Thursday 27 February 2014

Inflation in Venezuela

An update on the rate of inflation in Venezuela from The Troubled Currencies Project. As at 19/02/14 the implied annual inflation rate for Venezuela was 330%.

A graph of a time series of the annual inflation rate is below:

Wednesday 26 February 2014

Acemoglu on inequality

From the Economist back in 2011 comes this comment by Daron Acemoglu about why inequality matters:
THERE are three main reasons why society may care about inequality. First, people's well-being may directly depend on inequality, for example, because they view a highly unequal society as unfair or because the utility loss due to low status of the have-nots may be greater than the utility gain due to the higher status of the haves. Second and more importantly, equality of opportunity may be harder to achieve in an unequal society. Many economists have, by and large rightly, focused more on poverty than inequality. Poverty not only causes low standards of living and poor health but damages both individuals and society by preventing those at the bottom from realising their potential, perhaps because they are unable to obtain a decent quality of education to prepare them for competition in the labour market. While poverty is clearly the more important factor in creating a non-level playing field, inequality may also be a nontrivial factor: those with greater wealth provide to their children resources and thus opportunities that the less wealthy cannot, and this may make it more difficult for society to achieve equality of opportunity.

Third and most importantly, inequality impacts politics. Economic power tends to beget political power even in democratic and pluralistic societies. In the United States, this tends to work through campaign contributions and access to politicians that wealth and money tend to buy. This political channel implies another, potentially more powerful and distortionary link between inequality and a non-level playing field. It may also create pathways from inequality to instability, because both the economic and political implications of inequality can create various backlashes.
The first argument may be true, but so could the opposite argument. And how could we ever measure people's utility anyway? The second argument is more about poverty than inequality per sec while the third is more a political argument than an economic one. You could imagine a state of the world where such an argument would hold but equally you could imagine ones in which it doesn't. A strong 'politics of envy' type effect could generate instability. But isn't instability more likely to be driven by poverty and people's react to that? Consider two economies, one where the four people in it have incomes of 1,1,1 and 1 and the other where incomes of these people are 100, 1000, 5000 and 7000. Further assume that incomes have been scaled so that 0 is the least acceptable level of income, say, for argument's sake that 0 means you are dead. Which of the two economies is more likely to be stable, the equal but poor one  or the wealthier but more unequal one?

Tuesday 25 February 2014

Dishonesty and selection into the government sector

An often stated reason for going into the government service is to "do good", in some sense. That is, people who enter the government sector are driven by high prosocial and ethical standards.

Or are they?

For India at least the answer may be no. Rema Hanna and Shing-Yi Wang have an NBER working paper where they look at Dishonesty and Selection into Public Service. The abstract reads,
In this paper, we demonstrate that university students who cheat on a simple task in a laboratory setting are more likely to state a preference for entering public service. Importantly, we also show that cheating on this task is predictive of corrupt behavior by real government workers, implying that this measure captures a meaningful propensity towards corruption. Students who demonstrate lower levels of prosocial preferences in the laboratory games are also more likely to prefer to enter the government, while outcomes on explicit, two-player games to measure cheating and attitudinal measures of corruption do not systematically predict job preferences. We find that a screening process that chooses the highest ability applicants would not alter the average propensity for corruption among the applicant pool. Our findings imply that differential selection into government may contribute, in part, to corruption. They also emphasize that screening characteristics other than ability may be useful in reducing corruption, but caution that more explicit measures may offer little predictive power.
The importance of these findings is that they demonstrate that the variation in the levels of observed corruption may, in part, be driven by who selects into government service, the more corrupt enter into the government sector. Hanna and Wang argue that there are two key policy insights that follow from their work. First, the recruitment and screening process for bureaucrats may be improved by increasing the emphasis on characteristics other than ability. So the brightest may not be the best. It is important to note that individuals may not want to reveal their characteristics, especially their propensity for dishonesty, so the method of measurement matters. The simple, experimental measure that Hanna and Wang employed predicted the corrupt behaviours of the government employees, but the game in which corruption was explicitly framed and the fairly standard attitudinal questions had little predictive value. Second, while recent empirical papers have shown that reducing the returns to corrupt behaviour decreases the probability that bureaucrats engage in corruption, the work by Hanna and Wang suggests that these interventions may have had even broader effects by changing the composition of who might apply.

EconTalk this week

Robert Frank of Cornell University talks with EconTalk host Russ Roberts about the implications of Ronald Coase's views on externalities. Drawing on his book, The Darwin Economy, Frank explores the implications of Coase's perspective for assessing public policy challenges where one person's actions affect others. Examples discussed include pollution, cigarette smoking and related issues.

A direct link to the audio is available here.

Monday 24 February 2014

George Selgin interview

George Selgin, Professor of Economics in the the University of Georgia's Terry College of Business, was interviewed on RT television's "Boom and Bust" show and talked about price and debt deflation. The segment with Professor Selgin comes on about halfway through.

McCloskey on groceries

At the Cafe Hayek blog Don Boudreaux writes
... is from page 62 of the manuscript of Deirdre McCloskey‘s forthcoming volume, The Treasured Bourgeoisie: How Markets and Improvement Became Virtuous, 1600-1848, and Then Suspect (original emphasis):
The four heirs of Sam Walton (Alice, Jim, Christy, and S. Robson) were worth a combined total of $107.3 billion (which puts them half-again above Bill Gates), earn from retailing in which profit margins are low (in groceries, which they now lead, extremely low). Wal-Mart must be doing something right (no, dears: not by underpaying its staff, which the lively forces of entry and exit in the labor market prevent it from doing even if it wanted to; but by pioneering control of inventory and by pioneering mass but negotiated buying, for the benefit of its shoppers, with a small margin left overt for Alice, Jim, Christy, and S. Robson).
I wonder if one of those things Wal-Mart does right is bargaining hard with its suppliers and how much consumer surplus does it generate for its consumers via its lower prices caused, at least in part, by its tough bargaining?

The economics of conscription

One of the many things economist Milton Friedman was well known for was his oppression to the draft. In this article another University of Chicago economist, Allen Sanderson, discusses the economics and political economy of conscription. In part Sanderson writes,
After a few weeks of class, any Economics 101 student should be able to demonstrate that the lowest cost way to provide a military force is our current “volunteer” or free-market army, a system we have employed since 1973.

Why? Because only those whose opportunity cost is at or below the established market wage rate, plus those who are extremely patriotic, will enlist. By contrast, drafting LeBron James may appear cheaper on the Pentagon’s budget by paying him a draftee’s salary, but that entails—to him and to the economy—an implicit tax of several million dollars a year (that is, what he would have earned, and would now be forgoing, as a member of the NBA Miami Heat).

In addition, a volunteer force is more likely to have higher morale as well as lower turnover and training costs because these recruits want to be involved in defending the nation rather than serving grudgingly because they were taken away from family, friends and other preferred options.
Opportunity cost and incentives come to the fore in this issue as with so much of economics. I do wonder however just how many econ 101 students - or politicians for that matter - could actually could give this analysis of conscription.

Sunday 23 February 2014

Lanny Ebenstein on Milton Friedman’s ideological evolution

This link goes to an audio interview from Econ Journal Watch Audio in which Dan Klein and Lanny Ebenstein discuss Milton Friedman’s ideological evolution. The discussion is based on Ebenstein EJW article “The Increasingly Libertarian Milton Friedman”. Ebenstein discusses how Friedman’s support for liberalisation became more pointed, sometimes even abolitionist, on a number of government interventions.

Saturday 22 February 2014

Nokia's decline, illustrating existing theory on disruptive technologies

Dr. Christian Sandström provides a definition of disruptive technology and explains how it introduces new features to an already existing product, elaborating on the struggles many well rooted, competitive companies have faced, either raising to the challenge or failing, as are the cases of Nokia and Kodak. He comments on the oversights of established businesses, such as Nokia, that failed to progress on technological changes, and consequently missed out on growth opportunities, as they stayed too close to their existing customers. He concludes by suggesting that the markets and value should be appreciated from an Austrian perspective, in order to be fully understood and taken advantage of.

More information is available at Newmedia at

Interesting blog bits

  1. Jeremy Greenwood, Nezih Guner, Georgi Kocharkov and Cezar Santos on US inequality due to assortative marriages.
    How Americans form and dissolve families has changed dramatically since 1950. One of these changes has been an increase in assortative mating, i.e. how likely a person is to marry someone of similar educational background. This column argues that since education is an important determinant of income, these patterns of matching have had an important impact on the economy's distribution of income.
  2. John Taylor on Next Time Remember the Lessons from Stimulus Packages
    It’s the five-year anniversary of the 2009 stimulus package. I’ve done a slew of empirical research on the stimulus in those years from predicting in advance that its impact would be small to estimating afterwards that its impact was small.
  3. John Taylor asks Should Policymakers or Macro Models Be Taken to the Woodshed?
    There’s a good debate going on about the usefulness of macro models, and in particular whether the so-called New Keynesian models let us down or even helped bring on the financial crisis and the Great Recession.
  4. Alexander Czombera on Zimbabwean Currencies: Condoms, Sweets and Paper Money
    If there is one single law in economics then it is that markets tend to equilibrium. Or, to align this with Grove’s law (“Technology will always win. You can delay technology by legal interference, but technology will flow around legal barriers”), the free market will find its ways, whether in white, grey or black market.
  5. David Henderson on CBO's Minimum Wage Study: Dealing with Publication Bias
    I've finally got around to reading more details about the Congressional Budget Office's report on the number of jobs lost from raising the minimum wage.
  6. Don Boudreaux on The CBO On Minimum-Wage Studies.
    If I understand correctly what’s going on here, it’s not obvious to me that publication bias for minimum-wage studies runs the way the CBO assumes.
  7. Robert P. Murphy on Economists Debate the Minimum Wage
    Economists famously argue about everything. Even so, it used to be that economists across the board—whether left, right, or center—generally agreed that the minimum wage was ill-suited to help the poor.
  8. Henrik Braconier and Mauro Pisu on Roads to deeper European integration
    Despite substantial integration, national borders still provide a large obstacle to trade in Europe. This column shows that much of these ‘iceberg costs’ can be attributed to underdeveloped infrastructure, namely roads. Improving international roadways to the level of national ones could substantially raise gains to trade.
  9. Chris Dillow on The "Middle Class", & Marxism
    Is Marx more relevant than ever before? This is the question posed by talk of the falling middle class and poorly-paid self-employed.
  10. Chris Dillow on the Bonnie Tyler syndrome
    Trouble in Venezuela has led to some rightists sneering at Owen Jones for supporting the socialist government. Such partisan point-scoring, however, hides an interesting question: what is the origin of Owen's mistake, assuming it to have been one?

The deflation debate

I have discussed the difference between good and bad deflation a number of times before, see for example here, here and here. The basic point is that there are two forms of deflation, the bad driven by demand shrinking and the good caused by supply expanding. The good kind of deflation is the result of increases in productivity. Research and development means new technology, efficiency gains, cost-cutting, price-cutting and, yes, deflation. Productivity gains mean that businesses could afford to sell their products for less since it is costing less to make them. The bad kind usually follows a collapse of aggregate demand. There is a severe drop in spending: producers have to cut prices to find buyers. This has the effect of causing recession, high unemployment and widening financial stress. This the 1930s type deflation that people fear.

In a new column at Mickey Levy argues that a popular view among economic commentators is that rich countries face a serious risk of deflation, and should adopt aggressive macroeconomic stimulus policies to ward it off. His column argues that despite similar headline inflation rates, the US, Europe, and Japan in fact face very different macroeconomic conditions. In the US, much of the recent disinflation is attributable to positive supply-side developments. In Europe, an aggressive round of quantitative easing might encourage policymakers to delay the reforms that are necessary to avoid a prolonged Japanese-style malaise.

Levy goes on to argue,
Deflation stemming from insufficient demand and growth-constraining economic policies can drain confidence and become negatively reinforcing, as Japan has shown. In such situations, aggressive macroeconomic policy stimulus designed to jar expectations and boost demand is appropriate. Europe’s downward price and wage pressures are necessary adjustments to its earlier excesses, and relying excessively on aggressive monetary policy to stimulate demand is not a lasting economic remedy. Europe is not destined to fall into a Japanese-style prolonged malaise, but it must continue to pursue reforms that lift productive capacity and confidence.

The US situation is very different. The economic expansion is gaining momentum (temporarily sidetracked by unseasonal winter storms), unemployment is falling steadily, personal income is growing faster than inflation, and household net worth is at an all-time high. Expectations of deflation are not apparent in either household or business behaviour. Concerns about lingering labour-market underperformance are warranted; angst about deflation is not.

Prices of some goods and services in the US have been falling, benefitting from technological innovation, improved product design, or heightened competition and distribution efficiencies through the internet. Examples abound: flat-screen TVs, computers, automobiles, reduced fees on financial transactions, online consumer and business purchases, etc. These lower prices and quality improvements explain the vast majority of the recent deceleration in inflation – the PCE deflator for goods continues to decline and is flat for nondurables, while it has been rising at a fairly steady pace of 2% for services.

These innovation-based price reductions improve standards of living and free up disposable income to spend on other goods and services. They boost aggregate demand and enhance economic performance. And they contribute positively to longer-run potential growth.

It is unclear why US policymakers and commentators fear disinflation that stems from innovation-based price reductions amid accelerating aggregate demand. European policymakers face tougher choices.
In short, the proper policy response depends on the underlying causes of deflation. One size does not fit all when it comes to deflation.

Friday 21 February 2014

Technological change and the make-or-buy decision

An issue commonly raised by critics of the mainstream approach to the theory of the firm involves the fact that the differences in productive capabilities of firms have been suppressed in the modern theory. While the neoclassical approach of seeing the firm as a production function is inadequate so is the idea that technology can be ignored altogether. The critics emphasise that firms have differential productive capabilities and that this may influence economic organisation. In short, the contemporary theory of the firm ignores technology.

In a new paper in the Journal of Law, Economics, and Organization Ann P. Bartel, Saul Lach, and Nachum Sicherman look at Technological Change and the Make-or-Buy Decision
A central decision faced by firms is whether to make intermediate components internally or to buy them from specialized producers. We argue that firms producing products for which rapid technological change is characteristic will benefit from outsourcing to avoid the risk of not recouping their sunk cost investments when new production technologies appear. This risk is exacerbated when firms produce for low volume internal use, and is mitigated for those firms that sell to larger markets. Hence, products characterized by higher rates of technological change will be more likely to be produced by mass specialized firms to which other firms outsource production. Using a 1990–2002 panel data set on Spanish firms and an exogenous proxy for technological change, we provide causal evidence that technological change increases the likelihood of outsourcing.
So we see one way in which technology can affect the boundaries of the firm.

On Coasean economics

At the Coordination Problem blog Peter Boettke writes on On Coase and Coasean Economics. In part Boettke says,
The Nobel Prize lecture [The Institutional Structure of Production] highlights how the socialist calculation debate -- as communicated through Arnold Plant -- influenced the young aspiring economist Ronald Coase at the LSE, and led to his work on the theory of the firm. The lecture also straightens out the meaning and purpose of the "Coase Theorem" --- as Coase says:
What I showed in that article, as I thought, was that in a regime of zero transaction costs, an assumption of standard economic theory, negotiations between the parties would lead to those arrangements being made which would maximise wealth and this irrespective of the initial assignment of rights. This is the infamous Coase Theorem, named and formulated by Stigler, although it is based on work of mine. Stigler argues that the Coase Theorem follows from the standard assumptions of economic theory. Its logic cannot be questioned, only its domain. I do not disagree with Stigler. However, I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion; let us study the world of positive transaction costs.
Too many commentators -- and that includes an entire generation of Austrian economists -- have completely missed the importance of Coase's insight. There is obviously room for disagreement with Coase on fine points of theory and the implications of those points. But the quoted passage deserves to be read very carefully again and again so that its very subtle point sinks in. In Coase's hands the Pigovian remedies of tax and subsidies to address externalities are rendered either redundant or non-operationaly by a logical analysis grounded in the standard assumptions of economic theory upon which those remedies were recommended in the first place.
While I agree with what Boettke says I would also add that the really important point Coase makes in the above quote is the call to study, not the zero transaction cost world of neoclassical economics, but the world of positive transaction costs. In such a world Pigou's use of taxes and subsidies may make sense but this can only be determined on a case by case basis, there are not general results.

It should also be noted that it is the study of the positive transaction cost world which makes sense of things like firms - Coase's 1937 paper - and the role of the law - Coase's 1960 paper. To take the firm as an example, in the standard neoclassical model there is no need for firms, consumers can do it all since they live in a world of perfect and costless contracting which means that they can contract directly with owners of the factors of production to arrange production of whatever they want and wouldn’t therefore need the services of the intermediaries we know as firms. Positive transactions costs mean that it is no longer always the case that market transactions are the most efficient method of production.

Wednesday 19 February 2014

CEO pay

Greg Mankiw points us to this paper on CEO pay:

Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges

Steven N. Kaplan
The abstract reads:
In this paper, I consider the evidence for three common perceptions of U.S. public company CEO pay and corporate governance: (1) CEOs are overpaid and their pay keeps increasing; (2) CEOs are not paid for their performance; and (3) boards do not penalize CEOs for poor performance. While average CEO pay increased substantially through the 1990s, it has declined since then. CEO pay levels relative to other highly paid groups today are comparable to their average levels in the early 1990s although they remain above their long-term historical average. The ratio of large-company CEO pay to firm market value is roughly similar to its level in the late-1970s and lower than its pre-1960s levels. These patterns suggest that similar forces, likely technology and scale, have played a meaningful role in driving CEO pay and the pay of others with top incomes. With regard to performance, CEOs are paid for performance and penalized for poor performance. Finally, boards do monitor CEOs. The rate of CEO turnover has increased in the 2000s compared to the 1980s and 1990s, and is significantly tied to poor stock performance. While corporate governance failures and pay outliers as well as the very high average pay levels relative to the typical household undoubtedly have contributed to the common perceptions, a meaningful part of CEO pay appears to be market determined and boards do appear to monitor their CEOs. Consistent with that, top executive pay policies at over 98% of S&P 500 and Russell 3000 companies received majority shareholder support in the Dodd-Frank mandated Say-On-Pay votes in 2011.
Another thing about CEO pay and performance worth considering isn't the relationship between the current CEO's performance and pay but the relationship between the next CEO's performance and the CEO's pay. That is, what effect does CEO pay have on the performance of the guys who want to replace the current CEO? A decent remuneration package for the CEO may well increase effort on behalf of those who want to be the next CEO.

Tuesday 18 February 2014

Wages and productivity

The relationship between productivity and wages has come alive on Twitter. For some strange reason @smalltorquer asked,
But the New Zealand Productivity Commission noted:
When it comes to wages and productivity even Paul Krugman has managed to realise,
Economic history offers no example of a country that experienced long-term productivity growth without a roughly equal rise in real wages. In the 1950s, when European productivity was typically less than half of U.S. productivity, so were European wages; today average compensation measured in dollars is about the same. As Japan climbed the productivity ladder over the past 30 years, its wages also rose, from 10% to 110% of the U.S. level. South Korea's wages have also risen dramatically over time. ("Does Third World Growth Hurt First World Prosperity?" Harvard Business Review 72 n4, July-August 1994: 113-21.)
and Krugman and Obstfeld have written,
As it happens, the past 40 years offer considerable evidence on what happens to the wages of a country whose productivity gains on that of higher-wage nations. Four decades ago, productivity in Europe was well below U.S. levels in most industries, and Japan lagged even further; since then, productivity levels in the advanced world have converged, although most measures still suggest that the United States retains some edge. More recently, a group of "newly industrializing economies" in Asia has achieved spectacular productivity increases starting from a very low base. Given these dramatic changes in relative productivity, what has happened to relative wages?

The answer is that wages have risen in each country, more or less in line with productivity. Table 2-3 shows data on long-run increases in productivity and real wages in several representative countries. Bearing in mind that there are some slippages in the data (for example, there are a number of technical problems in the way that both productivity and real wages are calculated), the basic picture is one in which converging productivity has produced a convergence in wages, just as the theoretical analysis would predict.

Notice that we do not have good data on South Korean wages over the full sample. However, the United States government has been collecting hourly compensation (wages plus benefits) data for the industrial sector of several newly industrializing countries since the mid 1970s. According to these data, South Korean compensation rose from only 5 percent of the U.S. level in 1975 to 46 percent in 1996. An index of compensation in several newly industrializing Asian economies rose from 8 percent of the U.S. level in 1975 to 32 percent by 1996. In short, the experience to date is that wages always do move more or less in line with productivity. (Paul Krugman and Maurice Obstfeld, "International Economics: Theory and Policy", Prentice Hall.)
Following up this, the information below comes from a paper by Martin Feldstein, Professor of Economics, Harvard University and President and CEO of the National Bureau of Economic Research [he has since retied from the NBER post], given to the American Economic Association on January 5, 2008. The paper is entitled "Did Wages Reflect Growth in Productivity?" Feldstein writes,
The level of productivity doubled in the U.S. nonfarm business sector between 1970 and 2006. Wages, or more accurately total compensation per hour, increased at approximately the same annual rate during that period if nominal compensation is adjusted for inflation in the same way as the nominal output measure that is used to calculate productivity.

More specifically, the doubling of productivity represented a 1.9 percent annual rate of increase. Real compensation per hour rose at 1.7 percent per year when nominal compensation is deflated using the same nonfarm business sector output price index.

In the period since 2000, productivity rose much more rapidly (2.9 percent a year) and compensation per hour rose nearly as fast (2.5 percent a year).
and later he says
The relation between wages and productivity is important because it is a key determinant of the standard of living of the employed population as well as of the distribution of income between labor and capital. If wages rise at the same pace as productivity, labor’s share of national income remains essentially unchanged. This paper presents specific evidence that this has happened: the share of national income going to employees is at approximately the same level now as it was in 1970.

EconTalk this week

Charles Calomiris of Columbia University and Stephen Haber of Stanford University, co-authors of Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, talk with EconTalk host Russ Roberts about their book. The conversation focuses on how politics and economics interact to give some countries such as Canada a remarkably stable financial system while others such as the United States have a much less stable system. The two authors discuss the political forces that explain the persistence of seemingly bad financial regulation. The conversation includes a discussion of the financial crisis of 2008.

Highlights include making fun of Post-Modern English professors and calling Canada "a very boring place"!

A direct link to the audio.

Incentives matter: ABBA file

From the Guardian
Abba admit outrageous outfits were worn to avoid tax

The glittering hotpants, sequined jumpsuits and platform heels that Abba wore at the peak of their fame were designed not just for the four band members to stand out – but also for tax efficiency, according to claims over the weekend.


And the reason for their bold fashion choices lay not just in the pop glamour of the late 70s and early 80s, but also in the Swedish tax code.

According to Abba: The Official Photo Book, published to mark 40 years since they won Eurovision with Waterloo, the band's style was influenced in part by laws that allowed the cost of outfits to be deducted against tax – so long as the costumes were so outrageous they could not possibly be worn on the street.

Sunday 16 February 2014

A brief history of the efficient market hypothesis

From 2008 comes this video, made for the American Finance Association, in which Gene Fama gives a brief history of the efficient markets hypothesis.

"Prisonomics": A case for penal reform in the UK

Vicky Pryce talks to Viv Davies about her recent book ‘Prisonomics: Behind bars in Britain’s failing prisons’, which analyses the economic and social costs and consequences of women in prison and women’s prisons in the UK. Pryce presents the case for penal reform and provides a number of policy recommendations.

A direct link to the audio is available here.

Bill Easterly interview

NPR’s The Takeaway interviews Bill Easterly. The basic question being, Are billionaire philanthropists the true champions in the fight against poverty? The interview runs, roughly, from 1.40 to 11.30  mins.

Saturday 15 February 2014

Interesting blog bits

Storms, tea cups

Tuesday 11 February 2014

EconTalk this week

Paul Sabin of Yale University and author of The Bet talks with EconTalk host Russ Roberts about his book. Sabin uses the bet between Paul Ehrlich and Julian Simon--a bet over whether natural resources are getting scarcer as population grows--as a lens for examining the evolution of the environmental movement and its status today. Sabin considers the successes and failures of the movement and the challenges of having nuanced public policy discussions on issues where both sides have passionate opinions.

A direct link to the audio is here.

Sunday 9 February 2014

Relational contracts and the decline of General Motors

In many cases, it is difficult, if not impossible, to write complete state-contingent contracts. In such circumstances, people will often rely on ‘informal agreements sustained by the value of future relationships’, that is, relational contracts. The underlying idea in the relational contract theory of the firm is that there are differences in the way relational contracts function between firms (outscoring) and within firms (an employment agreement).

Baker et al. (BGM, 2002) make this point that relational contracts occur both within and between firms and argue that the difference between them lies in what happens if the relational contract breaks down. An independent contractor can leave the relationship and take the assets belonging to it with him. This an employee cannot do. In BGM, an independent contractor can, if he wants, sell the finished product elsewhere while an employee does not own the finished product and thus cannot leave the relationship with the asset or the product. The strength of the threat to discontinue the relationship determines the implementability of relational contracts. As an example consider the situation where the market for the good is highly volatile. In this case, a relational contract may be unworkable since the supplier has an incentive to violate the relational contract when the market price is high. If the supplier is part of the firm, such an option does not exist and the relational contract that holds the internal transfer ‘price’ constant may be self-enforcing. The relational contracting theory can be seen as being related to Williamson’s idea that the resolution of disputes is more easily achieved within firms them between firms in the sense that mechanisms for dispute resolution can be seen as a feature of a system of self-enforcing relational contracting within the firm.
That's me discussing the application of relational contracts to the theory of the firm. Over at the Organizations and Markets blog Nicolai Foss highlights an application of relational contracts to the decline of General Motors over the last 30 years. Foss comments on a recent NBER paper by Susan Helper and Rebecca M. Henderson on Relational Contracts and the Decline of General Motors. Foss writes,
In a new NBER paper, “Management Practices, Relational Contracts, and the Decline of General Motors“, Susan Helper and Rebecca Henderson argue, however, that GM and Toyota are directly comparable in terms of the relational contracts existing inside their corporate hieararchies and across the boundaries of these two companies, and that their differential performance is explainable in terms of the differences between the contracts. Relying on recent contract theory research on relational contracts (rather than the older, but neglected work of Harvey Leibenstein), Helper and Henderson reject a number of conventional explanations (e.g., that GM’s investment policy was oriented towards the short term), and convincingly argue that GM had difficulties understanding the nature and important role of relational contracts behind Toyota’s success and therefores truggled to implement similar relational contracts. They point to a number of reasons why relational contracts may be difficult to build, centering on problems of creating credible commitments and communicating clearly and suggest that these problems were rampant in GM. In all, a very nice read that can be used in a number of different classes (org theory, economics of the firm, strategic management). Highly recommended!
The abstract of the paper reads,
General Motors was once regarded as one of the best managed and most successful firms in the world, but between 1980 and 2009 its share of the US market fell from 62.6 to 19.8 percent, and in 2009 the firm went bankrupt. In this paper we argue that the conventional explanation for this decline – namely high legacy labor and health care costs – is seriously incomplete, and that GM’s share collapsed for many of the same reasons that many of the other highly successful American firms of the 50s, 60s and 70s were forced from the market, including a failure to understand the nature of the competition they faced and an inability to respond effectively once they did. We focus particularly on the problems GM encountered in developing the relational contracts essential to modern design and manufacturing. We discuss a number of possible causes for these difficulties: including GM’s historical practice of treating both its suppliers and its blue collar workforce as homogeneous, interchangeable entities, and its view that expertise could be partitioned so that there was minimal overlap of knowledge amongst functions or levels in the organizational hierarchy and decisions could be made using well-defined financial criteria. We suggest that this dynamic may have important implications for our understanding of the role of management in the modern, knowledge based firm, and for the potential revival of manufacturing in the United States.

Saturday 8 February 2014

Politically acceptable debt restructuring in the Eurozone

In this audio from Charles Wyplosz talks to Viv Davies about the recent Special Geneva Report, ‘The PADRE Plan: politically acceptable debt restructuring in the Eurozone’, co-authored with Pierre Pâris and published jointly by CEPR and ICMB. Wyplosz explains how debt restructuring can be managed in a safe way, why it would not have an inflationary effect and how moral hazard could be mitigated, if not eliminated.

A direct link to the audio.

See also: Pâris, P and C Wyplosz (2014), PADRE: Politically Acceptable Debt Restructuring in the Eurozone, 28 January.

Friday 7 February 2014

Transaction costs 2

Peter Klein over at the Organisations and Markets blog asks What Are “Transaction Costs” Anyway? He writes,
A friend complains that management and entrepreneurship scholarship is confused about the concept of transaction costs. Authors rarely give explicit definitions. They conflate search costs, bargaining costs, measurement costs, agency costs, enforcement costs, etc. No one distinguishes between Coase’s, Williamson’s, and North’s formulations. “Transaction costs seem to be whatever the author wants them to be to justify the argument.”

It’s a fair point, and it applies to economics (and other social sciences and professional fields) too. I remember being asked by a prominent economist, back when I was a PhD student writing under Williamson, why transaction costs “don’t simply go to zero in the long run.” Indeed, contemporary organizational economics mostly uses terms like “contracting costs,” and since 1991 Williamson has tended to use “maladaptation costs” (while retaining the term “transaction cost economics”).
Klein also usefully points us to two articles on transaction costs: Doug Allen’s essay from the Encyclopedia of Law and Economics and Lee and Alexandra Benhams’ more recent survey from the Elgar Companion to Transaction Cost Economics.

But not only do we have the problems of defining transaction costs we also have to worry about, when it comes to the theory of the firm, the difference between the transaction costs, property rights and reference point models each of which claims to use some concept of "transaction costs". As I have written before:
Hart (2008, p. 406) argues that shading costs are akin to ‘haggling costs’. The modelling of haggling costs can be seen as a move towards the modelling (however imperfectly) of transaction costs. Hart and Moore (2008, pp. 4–5) argue that ‘[...] the costs of flexibility that we focus on–shading costs–can be viewed as a shorthand for other kinds of transaction costs, such as rent-seeking, influence, and haggling costs’. Exactly how similar the reference point and transaction-cost explanations are is, however, open to debate. There is also the question of the relationship between these two approaches to the firm and the property rights approach.

In a discussion of the differences between the Grossman-Hart-Moore (GHM) theory of the firm and the transaction-cost approach, Williamson (2000, pp. 605–606) argues that the most important difference between them is that GHM introduce inefficiencies at the ex ante investment stage while the transaction-cost approach emphasises that ex post haggling and maladaptation drive inefficiencies. There are no ex post inefficiencies in GHM due to their assumption of common knowledge and ex post costless bargaining. Gibbons (2010, p. 283) explains it this way:
'[t]he model in question is Grossman and Hart’s (1986), which explores an alternative to Williamson’s (2000, p. 605) emphasis that “maladaptation in the contract execution interval is the principal source of inefficiency.” Instead, in the Grossman-Hart model, there is zero maladaptation in the contract execution interval, and the sole inefficiency is in endogenous specific investments.

It is striking how different the logic of inefficient investment can be from the logic of inefficient haggling. In their pure forms envisioned here, the two can be seen as complements. For example, the lock-in necessary for Williamson’s focus on inefficient haggling could result from contractible-specific investments chosen at efficient levels. But by assuming efficient bargaining and hence zero maladaptation in the contract execution interval, Grossman and Hart focused attention on non-contractible specific investments and hence discovered an important new determinant of the make-or-buy decision: in the Grossman-Hart model, an important benefit of non-integration is that both parties have incentives to invest; in Williamson’s argument, an important cost of non-integration is inefficient haggling. In short, the two theories are simply different’.
This emphasis on ex post haggling and maladaptation can be interpreted as reflecting a view that internal organisation is better at reconciling the conflicting interest of the parties to a transaction and facilitating adaptation to changing supply and demand conditions when such cost are high. The reference point approach can be seen as a movement away from the ex ante GHM approach and back towards transaction cost thinking in so much as contracting is not perfectly contractible ex post. This fact, as Hart (2008, p. 294) points out ‘[...] is a significant departure from the standard contracting literature. The literature usually assumes that trade is perfectly enforceable ex post (for example by a court of law). Here we are assuming that only perfunctory performance can be enforced: consummate performance is always discretionary’, and thus inefficiencies can arise ex post. The development of a tractable model of contracts and organisational form that exhibits ex post inefficiency is one of motivations for advancing the reference point approach in the first place. (Hart and Moore, 2008, p. 4). Hart’s interpretation of the reference point theory is ‘[i]n a sense, this work can be viewed as a “merger” of the transaction cost and property rights literatures’. (Hart, 2011b, p. 106).

Also the reference point approach differs from the property rights theory in that it does not require an assumption of the use of relationship-specific investments as is standard in the property rights theory. Relationship-specific investments can be introduced to the reference point theory, Hart (2011a) is an example where this is done, but, in general, the reference point theory does not rely on such investment.

The reference point approach also highlights the importance of Williamson’s notion of the ‘fundamental transformation’. Hart and Moore argue that the move from an ex ante competitive market to an ex post bilateral setting – what Williamson (1985, pp. 61–63) terms the fundamental transformation – provides a rationale for the idea that contracts are reference points. ‘A competitive ex ante market adds objectivity to the terms of the contract because the market defines what each party brings to the relationship. HM assume that the parties perceive a competitive outcome as justified and accept it as a salient reference point’. (Fehr et al., 2009, p. 562). This is an idea which finds experimental support: see Fehr et al. (2009), Fehr et al. (2011) and Hoppe and Schmitz (2011).

But we must also be aware that important features of the transaction-cost theory may still have been left out. How fully shading costs capture the costs of ex post maladaptation and haggling is an open question. When discussing some opportunities for the future of transaction-cost economics, Robert Gibbons (2010, p. 283) notes that ‘[...] it may be that Hart and Moore’s (2008) “reference points” approach is a productive path. Time will tell [...]’. Hart (2011b, p. 106) concludes ‘[w]hether this merger [resulting in the reference point theory] will be successful remains to be seen’.

A conversation with Israel Kirzner

Israel Kirzner, now Professor Emeritus at NYU, is among the foremost scholars in the continuing development of the Austrian school of economic theory. He has extended our understanding of the workings of a free society, illuminated the role of entrepreneurs in the process of economic discovery, and shed new light on the dynamics of market forces. In this interview, recorded in 2000, Kirzner explores these differences, as well as his experiences as student of Ludwig von Mises, his interaction with other Austrian greats such as Friedrich Hayek, and his career as a professor at New York University. He displays his keen understanding of the differences between the Austrian school and neo-classical economics, and how Austrian economics affords new and exciting avenues for future work.

More information is available at Newmedia at

John Roemer on workable socialism

John E. Roemer recently published a paper in Analyse & Kritik on "Thoughts on Arrangements of Property Rights in Productive Assets". The abstract reads,
State ownership, worker ownership, and household ownership are the three main forms in which productive assets (firms) can be held. I argue that worker ownership is not wise in economies with high capital-labor ratios, for it forces the worker to concentrate all her assets in one firm. I review the coupon economy that I proposed in 1994, and express reservations that it could work: greedy people would be able to circumvent its purpose of preventing the concentration of corporate wealth. Although extremely high corporate salaries are the norm today, I argue these are competitive and market determined, a consequence of the gargantuan size of firms. It would, however, be possible to tax such salaries at high rates, because the labor?supply response would be small. The social-democratic model remains the best one, to date, for producing a relatively egalitarian outcome, and it relies on solidarity, redistribution, and private ownership of firms. Whether a solidaristic social ethos can develop without a conflagration, such as the second world war, which not only united populations in the war effort, but also wiped out substantial middle-class wealth in Europe?thus engendering the post-war movement towards social insurance?is an open question.
Peter Boettke at the Coordination Problem blog makes a good point about Roemer's paper,
Roemer seems to be suggesting that if the population could coordinate around a solidaristic social ethos, then the social-democratic model, perhaps even the market socialist model, might be workable. I have always found these arguments weak whether they are made by libertarians, conservatives, progressives, or socialist. It amounts to arguing that the entire system turns of the moral character of the individuals who populate the system. If everyone was a libertarian (socialist), then we could have a libertarian (socialist) world. But think about that for a second, the more everyone coordinates around the norm, the greater the potential scope for gain by opportunistically violating that norm.
Roemer's argument  looks like a version of the idea that "the world would be perfect if only we could make people perfect", which may be true but I don't like your chances of making people perfect.

Boettke continues,
So rather than rely on moral character to make the argument work, I have always been more attracted to instituitonal solutions that do not require for their working improved moral character let alone a fundamental change in human nature. Instutitional problems demand institutional solutions. Human beings do have the Smithian propensity to truck, barter and exchange, as well as Smithian sentiments about others --- that is our better nature --- but human beings are also haunted by the Hobbesian propensity to rape, pillage and plunder, and sentiments such as envy, jealousy, resentment, and loathing of the other. Which propensity manifests itself is a function of institutional environment in which we interact with each other and with nature. The logic of the situation rules, not a sense of solidarity. Solidarity, instead, is a by-product of institutions. So back to the test --- is a proposed system coherent -- are the means chosen consistent with the ends sought? --- and is a proposed system vulneralbe --- can opportunistic actors disrupt the ability of the system to achieve its goals?
One of the great things about competitive markets is that they harness the Hobbesian propensities and often create social good out of them, As Keynes noted,
It is better that a man should tyrannize over his bank balance than over his fellow-citizens and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative.

Thursday 6 February 2014

The effect of minimum wages on employment

Recently Eric Crampton at Offsetting Behaviour wrote,
I suppose it's also relevant that Obama wants a substantial hike to the US minimum wage. A dark side of me wants him to do it, just so we can get some clean estimates of just how bad the disemployment effects would be.
Some people would claim that the disemployment effects would be zero or even that the effects on employment would be positive. But economists, by and large, go for there being a disemployment effect of minimum wage increases. Wilson (2012) summaries economists thinking on this as,
The main finding of economic theory and empirical research over the past 70 years is that minimum wage increases tend to reduce employment. The higher the minimum wage relative to competitive-market wage levels, the greater the employment loss that occurs. While minimum wages ostensibly aim to improve the economic well-being of the working poor, the disemployment effects of a minimum wages have been found to fall disproportionately on the least skilled and on the most disadvantaged individuals, including the disabled, youth, lower-skilled workers, immigrants, and ethnic minorities.
In 2006 David Neumark and William Wascher published a comprehensive review of more than 100 minimum wage studies published since the 1990s. They found a wider range of estimates of the effects of the minimum wage on employment than the 1982 review by Brown, Gilroy, and Kohen. The 2006 review found that “although the wide range of estimates is striking, the oft-stated assertion that the new minimum wage research fails to support the traditional view that the minimum wage reduces the employment oflow-wage workers is clearly incorrect. Indeed . . . the preponderance of the evidence points to disemployment effects.”

Nearly two-thirds of the studies reviewed by Neumark and Wascher found a relatively consistent indication of negative employment effects of minimum wages, while only eight gave a relatively consistent indication of positive employment effects. Moreover, 85 percent of the most credible studies point to negative employment effects, and the studies that focused on the least-skilled groups most likely to be adversely affected by minimum wages, the evidence for disemployment effects were especially strong. In contrast, there are very few, if any, studies that provide convincing evidence of positive employment effects of minimum wages. These few studies often use a monopsony model to explain these positive effects. But as noted, most economists think such positive effects are special cases and not generally applicable because few low-wage employers are big enough to face an upward-sloping labor supply curve as the monopsony model assumes.

  • Wilson, Mark (2012). "The Negative Effects of Minimum Wage Laws" Policy Analysis, June 21, No. 701, Cato Institute.

Wednesday 5 February 2014

Interesting blog bits

A little midweek relaxing local reading:
  1. Bill Kaye-Blake on Summary theories of the firm
    I can't recommend this posting too highly ...!!!!
  2. Eric Crampton on Lockean Parking
    In the Lockean framework, private property can be appropriated from the commons through the mixing of labour. If you mix your labour with the untilled soil, leaving as much and as good yet for others to till, then that tilled soil is yours. You have homesteaded it.
  3. Matt Nolan on ICT, factor shares, employment, and inequality
    Matt is am going to take you on a journey of a series of fortunate events, and at the end hopefully he has a point!
  4. Donal Curtin asks Why are we where we are on this league table?
    League tables are always fascinating, and I came across a rather suggestive one in the January 11 issue of the Economist, in an article, 'Setting out the store', which was making the case for governments to sell off more of their assets.
  5. Not PC on "Trickle Down"
    "Trickle down" does exist. It emanates from government.
  6. Brennan McDonald on University As Consumption Good
    The literature generally looks at university as an investment. You incur costs – foregone wages, tuition, lower income etc. for a few years in the hope of earning a higher labour market income after graduation but it's hard to classify university as an investment if almost everyone is treating it like a consumption good.

Transaction costs

Per Bylund on twitter:
A good question which has be recognised for many years. As Coase himself has written,
Williamson agrees with what he terms my "grim assessment" of the position in 1970. However, he ascribes the non-use of my thesis, so often acclaimed as a "fundamental insight," to the fact that it has not been made "operational." As he said in 1975: "Transaction costs are appropriately made the centerpiece of the analysis but these are not operationalized in a fashion which permits one to assess the efficacy of completing transactions as between firms and markets in a systematic way." Williamson has reaffirmed this view in 1985 and 1986. I think it is largely correct.
The term is used too widely and can mean almost anything these days. When referring to what are now called "transaction costs" Coase was referring to the costs of using the market but today we see comments about transaction costs within firms! On this basis the boundaries of a firm are where transaction costs equal transaction costs.

Age and scientific genius

Just to make those in "middle age" feel better, entrepreneurial creativity may peak at middle age rather than in early age. It is commonly argued that successful technology companies are founded by people in their 20s, but are people really more creative early on?

A new NBER working paper by Benjamin Jones, E.J. Reedy, and Bruce Weinberg looks at the relationship between age and scientific creativity. The paper discusses the widely accepted empirical finding that scientific creativity — measured by high-profile scientific contributions such as Nobel Prizes — tends to peak in middle age. They also review more recent research on variation in creativity life cycles across fields and over time. Jones, for example, has observed that the median age of Nobel laureates has increased over the 20th century, which he attributes to the rapid growth in the body of accumulated knowledge one must master before making a breakthrough scientific contribution (the “burden of knowledge” thesis).

So "old" doesn't mean non-creative.

Age and Scientific Genius
Benjamin Jones, E.J. Reedy, Bruce A. Weinberg
NBER Working Paper No. 19866
Issued in January 2014
NBER Program(s): LS
Great scientific output typically peaks in middle age. A classic literature has emphasized comparisons across fields in the age of peak performance. More recent work highlights large underlying variation in age and creativity patterns, where the average age of great scientific contributions has risen substantially since the early 20th Century and some scientists make pioneering contributions much earlier or later in their life-cycle than others. We review these literatures and show how the nexus between age and great scientific insight can inform the nature of creativity, the mechanisms of scientific progress, and the design of institutions that support scientists, while providing further insights about the implications of aging populations, education policies, and economic growth.
(HT: Organizations and Markets.)

Tuesday 4 February 2014

A conversation with Ronald Coase

Ronald Coase (1910-2013), the greatest economist of the 20th century, is interviewed by legal scholar Richard A. Epstein. In the course of the 2001 interview a broad number of subjects are discussed, involving the intellectual activities Coase carried out, ranging from his interest in economics and law, his transition from socialism up to the various publications and theories laid out by him. The discussion includes discourse on the hows and whys of Coase's analyses, providing insights on topics like business firms, transaction costs, externalities and durable goods. We also learn what lead Coase to write articles such as "The Nature of the Firm", "Durability and Monopoly", "The Lighthouse in Economics" as well as "The Problem of Social Cost", which was considered to be the basis of what is known as the Coase theorem.

More information is available at Newmedia at

A conversation with Armen A. Alchian

Recognized as one of the most influential voices in the areas of market structure, the theory of the firm, law and economics, resource unemployment, and monetary theory and policy, in this 2001 interview, Armen Alchian (1914-2013) outlines the "UCLA tradition" of economics which he founded and explores the many unanticipated consequences of self-seeking individual behaviour.

Additional materials are available at Newmedia at

EconTalk this week

Erik Brynjolfsson of MIT and co-author of The Second Machine Age talks with EconTalk host Russ Roberts about the ideas in the book, co-authored with Andrew McAfee. He argues we are entering a new age of economic activity dominated by smart machines and computers. Neither dystopian or utopian, Brynjolfsson sees this new age as one of possibility and challenge. He is optimistic that with the right choices and policy responses, the future will have much to celebrate.

Direct link to audio.

Monday 3 February 2014

The Big Mac Index

The 2014 Big Mac Index is available from the Economist magazine.
THE Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries. For example, the average price of a Big Mac in America in January 2014 was $4.62; in China it was only $2.74 at market exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 41% at that time.

According to the Big Mac Index the New Zealand dollar is about right
New Zealand January 2014 Price: $4.57 (NZ$5.50)
Raw index: undervalued by 1.1%
Actual exchange rate: 1.20
Implied exchange rate: 1.19 (Local price divided by dollar price)

So people should stop complaining about the "too high" exchange rate.

Sunday 2 February 2014

But why does inequality matter? 2 (updated)

Brennan McDonald offers an answer to the question from my previous blog posting here. Brennan writes
  • Inequality is on the agenda because the media are writing about it
  • The media are writing about it because envy is as old as the hills and journalists earn rubbish wages so anyone on a higher income is a fair target for them
  • Most journalists’ eyes glaze over when they see numbers so clear discussion is not possible
  • So despite a lot of evidence to suggest that maybe income and wealth inequality in New Zealand isn’t as bad as it’s made out to be, that conclusion doesn’t get page views so emotive language rules how the discussion is framed
I fear that to a large degree he is right, but this just moves the problem back one stage, Why are the media talking about it? A some point I assume its because they think something bad is caused by inequality so I ask what is the something and what is the evidence that inequality caused that something?

Also I would like to think well of my fellow economists so I hope they have a better reason for worrying about inequality than envy and that their eyes don't glaze over at the sight of numbers and thus they can undertake a clear and rational discussion of the topic. Starting with why they are concerned with the topic at all.

Update: Matt Nolan writes Are we all confusing status competition and ‘inequality’: Short answer, yes

But why does inequality matter?

There seems to be lots of talk on the blogs these days about inequality (e.g. here, here and here), but no one bothers to explain why we should care about it, it just seems to be taken as a given that we should care. Over at the The Fly Bottle blog Will Wilkinson writes,
I’m tired of arguing about inequality. It’s frustrating. It’s unproductive. Nobody is really interested in the analytical arbitrariness and moral insidiousness of measuring intra-national economic inequality. Nobody is really interested in the fact that multiple mechanisms–some good, same bad, some neutral–can produce the same level of measured inequality, rendering the level of inequality, taken in isolation, completely useless as a barometer of social or economic justice. Nobody really cares. Because many different combinations of causes can produce the same level of inequality, it’s not so clear that high inequality, as such, can reliably cause anything. The consequences of inequality depend on the mechanisms driving inequality. Nobody cares.
To Will I say, some people seems to care, at least people writing New Zealand based economics blogs seem to care, but they don't tells us why. The highlighted bits in the Wilkinson quote seems to me to make a couple nice points in that it seems to me that inequality is a useless measure of anything that matters and its not clear, to me at least, what exactly inequality causes.

So will those bloggers among you who are so fired up about the evils of inequality please explain why you are so agitated about it.