shapiro and Willig paper discussed above privatisation is considered in a context where the regulator pursues a different agenda from the framer. Assume that either information about profitability is known before investment is decided upon or that there are costs to rasing public funds. In these cases the neutrality results of Shapiro and Willig don't hold. The equilibrium behaviour of the minister who is in charge of the firm is virtually unconstrained and he will set the activity levels of the firm as to maximise his utility. The regulator of the private firm has a more complex problem to deal with. This involves the designing of regulatory scheme which ensures non-negative profits for the firm. Given this is a case of optimal regulation under asymmetric information we would expect to see the firm enjoying informational rent, which are proportional to the activity chosen. As public funds are costly to raise these transfers are costly to the state.

The trade-off in this model is driven by how easily the public official can interfere with the operations of the firm. If the public official's objectives are the same of the (welfare maximising) framer, i.e. the public official has not private agenda, then public ownership is optimal. In this case private ownership reduces performance since the firm extracts a positive information rent. But when there is a private agenda then a reduction in discretion may increase welfare. Politicians find it easier to distort the operations of a firm in their favour when that firm is an SOE and under the direct control of the minister. The regulated private firms does earn a positive rent but is less subject to the control of the regulator. This means that regulated private firms are likely to out perform SOEs in poorly functioning political systems,which are open to abuse by the minister, and where the private information about the profitability of the firm is less significant. This makes it easier for the regulator to get the firm to maximise social welfare.

In Boycko, Shleifer and Vishny (1996) information problems do not explain the difference between public and private firms. Here it is differences in the costs to a politician of interfering in the activities of the different types of firms that explains the effects of privatisation. The starting point of the paper is the observation that public firms are inefficient because they address objectives of politicians rather than maximise efficiency. One common objective for a politician is employment. Maintaining employment helps the politician maintain his power base. In their model Boycko, Shleifer and Vishny assume a spending politician, who controls a public firm, forces it to spend too much on employment. The politician does not fully internalise the cost of the profits foregone by the Treasury and by the private shareholders that the firm might have.

Boycko, Shleifer and Vishny argue privatisation can be a strategy to reduce this inefficiency in state-owned enterprises. By privatisation they mean the reallocation of control rights over employment from politicians to a firm's managers and the reallocation of income rights to the firm's managers and private owners. The spending politician will still want to maintain employment and can use government subsidies to `buy' excess employment at the private firm. In this model the advantage of privatisation is that it increases the political costs to maintaining excess employment. It is less costly for the politician to spend the profits of the state-owned firm on labour without remitting them to the Treasury than it is to generate new subsidies for a privatised firm. Given that voters will be unaware of the potential profits that a state firm is wasting on hiring excess labour they are less likely to object than they are to the use of taxes, which they know they are paying, to subsidise a private firm not to restructure. This difference between the political costs of foregone profits of state firms and of subsidies to private firms is the channel through which privatisation works in this paper.

Shleifer and Vishny (1994) is a continuation of research stated in Boycko, Shleifer and Vishny (1996). As with the 1996 paper Shleifer and Vishny assume that there is a relationship between politicians and firm mangers that is governed by incomplete contracts and thus ownership becomes critical in determining resource allocation. As noted above the Shleifer and Vishny model is a game between the public, the politicians and the firm managers. The model derives the implications of bargaining between politicians and managers over what the firms will do. A particular focus is on the role of transfers between the private and state sectors including subsidies to firms and bribes to politicians.

To consider the determinants of privatisation and nationalisation Shleifer and Vishny utilise what they term a "decency constraint" which says that the government cannot openly subsidise a profitable firm. To do so would be seen as politicians enriching their friends. The first, obvious, point made is that politicians are always better off when they have control rights. Control brings political benefits, via excess employment, and bribes, to allow a reduction in the excess employment. Both the Treasury and the politicians prefer nationalisation. (Remember that as a SOE the Treasury has income rights and the politician has control rights.) to subsidising a money-losing private firm. Control brings bribes and even without bribes politicians get a higher level of employment and lower subsidies when they have control. The Treasury likes the smaller subsidies that come with nationalisation. When it comes to profitable firms politicians like control or Treasury ownership because these firms have a strong incentive to restructure since the profits go to the private owners and they lose little in terms of subsides due to the decency constraint. To ensure the firms achieve political objectives politicians need control. Given the decency constraint politicians don't want managers who have control rights to also have large income rights since the decency constraint means smaller subsidies are lost if employment is cut and income rights mean the managers gain from restructuring and maximising profits. Politicians who have control prefer higher private and lower Treasury ownership since higher private ownership implies higher bribes. Without bribes the private surplus is extracted via higher levels of employment.

Given that politicians like control, Why would they ever privatise a firm? To explain privatisation the interests of taxpayers must become more prominent. Given this the decision to privatise then becomes the outcome of competition between politicians who benefit from government spending (and bribes) and politicians who benefit from low taxes and support from taxpayers. We would expect privatisation to take place when political benefits of public control are low, and the desire of the Treasury to limit subsidies is high. This is most likely to occur when the political costs of rasining taxes to pay subsides is high and when the political benefits from excess employment are low.

The final paper to be considered is Hart, Shleifer and Vishny (1997). Again in this paper information problems are not the driving force of the analysis of contracting out. The provider of a service, either public or private, can invest his time in improving the quality of the service or reducing the cost of the service. The important assumption is that investments in cost reduction have negative effects on quality. Investments are non-contractible ex ante. For the case where the provider is a government employee he must obtain approval from the government to implement any innovation he has created. Given that the government has residual rights the employee will gain only a fraction of return on his investment. This gives him weak incentives to innovate. If the service provider in an independent contractor, i.e. the service has been contracted out, then he will have stronger incentives to both cut costs and improve quality. This is because he keeps the returns to his investment. The downside to private provision is that the incentives to cut costs are strong and the provider does not fully internalise the negative effects on quality of the reductions in cost. With public provision the incentive for excessive cost cutting are reduced as are the incentive for innovation and quality improvements. Costs are always lower under private ownership but quality may be higher or lower under a private owner. Hart, Shleifer and Vishny argue that the case for public provision is generally stronger when (i) non-contractible cost reductions have large deleterious effects on quality; (ii) quality innovations are unimportant; (iii) corruption in government procurement is a severe problem. On the other hand their argument suggests that the case for privatisation is stronger when (i) quality-reducing cost reductions can be controlled through contract or competition; (ii) quality innovations are important; (iii) patronage and powerful unions are a severe problem inside the government.

  • Bos, Dieter (1991). Privatization: A Theoretical Treatment, Oxford: Oxford University Press.
  • Boycko, Maxim, Andrei Shleifer and Robert W. Vishny (1996). `A Theory of Privatisation', The Economic Journal, 106 no. 435 March: 309-19.
  • Hart, Oliver D. (2003). `Incomplete Contracts and Public Ownership: Remarks, and an Application to Public-Private Partnerships', The Economic Journal, 113 No. 486 Conference Papers March: C69-C76.
  • Hart, Oliver D., Andrei Shleifer and Robert W. Vishny (1997). `The Proper Scope of Government: Theory and an Application to Prisons', Quarterly Journal of Economics, 112(4) November: 1127-61.
  • Laffont, Jean-Jacques and Jean Tirole (1991). `Privatization and Incentives', Journal of Law, Economics, & Organization, 7 (Special Issue) [Papers from the Conference on the New Science of Organization, January 1991]: 84-105.
  • Sappington David E. and Joseph E. Stiglitz (1987).`Privatization, Information and Incentives', Journal of Policy Analysis & Management, 6(4) Summer: 567-85.
  • Schmidt, Klaus (1996a). `Incomplete Contracts and Privatization', European Economic Review, 40(3-5): 569-79.
  • Schmidt, Klaus (1996b). `The Costs and Benefits of Privatization: An Incomplete Contracts Approach', The Journal of Law, Economics & Organization, 12(1): 1-24.
  • Shapiro, Carl and Robert D. Willig (1990). `Economic Rationales for Privatization in Industrial and Developing Countries'. In Ezra N. Suleiman and John Waterbury, (eds.), The Political Economy of Public-Sector Reform and Privatization, Boulder: Westview Press.
  • Shleifer, Andrei and Robert W. Vishny (1994). `Politicians and Firms', Quarterly Journal of Economics, 109(4) November: 995-1025.

Wednesday 28 November 2012

What if. Tonight

What If alcohol was not as socially costly as everyone says?

Presented by Dr Eric Crampton, Wednesday, 28 November, from 7.30pm to 9.00pm, Lecture theatre A1.

Was The Hobbit worth it?

A question asked at the Homepaddock blog and we are offered this picture claiming it was,

Let us assume the numbers themselves are totally correct (a big assumption). The question we should ask ourselves is, If these are the benefits what are the costs? We need to trade-off benefits against costs to make a judgement about the usefulness of The Hobbit. After all we are often told of the great benefits of many things that governments back, like sports stadiums, and such claims turnout to be false, so why should we think otherwise about a movie?

Thus, what are the costs of the subsidies to the movie? And most importantly what are the opportunity costs of these subsidies. The money that went to the movie could have been used for something else which also would have produced benefits that we could make a graphic of.

So we need a full cost-benefit analysis before we can say the movie was worthwhile.

Adam Darwin

This video is of a talk by Matt Ridley, given at the Adam Smith Institute, entitled Adam Darwin - Spontaneous order in biology and economics..

Tuesday 27 November 2012

Global climate talks

Dr. Richard S J Tol, Research Professor, Economic and Social Research Institute; and Professor of the Economics of Climate Change, Vrije Universiteit Amsterdam, writes that the 18th UN Conference on climate change negotiations has just started in Doha and he argues that the probability of success is a mere 2.3%. Recently, over $100 million per year was spent on fruitless negotiations. Tol suggests that having flogged, ever harder for 18 years, the dead horse of legally binding emission targets, the UN should close that chapter and try something new.

Tol writes,
The previous 17 conferences have failed to reduce emissions. There were glimmers of hope in 1997 and 2001 when the Kyoto Protocol was, respectively, initiated and finalised. This international treaty, however, bound Europe and Japan to do nothing much and most other countries to do nothing at all. The US and Canada would have had substantial obligations under the Kyoto Protocol, but the US decided not to ratify the treaty and Canada withdrew after ratification.
Tol then argues that if we assume that the first Conference of the Parties in Berlin in 1995 had a 50-50 chance of succeeding and if we also assume that the successive negotiations were independent tries, we can estimate the probability of success in Doha. The outcome of the series of negotiations follows a binomial distribution. Initialising with a Jeffrey uninformative natural conjugate Beta prior, then there is a 2.3% change of success in Doha, and we are 95% confident that the success probability is smaller than 22%.

Tol also says,
The international climate negotiations are expensive, though. Almost 1,000 delegates attended in 1995 [...]. This rose to almost 11,000 in 2005 and to 24,000 in 2009. The numbers have fallen somewhat since then, with only 16,000 delegates in Durban in 2011. 17,000 delegates are expected in Doha. Almost 7,000 person-working-years have been spent on the conferences alone.

But the UNFCCC organises more than one meeting per year. In 2012, 107 meetings were held, down from 111 meetings in 2011. Meetings were (much) rarer in the earlier years. I reckon that the UNFCCC has organised 682 meetings since 1995. Some of these were small. Negotiation meetings, now held once every quarter, attract thousands of participants. Assuming an average attendance of 200 delegates (one per country) and a duration of one week (including travel), 3,000 person-working-years have been spent at subsidiary meetings. Travel and subsistence for these meetings (say $2,000/person for a subsidiary meeting and $3,000/person for a conference) would amount to over $700 million. If delegates earn $30,000/year on average, the total costs of the UNFCCC meetings alone (ignoring preparation and overhead) would be $1 billion.

[ ... ] Recently, over $100 million per year was spent in fruitless negotiations. This is not a large sum of money, but [the data] suggests that ever more effort has been put into an increasingly obviously hopeless venture. This seems foolhardy.
This does seem a hell of a lot of money to have spent for nothing.

Poor old WalMart

I have come across a survey article on the efforts of WalMart on local economies. The abstract reads:
This article reviews the literature that evaluates WalMart’s impacts on local economies. The authors first describe the methods used to account for potential reverse causality of WalMart’s store location decisions, and then they discuss the literature assessing the company’s effect on three aspects of community life: (a) retail (and nonretail) businesses, across large- and small-sized stores and in different business environments; (b) retail workers, wages, and types of jobs; and (c) producer and consumer welfare through the company’s price-decreasing effect and other potential indirect effects. Last, articles focusing on a broad spectrum of local conditions that could be affected by the company, including poverty rates, social capital, food insecurity, policy effectiveness, and obesity are reviewed. For each dimension, evidence is found of both positive and negative effects, suggesting that we are still far from truly understanding the net effect of WalMart on local economies, let alone the overall consequences in the long run. (Emphasis added)
The bit in bold is what gets me. Are they seriously trying to hold WalMart responsible for poverty rates, social capital (what ever that means), food insecurity, policy effectiveness, and obesity?!!!

Bloody hell, poor old WalMart just can't win, they manage to get blamed for everything!

Interesting blog bits

  1. Eric Crampton on Do Costs Matter (Revisited)
    Crikey's Bernard Keane has been questioning the taxpayer-subsidised anti-alcohol campaign in Oz. And, usefully, he's drawn a response from Sandra Jones. Let's have a bit of a look.
  2. Mattia Nardotto, Tommaso Valletti and Frank Verboven, on Unbundling the incumbent: Evidence from UK broadband
    In many countries, incumbent broadband providers are required to let new entrants access their network, what is called ‘local loop unbundling’ (LLU). This column uses data from the UK to ask whether such a policy stimulates broadband penetration. In contrast to what is commonly believed, local loop unbundling doesn’t provide more choice. However, it does raise both the quality of service and the speed of internet connections.
  3. Gary Becker on Online Courses and the Future of Higher Education
    What is new about the MOOCs (which stands for “massive open online courses”) is not the use of the Internet to instruct in particular subjects, but that they are free, and they often are sponsored by some of the very best universities, such as MIT, Harvard, and Stanford. Since they cost little if anything to take, it is much easier for the MOOCs to get massive enrollments than the fee-charging courses offered during the earlier boom in online courses. Various recent articles on MOOCs in the New York Times by Tamar Lewin show that the massiveness of the enrollments is somewhat misleading since, as one would expect with free courses, the great majority of those initially enrolled fail to finish. Still, the number of persons who do finish these courses is very large compared even to what are considered very big enrollments in on-site courses.
  4. Eric Posner on MOOCs—Implications for Higher Education
    Not that online education is new; there are adult-education online courses such as are sold by The Teaching Company; there are even online college degree programs, offered mainly by for-profit colleges. What is new is the scale and potential of free online education offered by, or in conjunction with, the nation’s leading universities.
  5. Greg Mankiw on Slugging It Out, Inside Obama’s Mind
    Throughout Washington, policy makers are debating how to avoid hitting a wall on Jan. 1, when large and abrupt tax increases and spending cuts will take effect automatically unless Congress acts. The debate is perhaps no more fervent than it is inside the head of our newly re-elected president, who must now decide what kind of policy leader he will become, both in this confrontation and throughout his second term.
  6. Nicolai Foss asks A Naturalistic Foundation for the Hierarchy?
    In economics, the hierarchical firm arises for reasons related to economizing with transaction costs, managerial attention allocation, information synthesis and what not. Many organizational economists would argue that absent transaction costs, there would be no hierarchies as there would be no firms. But, what if the existence of hierarchy has a partly genetic basis, that is, humans evolved in such a way that they have come to “like” hierarchies (which may therefore exist even if transaction costs were zero)? After all, those small hunting bands roaming the African savannahs 30, 000 years ago likely had leaders, a division of labor and so on, and evolutionary anthropology suggests that our brains evolved to handle the intricacies of handling this division of labor. Thus, we may be “hardwired for hierarchy.”
  7. Diego Comin, Mikhail Dmitriev and Esteban Rossi-Hansberg on Heavy technology: The process of technological diffusion over time and space
    Geographical distance is a fundamental impediment to virtually all economic transactions. This column, using data on technology adoption in 161 countries over 140 years, argues that it also inhibits the spatial diffusion of technology. Moreover, it shows that technology spreads like an epidemic. As more people adopt a technology, the importance of distance to the technological leader diminishes until it eventually becomes irrelevant.
  8. John Cochrane on Taxes and cliffs
    The whole tax debate is supremely frustrating to anyone who survived econ 1.
  9. Mark Hubbard on The Dairy Cliff in America: An Alice in Wonderland of the Planned.
    A journalist from the land of fiat money and central banking sat down this week and, no doubt with a straight face, wrote the following about the American ‘dairy cliff’:

EconTalk this week

Marcia Angell of Harvard Medical School and the author of The Truth About the Drug Companies talks with EconTalk host Russ Roberts about the impact of pharmaceutical companies on academic research, clinical trials and the political process. Angell argues that the large pharmaceutical companies produce little or no innovation and use their political power to exploit consumers and taxpayers.

Sunday 25 November 2012

Incentives matter: recycling file

The Conversable Economist, Timothy Taylor, writes
If we want people to be serious about recycling, having a policy of 5-10 cents for returning cans and bottles is likely to be a more effective tools than curbside recycling.

Arnold Kling is blogging again

This is news worth knowing. Go here to see Arnold's new blog.

Friday 23 November 2012

"What if?" lecture (Wednesday 28 November, 7.30 – 9.00pm)

Next week's University of Canterbury "What If?" lecture will be given by Dr Eric Crampton on the topic:
What if alcohol was not as socially costly as everyone says?
In his review of New Zealand's alcohol legislation, Law Commissioner Rt. Hon. Sir Geoffrey Palmer pointed to the large gap between alcohol's social costs, estimated at $5.3 billion, and the excise tax take of $795 million as justifying much tighter controls. But what if the cost figure were wildly wrong? Should we really consider, for example, $700 million of drinkers' own expenditures on alcohol as a social cost? Dr. Crampton will discuss his work comparing social costs, as measured in the public health literature, with more standard economic notions of cost. For economic numbers to meaningfully inform policy, they must be produced using standard economic methods that allow comparison of costs across different policy areas. Dr. Crampton will then discuss the influence of bad statistics around alcohol on the Law Commission's review and on legislation before noting some of the other, less publicized, findings around alcohol and moderate drinking. While the harms from hazardous drinking are very real, exaggerating alcohol's harmful effects while ignoring moderate drinkers' enjoyment makes for poor policy.
Date:            Wednesday 28 November

Time:            7.30 – 9.00pm

Innovative govenrment?

When writing, at the Groping towards Bethlehem blog, about how to make government more innovative Bill Kaye-Blake says that private business has a pretty clear goal - make money - and this forces them to be innovative. But he says,
Government, on the other hand, doesn’t necessarily have clear goals. It’s a bit about keeping people happy, keeping things ticking over, improving the living standards of some people while not harming others too much, responding to pressures from all sides. The goals are fuzzy and changing. The bureaucracy compensates by creating clear processes. When things go wrong, bureaucracies often defend their actions by saying, ‘we followed the correct procedures.’

The push for innovation puts government in a new quadrant. Now, bureaucrats are asked to challenge their own processes, to think continuously about how they can do better. The goals are still fuzzy — that’s the nature of governing — but now the process is, too. This quadrant creates a quandary: how are they to know what ‘better’ is?
We may be able to get a handle on how to make government more innovative by asking what could seem an odd question in this context: Which goods or services the government should provide? This question has addressed in a paper by Oliver D. Hart, Andrei Shleifer and Robert W. Vishny, 'The Proper Scope of Government: Theory and an Application to Prisons'. "Quarterly Journal of Economics", 112(4) November 1997: 1127-61.

Why the scope of government question may help us with the innovative question is the answer that HSV come up with when they examined the conditions which determine the relative efficiency of in-house provision versus outside contracting of government services. Their arguments suggest that the case for in-house provision is generally stronger when noncontractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem. In contrast, the case for privatisation is stronger when quality reducing cost reductions can be controlled through contract or competition, when quality innovations are important, and when patronage and powerful unions are a severe problem inside the government.

The bits in bold can help us think about the question of how to make government more innovative, let the private sector do it!

The incentives faced by the public sector just aren't those you want if you want innovation. The private sector lives or dies by how well they innovate. How well they improve the goods and services they provide to customers. How well they can reduce costs while improving quality. It is the high-powered incentives of the market, a bottom line that matters, that drives innovation. Governments use softer incentives because they have different aims, they have goals which are "fuzzy and changing", for which lower-powered incentives are appropriate. But this does mean that government, because of its very nature, is unlikely to be hugely innovative.

Thursday 22 November 2012

Does economics need saving from economists?

In a piece in December 2012 issue of The Magazine Coase writes about Saving Economics from the Economists. He opens his article by noting,
Economics as currently presented in textbooks and taught in the classroom does not have much to do with business management, and still less with entrepreneurship.
He continues,
The degree to which economics is isolated from the ordinary business of life is extraordinary and unfortunate.
He goes on to write,
That was not the case in the past. When modern economics was born, Adam Smith envisioned it as a study of the “nature and causes of the wealth of nations.” His seminal work, The Wealth of Nations, was widely read by businessmen, even though Smith disparaged them quite bluntly for their greed, shortsightedness, and other defects. The book also stirred up and guided debates among politicians on trade and other economic policies. The academic community in those days was small, and economists had to appeal to a broad audience. Even at the turn of the 20th century, Alfred Marshall managed to keep economics as “both a study of wealth and a branch of the study of man.” Economics remained relevant to industrialists.

In the 20th century, economics consolidated as a profession; economists could afford to write exclusively for one another. At the same time, the field experienced a paradigm shift, gradually identifying itself as a theoretical approach of economization and giving up the real-world economy as its subject matter. Today, production is marginalized in economics, and the paradigmatic question is a rather static one of resource allocation. The tools used by economists to analyze business firms are too abstract and speculative to offer any guidance to entrepreneurs and managers in their constant struggle to bring novel products to consumers at low cost.
My own experience as someone with an interest in the theory of firm certainly is one where "production is marginalized in economics". In New Zealand the production side of the economy receives much less emphasis than the demand/consumer/government parts of the economy. Coase sees the lack of interaction between the working economy and economics as damaging to both.
Since economics offers little in the way of practical insight, managers and entrepreneurs depend on their own business acumen, personal judgment, and rules of thumb in making decisions. In times of crisis, when business leaders lose their self-confidence, they often look to political power to fill the void. Government is increasingly seen as the ultimate solution to tough economic problems, from innovation to employment.

Economics thus becomes a convenient instrument the state uses to manage the economy, rather than a tool the public turns to for enlightenment about how the economy operates. But because it is no longer firmly grounded in systematic empirical investigation of the working of the economy, it is hardly up to the task. During most of human history, households and tribes largely lived on their own subsistence economy; their connections to one another and the outside world were tenuous and intermittent. This changed completely with the rise of the commercial society. Today, a modern market economy with its ever-finer division of labor depends on a constantly expanding network of trade. It requires an intricate web of social institutions to coordinate the working of markets and firms across various boundaries. At a time when the modern economy is becoming increasingly institutions-intensive, the reduction of economics to price theory is troubling enough. It is suicidal for the field to slide into a hard science of choice, ignoring the influences of society, history, culture, and politics on the working of the economy.
As I have said before,
I see it as a social science with close relationship with moral and political philosophy, political science, psychology etc. But this it seems is a minority view.
and I would argue that to include the "the influences of society, history, culture, and politics on the working of the economy" economics need to expand its interaction with the other social sciences and not just see itself as purely a handmaiden to management and accounting, as others I know seem to think.

Peter Klein argues that the inductive method being utilised by Coase has its limits,
Economics provides general principles, or laws, about human action and interaction, mostly stated as “if-then” propositions. Applying the principles to concrete, historical cases requires Verstehen, and is the task of economic historians (as analysts) and entrepreneurs (as actors), not economic theorists. Deductive theory does not replace judgment. Without deductive theory, however, we’d have no principles to apply, and nothing to contribute to our understanding of the economy except — to quote Coase’s own critique of the Old Institutionalists — “a mass of descriptive material waiting for a theory, or a fire.” To be sure, Coase’s own inductive method has led to several brilliant insights. Coase himself has a knack for intuiting general principles from concrete cases (e.g., theorizing about transaction costs from observing automobile plants, or about property rights from studying the history of spectrum allocation), though not perfectly. But, as I noted before, Coase himself is probably the exception that proves the rule — namely that induction is a mess.
Coase turns 102 in December and yet he can still generate and stimulate debate about big issues in economics.

Economics is fun!

Beeronomics 2013 - The Economics of Beer and Brewing


18th to 21st September 2013
York, United Kingdom

Contact person: Dr Ignazio Cabras

Beeronomics 2013 aims to be an ideal forum for high-quality economic research related to beer and brewing activities. The conference will cover topics such as economics, law and policy, marketing and consumption, industrial organisation, innovation.

Organized by: The York Management School, University of York
Deadline for abstracts/proposals: 8th March 2013

Check the event website for more details.
This is one area where doing empirical work has a lot going for it!

Is corruption bad for growth?

The obvious answer is yes, but is that right. As Peter Boettke argues it may not be
Chris Blattman argues that many development experts overstate the case against corruption. He argues that: "Most of us fail to imagine that corruption can also grease the wheels of prosperity. Yet in places where bureaucracies and organizations are inefficient (meaning entrepreneurs and big firms struggle to transport or export or comply with regulation), corruption could improve efficiency and growth. Bribes can act like a piece rate or price discrimination, and give faster or better service to the firms with highest opportunity cost of waiting." This is an important argument to consider.
In a 1994 paper Shleifer and Vishny show that when side payments between a politician and the manager of a firm are allowed, or more bluntly, when the manager and the politician can freely bribe each other, then the manager and the politician will reach the jointly efficient solution independently of the initial allocation of ownership and control rights. Such analysis is a straightforward application of the Coase theorem to privatization and does suggest that.corruption does have its uses.

Wednesday 21 November 2012

First it was price gouging now its rent gouging

New Zealand First shows off its level of economic understanding by saying:
More Evidence Of Rent Gouging In Christchurch

New Zealand First says more evidence of rent gouging has emerged with a Christchurch family with nine young children landed with a rent increase of $100 a week to take their weekly rental from $460 to $560.

Christchurch Earthquake Issues spokesperson Denis O'Rourke says this vindicates repeated calls from New Zealand First for a short term rent freeze in the city.

“This is irrefutable evidence that rent gouging is continuing as a result of the housing shortage in Christchurch in the aftermath of the earthquakes.
No "rent gouging" is part of the solution to the housing shortage in Christchurch. Does Denis O'Rourke not realise that supply curves slope upwards. Yes as price (rent in this case) increases so does quantity supplied. If you want people to build more houses in Christchurch, or to supply more of the existing houses as rentals, the best incentive they can get in an increase in what they can rent those houses for. Letting the price system work for the best thing that can be done to fix the housing shortage. A rent freeze would just slow the rate of new house building and stop people from adjusting their living arrangements. A rent increase could mean, for example, that someone in a house that is too big for them would have an increase to sublease part of the house or move into a smaller home thereby freeing up their former house for someone who needs a larger home.

Tuesday 20 November 2012

Diversity in academia?

From the Daily Princetonian:
The majority of University faculty and staff members who have donated to the 2012 presidential candidates have donated to President Barack Obama’s campaign, according to numbers tracked by the Center for Responsive Politics in Washington, D.C.

A total of 157 University faculty and staff members donated directly to the presidential candidates, with only two of those donations going to Gov. Mitt Romney, the records show. Total donations directly to Obama exceeded $169,000, while donations to Romney summed to exactly $1,901.
The question is, How representative is Princeton?

Incentives matter: travel costs file

From the IEA, London, blog:
According to a review commissioned by the Department of Social Security, ‘the costs of travelling to work will ... be a factor in some people’s decisions about whether to look for or accept employment’. Indeed, one survey found that 50 per cent of unemployed people cited ‘extra costs such as travel’ as a major cause for concern about leaving benefits. Moreover, ‘travelling costs will also be a regular expense which may influence decisions about whether to remain in a particular job’. Studies of low-income families suggest that earnings from low-paid employment are significantly reduced by travel-to-work costs, with a particularly acute problem in rural areas.

EconTalk this week

John Cochrane of the University of Chicago and Stanford University's Hoover Institution talks with EconTalk host Russ Roberts about how existing regulations distort the market for health care. Cochrane argues that many of the problems in the health care market would go away if these distortions were removed. In this conversation, he explores how the market for health care might work in the United States without those distortions. He also addresses some of the common arguments against a more choice-oriented, less top-down approach.

You will be able to see Cochrane in person when you attend the 2012 Condliffe Memorial Lecture in Economics at Canterbury on Wednesday, 5 December, 6:30pm.

Sunday 18 November 2012

What’s a vote worth?

A question asked by John Gibson in a column at He notes that even before the turmoil of Hurricane Sandy, many Americans were considering not bothering to register a vote for their next president. By looking at the costs and benefits of voting, this column argues that not voting may actually be the rational choice.

Why bother voting? The probability of casting the deciding ballot is infinitesimally small in national elections. Hence, the cost of voting normally exceeds any plausible value of expected benefits from the preferred candidate winning.

It is highly unlikely that the benefits for a voter from any politician's platform are going to be large enough to counter the cost of voting. Thus if voting is rational it comes down to a comparison of the costs with the consumption benefits. But if these costs and benefits are small, the decision to vote is sensitive to small variations in either term. If these small effects are hard to measure, individual voter turnout will seem largely random and random voting presents a seemingly difficult challenge for the rational voter model.

Gibson offers some new research on the opportunity cost of voting.
Along with my collaborators, I have recently reported results in Public Choice [...] with very precise measures of the opportunity cost of voting. To calculate these costs we cross-referenced individual voter turnout in a general election from New Zealand with GIS estimates of the road distance from residential areas to the nearest polling station. By combining travel time estimates from Google Maps with estimated wages for the survey respondents, we obtained a detailed measure of the opportunity cost of time spent travelling to and from the polling station.

Our results show that even very small costs may deter voter turnout. Each extra kilometre – or two minutes’ driving time – to the nearest polling booth reduces turnout by one percentage point, all else the same. These effects are robust to various sources of confounding, including endogenous sorting of residential location, measurement error, and non-linearities. These results support one implication of rational voter theory [...] that “if the B (benefits) or PB (benefits weighted by the probability that a person’s vote matters) term is indeed quite small, then a small increase in the cost of voting – such as driving a mile instead of a half-mile to the polls – would significantly reduce turnout.”

Non-nested testing shows that using our new measure of the opportunity cost of time spent voting, formed by combining estimated travel time with imputed wages, outperforms simpler distance-based measures of costs. We find that small increases in the opportunity costs of time can have large effects in reducing voter turnout. For example, at an opportunity cost of NZ$10 (equivalent to US$8) the predicted national turnout would be just 75%, which is down seven percentage points from the mean. In urban areas, predicted turnout falls even more sharply with respect to opportunity costs.

While the external validity of findings from New Zealand would typically be limited, a number of features of this setting allow for especially clean estimates of the impacts of opportunity costs on turnout.
  • First, the general election voting is on a Saturday and almost always in person, so it is reasonable to assume that people are travelling from their home (the locations of which we use in the GIS algorithm).
  • Second, registering to vote is compulsory, while voting is not, so there is no two-stage decision to model of whether first to register and then to vote.
  • Third, our measure of individual turnout comes from an electoral survey which is validated by checking against the electoral rolls, so there is no over-reporting of voting as often happens with other surveys.
  • Finally, this is a setting with ample polling places per voter, little road congestion, little use of absentee ballots, and no state/provincial governments, upper house, or an elected executive or judiciary.
Hence, the triennial election for national parliament is the only politically important election in New Zealand, as well as the only one that involves in-person voting.

Showing that small opportunity costs of voting matter for voter turnout even in this setting extends and corroborates the findings of the previous, more spatially limited, case studies in the political science literature. An important implication follows from finding that opportunity costs are low, but that turnout is still sensitive to those low costs. If these low costs were not able to be accurately measured (as has typically been the case previously), then the decision to vote would (erroneously) appear largely to be random.
So all of us who choose not to vote in elections are, as we have always thought, making a rational decision.

I, Pencil: the video version

The Competitive Enterprise Institute offers here this six-plus-minute-long video that brings “I, Pencil” to life. The video is written by Nicole Woods Ciandella and produced by Nick Tucker.

(HT: Cafe Hayek)

Saturday 17 November 2012

Manufacturing fetishism

About a month ago Labour, New Zealand First and the Green party set out to create the perception that we have a manufacturing crisis in New Zealand when they launched a parliamentary inquiry into the manufacturing crisis. The use of such a political stunt does raise an interesting question, Why this obsession with manufacturing?

Why is it that these politicians - and others - seem to have a manufacturing fetish? They seem to think that only making physical things counts. "Thinking industries", for want of a better term, are discounted, they are subordinate to the real activity of making things.

Well the economist John Kay make have the answer: it's hard wired into us:
The rear cover of the iPhone tells you it is designed in California and assembled in China. The phone sells, in the absence of carrier subsidy, for about $700. Purchased components - clever pieces of design such as the tiny flash drive and the small but high-performing camera - may account for as much as $200 of this. The largest supplier of parts is Samsung, Apple's principal rival in the smartphone market. "Assembled in China" costs about $20. The balance represents the return to "designed in California", which is why Apple is such a profitable company.

Manufacturing fetishism - the idea that manufacturing is the central economic activity and everything else is somehow subordinate - is deeply ingrained in human thinking. The perception that only tangible objects represent real wealth and only physical labour real work was probably formed in the days when economic activity was the constant search for food, fuel and shelter.

A particularly silly expression of manufacturing fetishism can be heard from the many business people [PSW: and I would add politicians] who equate wealth creation with private sector production. They applaud the activities of making the pills you pop and processing the popcorn you eat in the interval. The doctors who prescribe the pills, the scientists who establish that the pills work, the actors who draw you to the performance and the writers whose works they bring to life; these are all somehow parasitic on the pill grinders and corn poppers. [Emphasis added]
Our politicians should realise that in a globalised world the physical labour incorporated in manufactured goods is a cheap commodity. But the skills and capabilities that turn that labour into products of extraordinary complexity and sophistication, that is the "thinking" that underlies these products, are not.

Interesting blog bits

  1. Gavin Kennedy writes on A Must Read New Book on Friedrich Hayek
    The publisher describes Eamonn Butler’s “Friedrich Hayek” as “a breath of intellectual fresh air”. I concur, for Butler is refreshingly easy to read. He is a brilliant communicator and needs to be to compress Hayek’s many volumes of his lifetime’s writings into 146 pages and hold his readers’ attention. Scholars familiar with Hayek’s works and general readers exposed to them for the first time will find much here worthy of their attention.
  2. Eric Crampton on Flynn effects
    Professor Flynn is trying to help you improve your mind. My review of his latest book should be in today's Christchurch Press. They gave me 450 words; I took 480.
  3. James Zuccollo asks Have election turnouts been falling?
    After appallingly poor turnouts in recent local elections in the UK The Guardian has a post implying that election turnouts have been falling over time.
  4. Matt Nolan on Careful with the CGT “silver bullet”
    In New Zealand people are looking for a lot of ways to solve many perceived problems with a quick policy solution. One that is being suggested is a capital gains tax.
  5. Tim Harford on Growth or bust
    If there were more corporate collapses, the economy would be a healthier place.
  6. Eric Crampton on Advertising, brands, and prices
    Advertising both persuades and informs. Informative advertising makes markets more competitive, reducing prices faced by consumers; persuasive advertising that reinforces brand loyalty segments markets and increases prices paid by consumers.
  7. Peter Cresswell on Hard Labour is coming for you
    Want to know what dangerous fantasies inhabit Labour activists’ minds? Wonder no longer, as all the dopy policy remits activists have dreamed up for consideration at this weekend’s Hard Labour conference have now been published online.
  8. Peter Cresswell on Deep Green
    Since I’ve just posted below just some of the dopiness promoted by Hard Labour activists, I thought it only fair to update my on-going study of their coalition partners favourite word: “ban.”
  9. Greg Mankiw asks Should we repeal anti-gouging laws?
    He gives some readings on this question.
  10. Jennifer Hunt on The impact of immigration on the educational attainment of natives
    Are poorly-educated immigrants’ kids dragging native classmates down? Or do schoolchildren push themselves when new, smarter immigrants join their class? This column argues that although child immigrants may sometimes bring down native minorities, on the whole, poorly educated natives upgrade their education in response to new immigrants in the classroom.
  11. Tim Harford on How Adam Smith could help the Church
  12. Gavin Kennedy on Adam Smith's Authentic Views On Church and State
    Tim Harford (of ”Undercover Economist” fame) writes in the Financial Times (16 November): “How Adam Smith could help the Church” “Laurence Iannaccone, an economist who has specialised in the economics of religion, developed an idea he drew from the writings of Adam Smith: that more competitive religious marketplaces lead to more dynamic churches.”
  13. Eric Crampton on Cheap plonk
    It's not crazy to argue for the combination of a lower alcohol excise tax and a minimum per-unit price for alcohol if harm-causing drinkers disproportionately choose the cheapest plonk while moderate drinkers choose more expensive drinks.

Pay and the quality of journalism

When talking about what to do about bad journalism at the BBC Chris Dillow at the Stumbling and Mumbling blog writes, with regard to the idea that better pay may lead to better journalists and thus better journalism, that:
The claim that high pay is necessary to attract and motivate good workers is not merely an economic postulate. If it were, it could apply across the wage distribution. Instead, it functions as a defence of inequality - used to justify higher pay for the rich, rather than for any job. For grunt workers, wages are a cost to be minimized regardless of consequence.
I don't follow Chris's argument. That pay can be used as a way of dealing with the problem of "low quality" workers arises in cases of asymmetric information. If we face pre-contractual asymmetric information then we have an adverse selection problem. If we are dealing with a low-skilled position, so even if we don't know the skills of a worker it may not matter much or the workers skills can be verified at relatively low cost, then adverse selection may not matter much. Such positions are likely to be at the lower end of the wage distribution while positions where a worker's skills matter and are unobservable are more likely to be high skilled jobs at the upper end of the wage distribution. Thus the use of high pay as a way of increasing the proportion of high quality workers in your pool of applicants is more likely to occur at the high wage end of the wage distribution.

If we are dealing with a case of post-contractual asymmetric information then moral hazard is the issue. Here if a worker's "effort" is not overly important to the outcome or where a worker's effect can be monitored reasonably costlessly then moral hazard would not be a great problem. But again, such jobs are likely to be lower paid jobs. The big moral hazard problems are more likely to occur in positions for which effort can not be monitored and where this matters for the outcome. Such jobs are likely to be at the high end of the wage distribution so using higher pay, via say some form of performance pay, to counter moral hazard is more likely to be seen at the high wage end of the wage distribution.

Also the notion that
For grunt workers, wages are a cost to be minimized regardless of consequence.
makes no sense. A profit maximising firm will select the profit maximising combination of pay and effort. While lowering pay will lower costs it can also lower profits if the detrimental effects on "effort" are large enough and thus firms will not choose this low wage/low effort combination.

Effects of "local" trade

An idea that comes up every now and then when talking about trade is that we should only trade "locally". Somehow local trade is more virtuous than non-local trade. Leaving aside the obvious problem of defining the "local" in local trade trade there is still the problem of the actual effects of such a restriction. One issue to keep in mind is that restricting trade to the local region means you limit the size of the market and thus you are limited in your ability to take advantage of specialisation and the division of labour. As George Stigler put it “The Division of Labor is Limited by the Extent of the Market”. In short you make yourself poorer than you would otherwise be.

Matt Ridley offers a nice example of the problem in his book "The Rational Optimist":
In the same vein, Kelly Cobb of Drexel University set out to make a man's suit entirely from materials produced within 100 miles of her home. It took twenty artisans a total of 500 man-hours to achieve it and even then they had to get 8 percent of the materials from outside the 100-mile radius. If they worked for another year, they could get it all from within the limit, argued Cobb. To put it plainly, local sourcing multiplied the cost of a cheap suit roughly a hundred-fold.
So local production is possible but only at a high price.

Friday 16 November 2012

Wise words

David Uren the economics editor at The Australian newspaper has written an article entitled Crude economic nationalism will impoverish us. A title that says it all really.

He writes,
At the root of economic nationalism is a belief that foreigners are taking control of what is rightfully ours. The profits that they are generating belong to us, and our children. Economic nationalists believe the state should regulate foreign influence, promoting national interest over that of the foreigner.

Treasury has usefully calculated what it would mean if Australia were to limit the inflow of foreign capital, which appears to be the preferred position of at least some in the Coalition.

In a new study, Treasury analysts consider what would occur if the inflow of foreign money, which has averaged about 4 per cent of gross domestic product over the past four decades, were restricted by one percentage point.

Certainly, Australia would accumulate fewer foreign liabilities, meaning that less would flow abroad in dividends and interest. The currency would fall with reduced demand for Australian dollars, and export volumes would rise as a result.

But these benefits would be outweighed by the fall in investment and the reduction in consumption. Wages would be lower over the long term, while employment would fall in the short term. People would be worse off overall, with national income falling by 0.5 per cent every year for at least a decade.

"Restrictions on capital inflow (including foreign investment) would reduce Australian investment, production and incomes," the study concludes.

It follows that liberalising capital flows would be wealth generating. Foreign capital is supplementing domestic savings to sustain much higher levels of investment than are achieved in any other advanced economy. Foreign direct investment is risk capital. Investors are taking a chance on Australia. Their investments will be serviced with dividends only for so long as they are profitable.
Yes the numbers are based on Australia data but the basic argument applies just as well to New Zealand. What makes us rich is having lots of goods and services to consume. Where the profits from producing these consumables goes doesn't matter. What does matter is making sure that the producers of the goods and services are the most efficient producers of them and allowing foreign investment increases the likelihood of having the most efficient firms doing the producing.

Thursday 15 November 2012

Incentives matter: statistics file

From The Times,
The challenges facing the new breed of politicians who take control of police forces tomorrow were put in sharp focus as five detectives were arrested in an anti-corruption investigation.

The Times can disclose that the officers from Kent Police — four men and a woman — were detained at their police station and questioned over allegations of manipulating statistics in order to meet crime detection targets.

The officers, a detective inspector, a detective sergeant and three detective constables, are accused of persuading suspects to confess to offences they had not committed in order to improve the unit’s performance statistics.
Be careful what targets you set to manage or measure outcomes because as soon as you’ve set them you give people the incentive to game them.

(HT: Tim Worstall)

Discrimination in labour markets: evidence from Italy

Of all topics in economics discrimination in the labour market maybe one of the most studied but it is also one of the least understood. Part of the problem when looking at the adverse labour-market outcomes of certain categories of workers (for example, ethnic minorities or women), it is very difficult to disentangle the effects of  discrimination and other often-unobserved aspects such as low ability or social norms and peer effects.

Eleonora Patacchini, Giuseppe Ragusa and Yves Zenou examine this topic using data from a study which utilised the sending of fictitious résumés to real help-wanted ads in Rome and Milan. Their results are summarised in a column at They were looking at the effects of homosexuality and beauty on labour markets outcomes.

Patacchini, Ragusa and Zenou write,
We experimentally manipulate 'perceived homosexuality' by randomly modifying résumés by adding items that reveal sexual preferences. At the same time, we randomly attach to the résumés a picture of the candidate where these pictures have been previously ranked in terms of beauty. We restrict the field experiment to seven occupations, the most frequent ones that do not require specific skills, i.e. administrative clerk, bookkeeper, call-centre operator, receptionist, sales clerk, secretary and shop assistant.
They continue,
The experiment started on 17 January 2012 and ended on 21 February 2012. During this period, for each city and occupation, we selected the most recent employment ads published in two websites, Job Rapido and Monster. They are the most popular websites among actual jobseekers. We answered to 531 ads, 336 in Milan and 195 in Rome. We typically sent four résumés in response to each ad, two from the treatment group and two from the control group. We sent 2,320 résumés in total.

The overall response rate was about 11%, with a minor difference between males and females (10.83% and 11.24%, respectively). Looking at the percentages by city, the response rate was higher in Rome (about 16%), where men were more likely to be called back than women (17.48% versus 14.96%). On the contrary, in Milan, the overall response was roughly divided by two (about 8%) and men were less likely to be called back than women (7.19% versus 9.10%).
We find that there is a statistically significant penalty (in terms of callback rates) associated to gay men of about 3% whereas gay women do not seem to show a significant difference in callback rate with respect to straight women. The 3% penalty for gay men is quite high since the callback rate for males is 10%, which means that compared to gay men, they have 30% less chance to be called back.

We also investigate whether the penalty associated with gay people is mitigated for high-skilled individuals. Interestingly, we find the opposite result. The penalty is actually higher for high-skilled gay people, with an associated magnitude of more than 8% for gay men. No penalty or premium is instead associated to high-skilled lesbians, confirming that only men are penalised in the labour market for their sexual orientation.

When we instead look at differences in response rates by picture beauty, our analysis indicates a significant premium for attractive women of about 2% and no significance difference between handsome and ugly men. We then investigate whether the beauty premium for women varies by skills. We find that high-skilled attractive women are called back less often than low-skilled attractive women. This may indicate that beauty might not be an advantage for high-skilled women.
So the results suggest the existence of discrimination against gay men and the less attractive female workers. The fact that high-skilled pretty women obtain less beauty premium than low-skilled pretty women may indicate the fear of competition with these women for certain types of jobs. Importantly, the results show that the beauty results are particularly relevant for occupations requiring the interaction with customers as secretaries, receptionists and general customer service.

The beginning of the "knowledge economy"

Over the last 30 years or so we have often been told we are in a new economy, a "knowledge economy". The knowledge economy is, we are told, something new and exciting, very different from any other economy we have known before.  But is this true, are we in any more of a "knowledge economy/society" now than we were during Neolithic times, the Agricultural Revolution, the Renaissance or the Industrial Revolution? When and why did the knowledge economy actually start?

Matt Ridley explains the knowledge economy's rather surprising origins in his book "The Rational Optimist":
"There is now little doubt that hominids spent much of those million and a half years eating a lot of fresh meat. Some time after two million years ago, ape-men had become more carnivorous. With their feeble teeth and with finger nails where they should have had claws, they needed sharp tools to cut the skins of their kills. Because of their sharp tools they could tackle even the pachydermatous rhinos and elephants. Biface axes were like external canine teeth. The rich meat diet also enabled erectus hominids to grow a larger brain, an organ that burns energy at nine times the rate of the rest of the body. Meat enabled them to cut down on the huge gut that their ancestors had found necessary to digest raw vegetation and raw meat, and thus to grow a bigger brain instead. Fire and cooking in turn then released the brain to grow bigger still by making food more digestible with an even smaller gut - once cooked, starch gelatinises and protein denatures, releasing far more calories for less input of energy. As a result, whereas other primates have guts weighing four times their brains, the human brain weighs more than the human intestine. Cooking enabled hominids in ids to trade gut size for brain size". (Ridley 2010: 51).
So our brains developed thanks to cooking and eating meat and it is our brain that allowed us to develop our social and economic institutions in such a way as to get us to our current economy. This tells us that the origins of our economy are ancient and it also suggest that only the economies humans can have are knowledge economies. Our brains are the foundation of our social and economic life and have been from the beginning.

When discussing the question, What happened to the Neanderthals? Tudge (1998: 25) argues
“[t]he Cro-Magnons [ ...] got to know the habits of the animals they hunted and knew where to lie in wait; and different bands shared information, so hunting parties could be forewarned of migrations days in advance.”
He goes on to say
“[m]ost importantly of all [ ...] the Cro-Magnons co-operated: that they traded tools - for which there is abundant evidence - and also traded information. Thus [ ...] the age of trade (and of information) is exceedingly ancient.” (Tudge 1998: 26).
In his discussion of the Gravettian culture which lasted in Upper Palaeolithic Europe from at least 29,000 years ago to around 21,000 years ago Finlayson (2009: 165) writes,
“[n]aturally people had to find ways of moving around without having to carry heavy loads; they also had to find ways of reading the land and of communicating with each other with precision. The Gravettians had entered the information age.”
He also notes the importance of information build-up and its relationship to population growth,
“[o]verall, Ancestors were displaying the adaptability and range of behaviours that has characterized their pre-glacial ancestors and also the Neanderthals. The main difference, and one that was to become increasingly evident as time went by, was that as populations increased in size and information networks became more sophisticated, these people had a corpus of accumulated knowledge that they could draw from. This process of information build-up became less vulnerable to loss as populations grew but at this stage was still not foolproof; the extinction of the knowledge and skills of the painters of western Europe shows us how precarious it remained.” (Finlayson 2009: 196).
When discussing the economic and geographic expansion of the Upper Paleolithic population Ofek (2001: 173) writes
“Upper Paleolithic people apparently used local resources more efficiently than their predecessors - or their Neanderthal neighbors - if the latter still existed as a separate entity at the time (Klein, 1989). Such a sudden increase in the “wealth” of populations suggests a corresponding improvement in the allocation of resources in society, most likely, in my opinion, through the mechanisms of division of labor, exchange, and investment in the most consequential resource of all: Human Capital [ ...].” (Emphasis in the original).
So the argument that the knowledge economy is new, in a historical time sense, is not entirely convincing.