Love it or hate it... the dollar's here to stay

In this audio from VoxEU.org Eswar Prasad talks to Viv Davies about Prasad's recent book, ‘The Dollar Trap: How the US dollar tightened its grip on global finance’, which examines how, paradoxically, in light of the financial crisis, the dollar continues to play a central role in the world economy and why it will remain the cornertsone of global finance for the forseeable future. They also discuss the current frameworks for international economic cooperation as well as currency wars, unconventional monetary policy and the prospects for the renminbi becoming the world's reserve currency.

A direct link to the audio is available here.

A revised version of a paper

you really want to read.

Yes you do!!!

Simple models of a human-capital based firm: a reference point approach by Paul Walker

The economics of the America's Cup - did we lose or win?

A question I'm very pleased to see Sam Richardson asking. As I'm sure most of you will have heard by now the Minister for Economic Development has been going round saying that the taxpayer money that went into the America's Cup campaign was money well spent. I wonder if he has asked any taxpayers about that?

Well now Sam Richardson of the econ department at Massey, likely the best guy in the country to do this, has given the Market Economics Limited report, written for MED,  the once over. Richardson writes,

The Government's share of the total Team NZ revenues of approximately $180m was 20 percent (it was capped at $36 million), with 66 percent coming from overseas. The report found that the total outcome of $87 million to the New Zealand economy would not have occurred without the Government's involvement.

and he continues,

I'm not going to question the final point - it isn't unreasonable to assume that the Government's contribution was pivotal to the challenge - but then, one could also argue that it wouldn't have happened without the overseas or private domestic funding either. That being said, however, there are two aspects of this report that do require challenging.

Getting down to business Richardson writes,

First, attributing the entire economic impact of a project to a 20 percent contribution is something I (and many others) have a real problem with. You could just as easily credit the economic impact figure of $87 million to the overseas funding (and you could do so with confidence, as it is 'new money' and thus more likely to be beneficial to the New Zealand economy) more than the Government's investment. Still, it is not an easy issue to resolve. It's not as easy as saying that because the Government contributed 20 percent means it should be 'credited' with 20% of the economic impact. The combination of public and private funding makes attributing the economic impact to one or the other parts problematic. A more accurate statement would be that the entire project (regardless of where the money came from) generated $87 million in impacts. After all, the tax revenues generated by Team New Zealand were between $38 and $40 million.

The second issue is the absence of opportunity costs of public funding in the report, which would help us to determine to what extent the $87 million impact be considered an economic benefit, and therefore money well spent. If there was no Team New Zealand, would nothing have happened? Of course not - life (and the economy) would have continued to tick away as per usual. $36 million of taxpayers money went into this campaign. Public funding has alternative uses, which should at the very least be considered as part of an objective analysis. If there was no Team New Zealand, what would have happened to the $36 million in taxpayer funding that was invested there? Chances are it would have gone to some other worthy recipient, for example the health sector or the education sector. In order to determine whether the $36 million spent on the America's Cup was money well spent, we need to know what $36 million would do when put to an alternative use. If the $36 million for Team New Zealand returned a higher impact than, say, paying each and every New Zealander $8 as compensation for there being no Team New Zealand, then it might have been money well spent. Determining what the appropriate alternative use for $36 million is the subject of debate - and my example above is very much tongue in cheek - but one thing is for sure: it is certainly not nothing. $87 million is the economic impact with no alternative use of public (and other) funds. Is it realistic to attribute this as a benefit?

That all costs are opportunity costs is stage one stuff, all economists know this. So not considering opportunity costs and comparing the campaign outcome with alternative uses of the money is big miss and I find myself wonder why the report did it. Or is it the only way they could put a positive spin on the campaign?

Just asking.

Football as a workers cooperative - or lack thereof 2

In a response to my previous post on Football as a workers cooperative - or lack thereof the always interesting Tim Worstall says, at The Pin Factory blog, But football clubs are already effectively owned by the players. Tim writes,

Football does, as we know, come in a number of different forms and codes. It also comes in a number of different organisational forms. The way that leagues are formed, franchises handed out, how teams are promoted and or relegated. And the effect, at least as I see it, is that large numbers of clubs that are supposedly capitalist in their form are in fact workers' cooperatives. Which makes an argument about why there aren't such workers' cooperatives a touch difficult: for I'm asserting that there are.

and

So far I agree except for the one point: that I think most clubs, European ones at least, are, in effect, workers' cooperatives. I agree entirely that in legal form they are not. There's a few fan cooperatives but no workers' ones. But pure legal form isn't quite, to my mind, the total definition. Of importance is to look at the flows of money. If the money flows as if an organisation were indeed a workers' cooperative then I'd be inclined to call it one even if the legal form wasn't so. And even a brief look at football club accounts shows that almost all of them make a loss almost all of the time. That's certainly not what we would imagine to be a defining feature of a seris of capitalist organisations. Further, the money all ends up in the pockets of the players.

Now why do I disagree with Tim? Why do I say there are no worker cooperatives in sport? The short answer I think is the definition of "ownership". For ownership you don't follow the money. The basic definition of ownership I'm using is that of Grossman and Hart ("The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration", Journal of Political Economy, 94: 691-719) who define the owner of an asset as the person who has residual rights of control over the asset; that is whoever can determine what is done with the asset, how it is used, by whom it is used, when they can use it etc - note that ownership is not defined in terms of income rights. Note, for completeness, that the legal scholar Oliver Wendell Holmes Jr. states that the rights of ownership are

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

What is important for our purposes is that ownership is not defined with regard to income.

To see why income is not a feature of the definition of ownership ask yourself what would happen if I have the control rights over a piece of land which is currently being used to grow politicians. The profits from the sale of politicians, say $1000 per year, goes to Tim. He has the income rights. Now let us assume that Eric Crampton, the smart lad that he is, has worked out that as cabbages are smarter than politicians they are worth more. So profitable are cabbages that Eric would be willing to rent the land for $1200 per year. Eric makes this offer to Tim who thinks its great but can not doing anything about it because he does not have control right over the land. (One such right is the right to rent out the land.) I on the other hand can agree to the rental deal as I have the control rights over the land. I get to make the decision as I am the owner. As an aside note that this example shows why ownership and income rights normally go together: income rights give you the incentive to do things, control rights give you the ability to do things. For efficiency reasons you normally want both of these rights to be held together.

Another way to see why economists define ownership in terms of control right is to consider the fact shareholders of a firm have both control rights and income rights. Income rights meaning they get a part of the firm's profits. Now consider a manager at the firm who is on an incentive contract which says he will receive a (small) part of the firm's profits so that his interests are aligned with the shareholders. Both the shareholders and the manger have income rights (claims to part of the firm's profits) but only the shareholders are considered owners. This is because they hold the control rights.

Also in a workers cooperative payments to workers are normally roughly the same. Some worker cooperatives do require all staff to be paid the same wages while others have a limit on the range of pay offered. Such a limit is normally expressed as a ratio of the highest paid worker to the lowest paid, e.g. 3:1 or 4.5:1 or some such ratio. Also an owner's allocation of the "profits" of the firm will be proportionate to that owner's labour input, so for similar labour inputs, owners receive a similar allocation of "profits". Thus overall compensation is commonly roughly equal. Ricketts (1999: 20) explains the situation as ``[f]urther, to minimise antagonism a rough equality in the division of the residual will be necessary and this may conflict with outside opportunities. Those with high transfer earnings reflecting high productivity elsewhere will desert the co-operative. It is for these reasons that control of the firm by its labour force is usually found in circumstances which permit a high degree of common interest." Jossa (2009: 709-10) explains the basic issue in terms of the management of capitalistic versus co-operative firms: ``[g]iven the tendency of cooperatives to distribute their income equitably among all the members, it is difficult to deny that few cooperatives are in a position to pay the high salaries that able managers can expect to earn in capitalistic firms. Whenever a group of people resolve to work as a team-we may add-the member who outperforms the others in initiative and organizational skills will inevitably take the lead. The crux of the matter is that such a person has no incentive to establish a cooperative and share power and earnings with others. He or she will prefer to found a capitalistic firm, where he or she will hold all authority and, if sole owner, appropriate the whole of the surplus [references deleted]"

Clearly equal payment is not the case for football clubs. Some players earn a lot more than others. Given heterogeneity among playing talent there is large variation in earning potential. This acts as a disincentive to the formation of a worker cooperative, with its equality of payment, since those players with the greatest earning potential, the largest outside options, will transfer away from the cooperative to maximise their income stream. Differential payment schemes can occur, especially within partnerships, but they require that the individual employee productivities are sufficiently easy to measure so that a relatively objective method of productivity related pay is possible. Given the team production nature of team sports productivities are difficult, if not impossible, to estimate and thus payment by productivity is not feasible, which argues in favour of equality in payments. Thus a worker-owned team would have few, if any, star players, a handicap in the winner-takes-all world of professional sports.

The question of ownership comes down to who has the control rights and the "who" isn't the players. The money may end up in the pockets of the players but that just makes them very well paid employees, not owners. They don't have the control rights.

Note that if by capitalist Tim means profit making, I make no such assumptions. The owners of the clubs may be trying to maximise profits, or they may be trying to maximise their utility. For my argument it doesn't matter.

Are business schools to blame?

This video is of a presentation by Professor Peter G. Klein at the Mises Circle in Newport Beach, California in November 2009 on "Are Business Schools to Blame?" for the financial crisis.

Football as a workers cooperative - or lack thereof

Everyones third favourite Marxist, Chris Dillow, wants to discuss Football as Financial Economics while the not-so-Marxist Jim Rose asks Why are there so few workers co-ops? Is there a connection here?

For me, yes. Right now I should be working on a revise and resubmit on a paper in which, in its conclusion, I argue why there are no worker cooperatives in football and in fact in professional sport more generally. So for me its "Football as a workers cooperative - or lack thereof".

As Chris highlights football is a great subject for the application of economics, even the theory of the firm. When considering a football team we have a situation where human capital, talent at playing football, is the basis for the "firm" which we may think would favour ownership by the workers. When human capital is the major input into production ownership by, at least some of the workers, is common, e.g. partnerships in law and accounting etc. This was also true of pirates! The interesting thing for professional sports is that ownership by the human capital, i.e. the players, is extremely rare. This is, I would argue, because a worker-owned team would be at a disadvantage relative to a player-as-employee based team.

There are many forms of ownership of football teams, from teams having shareholders and being traded on the stock exchange, to teams being owned by an individual, but one form of ownership not seen (as far as I know -a counter example would be great!) is a labour (in this case, player) owned firm.

Heterogeneity among playing talent and thus earning potential acts as a disincentive to the formation of a worker cooperative, which involves (rough) equality in payment¹, since those players with the greatest earning potential, the largest outside options, will transfer away from the cooperative to maximise their income stream.² Differential payment schemes can occur, especially within partnerships, but they require that the individual employee productivities are sufficiently easy to measure so that a relatively objective method of productivity related pay is possible. Given the team production nature of team sports productivities are difficult, if not impossible, to estimate and thus payment by productivity is not feasible, which argues in favour of equality in payments. Thus a worker-owned team would have few, if any, star players, a handicap in the winner-takes-all world of professional sports.^{3, 4}

Another issue for a cooperative sports team is that while the star players may leave the team too soon, the "average players" may stay too long. The average players will have smaller outside options and thus less incentive to leave but as they are also owners of the team it would be more difficult to get rid of those who are not performing. It would be easier for an employee-based team to remove under performing players as they are not owners of the firm.

Also to the degree that exit barriers are entry barriers a worker-owned organisation is at a disadvantage. Such an organisation could hinder rapid transfers between clubs. Problems with transfers could arise, for example, if the terms of the exit have to be negotiated with the remaining player-owners at the time of exit. Or the remaining owners may be unable or unwilling to buy out the exiting player - under a "right of first refusal" or "right of first offer" scheme - or any of them could veto an incoming replacement player-owner. Also there is the question of the value of a player's interest in the team as well as the question of the time period over which an agreed upon value would be paid. These costs make exit more difficult than it would be under an employment contract and thus tend to lock-in the player/owner to the team. Such lock-in is a disincentive to forming, or joining, a labour-owned firm, especially for the best players.⁵ Many of these problems can, to a degree, be contracted around but this imposes additional negotiation costs at the time of entry into the team, which again is a disincentive to forming an worker-owned team. Utilising a worker-owned organisation results in additional haggling costs, either ex ante or ex post, relative to a player-as-employee team.

Put simply, an employee can leave a organisation more quickly and easily than an owner and in the case of professional sports, transfers between teams, or at least a credible threat to transfer, are particularly valuable to the best players. Therefore a player-owned team would be at a competitive disadvantage compared to teams comprised of employee players.

What this suggests is that a labour-owned, human-capital only, firm with heterogeneous human capital, as in the football example, is likely to be unstable and thus a long lasting human-capital only firm which is labour owned will consist of homogeneous human capital, e.g. the pirate example. Thus the "types" of human capital in a firm is an important determinant of the organisational form the firm will take. This doesn’t mean you cannot have a firm which involves heterogeneous human capital but such a firm will require some “glue”, in the form of non-human capital of some kind, to remain viable. Given the importance of this glue to the firm, ownership of the firm by the owner of the non-human capital is likely. Hart (1995: 56) notes that such non-human capital could be as simple as “[ ... ] patents, client lists, files, existing contracts or the firm's name or reputation.” Or it could be a good location for carrying out the firm's business or a contract preventing the non-owner from working for competitors, etc

So overall we get two basic organisational forms for human-capital based firms: 1) a homogenous human capital firm which could be a labour owned firm and 2) a heterogeneous human capital firm which is owned by the owner of the "glue" that keeps the human capital in place.

Notes:

(1) Some worker cooperatives do require all staff to be paid the same wages while others have a limit on the range of pay offered. Such limit is normally expressed as a ratio of the highest paid worker to the lowest paid, e.g. 3:1 or 4.5:1. Also an owner's allocation of the "profits" of the firm will be proportionate to that owner's labour input, so for similar labour inputs, owners receive a similar allocation of  "profits". Thus overall compensation is commonly roughly equal.

(2) Ricketts (1999: 20) explains the problem as ``[f]urther, to minimise antagonism a rough equality in the division of the residual will be necessary and this may conflict with outside opportunities. Those with high transfer earnings reflecting high productivity elsewhere will desert the co-operative. It is for these reasons that control of the firm by its labour force is usually found in circumstances which permit a high degree of common interest." Jossa (2009: 709-10) explains the basic issue in terms of the management of capitalistic versus co-operative firms: ``[g]iven the tendency of cooperatives to distribute their income equitably among all the members, it is difficult to deny that few cooperatives are in a position to pay the high salaries that able managers can expect to earn in capitalistic firms. Whenever a group of people resolve to work as a team-we may add-the member who outperforms the others in initiative and organizational skills will inevitably take the lead. The crux of the matter is that such a person has no incentive to establish a cooperative and share power and earnings with others. He or she will prefer to found a capitalistic firm, where he or she will hold all authority and, if sole owner, appropriate the whole of the surplus [references deleted]

(3) Scully (2008) notes that there is a relationship between a team's finances and a team's success since better financed teams can buy the best players: ``[h]ow good a professional sports team is depends, of course, on the quality of its players. Because teams compete for better players by offering higher salaries, the quality of a team depends largely on how strong it is financially. The financially stronger teams will, on average, be the better teams."

(4) One way around he problem is to pay all players the amount necessary to retain the best player. But this implies paying most players more than their productivities and has obvious implications for the teams budget constraint. This would also aggravate the problem of non-performing average players-owners not wanting to leave the team.

(5) There are also problems such as those which could arise between the manager or coach and the player/owners in their roles as players and as owners. In addition to this there is the problem that if the players provide any financial capital the team needs themselves they risk being badly underdiversified. If the team goes bankrupt they lose not only their job but also (at least part of) their savings. Given the short time span that a player is likely to be a member of the team there is the issue of the return on any capital the player has invested in the team. To ensure a suitable post playing standard of living players are likely to place an emphasis on high returns on their investments.


Refs.:

• Hart, Oliver D. (1995).  Firms, Contracts, and Financial Structure, Oxford: Oxford University Press.
• Jossa, Bruno (2009). `Alchian and Demsetz's Critique of the Cooperative Firm Thirty-Seven Years After', Metroeconomica, 60(4) November: 686-714.
• Ricketts, Martin (1999).  The Many Ways of Governance: Perspectives on the control of the firm, The Social Affairs Unit, London.
• Scully, Gerald W. (2008). `Sports'. In David R. Henderson (ed.), Concise Encyclopedia of Economics, 2nd edn., available from http://www.econlib.org/library/Enc/Sports.html

EconTalk this week

John Christy, Distinguished Professor of Atmospheric Science and Director of the Earth System Science Center at the University of Alabama in Huntsville, and Kerry Emanuel, Cecil & Ida Green Professor of Atmospheric Science, Massachusetts Institute of Technology, talk with EconTalk host Russ Roberts about climate change. Topics discussed include what we know and don't know about global warming, trends in extreme weather such as hurricanes, rising sea level, the likely change in temperature in the next hundred years. Both scientists also give their perspective on what policies might be put in place to reduce risk from climate change. This episode was recorded before a live audience at the College of Business Administration at the University of Alabama in Huntsville.

A direct link to the audio is available here.

Another example of the law of unintended consequences

One of the more obvious problems with economic regulation is the law of unintended consequences. You can end up with results that are the opposite of those intended. What happens when product liability is strengthen in a world where production is vertical and crosses jurisdictional lines? If goods are produced by an upstream national or international firm and improved or distributed by local firms downstream does a strengthening of product liability have unintended consequences on product sales and consumer safety? This question is asked in a new NBER working paper, Unintended Consequences of Products Liability: Evidence from the Pharmaceutical Market by Eric Helland, Darius Lakdawalla, Anup Malani and Seth A. Seabury. The paper's abstract reads,

In a complex economy, production is vertical and crosses jurisdictional lines. Goods are often produced by an upstream national or global firm and improved or distributed by local firms downstream. In this context, heightened products liability may have unintended consequences on product sales and consumer safety. Conventional wisdom holds that an increase in tort liability on the upstream firm will cause that firm to (weakly) increase investment in safety or disclosure. However, this may fail in the real-world, where upstream firms operate in many jurisdictions, so that the actions of a single jurisdiction may not be significant enough to influence upstream firm behavior. Even worse, if liability is shared between upstream and downstream firms, higher upstream liability may mechanically decrease liability of the downstream distributor and encourage more reckless behavior by the downstream firm. In this manner, higher upstream liability may perversely increase the sales of a risky good. We demonstrate this phenomenon in the context of the pharmaceutical market. We show that higher products liability on upstream pharmaceutical manufacturers reduces the liability faced by downstream doctors, who respond by prescribing more drugs than before.

So when liability is increased on the upstream firm we can see greater risks being taken by the downstream firm and an increase in the sales of a risky good, which it seems fair to assume is not the intended outcome of an increase in product liability.

Selling a kidney: would the option necessarily be beneficial?

This is the question asked by Timothy Taylor at this blog Conversable Economist. Important here is the claim, popular among economists, that offering people an additional option--in this case to sell a kidney--must make the people better off, because they don't need to choose the option, but if they wish to do so, they can. That is to say, the basic idea that trade is voluntary.

Taylor is responding to an argument by Simon Rippon against this idea,

[...] that when an option is available, at least some people will find themselves under social pressure to select that option, or will be held responsible for failing to choose it. "For example, imagine a cashier at a rural filling station that is potentially vulnerable to an overnight robbery. It may be better for the cashier to have no key to the safe (and to have a prominent sign displaying that information) than for the cashier to have the key which gives him the option to open it. Possession of the key would make the cashier vulnerable to threats, and the filling station worth robbing."If selling a kidney was a legal option, Rippon argues:

"This means that even if you have no possessions to sell and cannot find a job, nobody can reasonably criticise you for, say, failing to sell a kidney to pay your rent. If a free market in organs was permitted and became widespread, then it is reasonable to assume that your organs would soon enough become economic resources like any other, in the context of the market. Selling your organs would become something that is simply expected of you as and when financial need arises. ...

We should ask questions such as the following: Would those in poverty be eligible for bankruptcy protection, or for public assistance, if they have an organ that they choose not to sell? Could they be legally forced to sell an organ to pay taxes, paternity bills or rent? How would society view someone who asks for charitable assistance to meet her basic needs, if she could easily sell a healthy ‘excess’ organ to meet them? ... Wherever there is great value in not being put under social or legal pressure to sell something as a result of economic forces, we should think carefully about whether it is right to permit a market and to thereby impose the option on everyone to sell it."

These are interesting arguments but do they not apply to any number of things we already allow to be traded, eg in the US blood, tissues, sperm and eggs? Do these bad things happen in these other markets? If not, why are kidneys different? If so how are they dealt with in these other markets? Surely the question is one of balancing the costs and benefits of allowing trade, not just pointing to a few possible bad outcomes and banning trade on that basis.

Taylor makes two points in the conclusion to his post,

First, at present, the main source of kidney donations is people who die unexpectedly, with a few voluntary donors. In the meantime, thousands of Americans die every year awaiting a kidney transplant. I can easily imagine that a substantial group of healthy people might not be willing to donate a kidney for free, but would be willing to do so for substantial compensation, and encouraging transplants from healthy donors could save thousands of lives. Second, it troubles me that we often expect the donors of kidneys and blood to act out of sheer altruism, but we have no such expectation of any of the other participants in an organ transplant, like the health care providers or the hospital.

The puzzling pervasiveness of dysfunctional banking

In this interesting audio from VoxEU.org Charles Calomiris talks to Romesh Vaitilingam about Calomiris's recent book, co-authored with Stephen Haber, ‘Fragile by Design: The Political Origins of Banking Crises and Scarce Credit’. They discuss how politics inevitably intrudes into bank regulation and why banking systems are unstable in some countries but not in others. Calomiris also presents his analysis of the political and banking history of the UK and how the well-being of banking systems depends on complex bargains and coalitions between politicians, bankers and other stakeholders.

Open in a pop-up window.

It appears Alfred Marshall is not guilty after all

One of the strangest things about basic microeconomics is that we write demand curves in the form,
q=D(p) that is, quantity demanded is a function of price,

but we draw them in the form,

The diagram is wrong, as any mathematician will tell you, since given the way the function is written, quantity demanded should be on the vertical axis.

This oddity I always thought was due to Alfred Marshall, which I found a bit odd since Marshall was trained as a mathematician and thus would know perfectly well how to graph a function.

But now I have, belatedly, discovered that Marshall may not be to blame for starting this habit of drawing after all.

In an essay "The influence of German economics on the work of Menger and Marshall" Eric W. Streissler writes,

The "peculiar curve" is Rau's demand curve, which is published in his later (not earlier) editions-to be more precise, from the fourth edition of 1841 onwards. Cournot has presented the first demand curve in the history of economics in 1838; Rau's was the second, only three years later. But Cournot posits his curve without explanation, i.e., quasi-axiomatically, Rau presents a derivation of it, the typical German derivation: individuals differ in their preferences or, more precisely, in their willingness and ability to pay. (His curve assumes each individual buying one unit of a commodity, the typical case for reservation analysis and thus for "price bounds.") But what is more interesting in relation to Marshall: Rau's demand curve alone is drawn exactly like Marshall's, with price on the vertical axis; Cournot's (or Mangoldt's) demand curves are drawn the other way round with prices measured horizontally.(Emphasis added)

The Rau mentioned is Karl Heinrich Rau and the book is Grundsatze der Volkswirthschaftslehre, 1st ed. 1826, 4th ed. 1841.

Ref.:

• Streissler, Eric W. (1990). 'The influence of German economics on the work of Menger and Marshall'. In Bruce J. Caldwell (ed.), Carl Menger and his legacy in economics, Durham: Duke University Press.

Benjamin Powell book panel: Out of Poverty: Sweatshops in the Global Economy

The video below is of a panel discussion hosted by the F. A. Hayek Program for Advanced Study in Philosophy, Politics and Economics at the Mercatus Center on Benjamin Powell's new book, Out of Poverty: Sweatshops in the Global Economy. The panel is made up of its chair, Peter Boettke, and commenters, Matthew Yglesias and Megan McArdle.

Powell's book provides a defence of third-world sweatshops. It explains how these sweatshops provide the best available opportunity to workers and how they play an important role in the process of development that eventually leads to better wages and working conditions.


A direct link to the video is available here.

EconTalk this week

Jeffrey Sachs of Columbia University and the Millennium Villages Project talks with EconTalk host about poverty in Africa and the efforts of the Millennium Villages Project to fight hunger, disease, and illiteracy. The project tries to achieve the Millennium Development Goals in a set of poor African villages using an integrated strategy fighting hunger, poverty, and disease. In this lively conversation, Sachs argues that this approach has achieved great success so far and responds to criticisms from development economists and Nina Munk in her recent EconTalk interview.

Suicide and property rights in India

There is an interesting but troubling result in a new NBER working paper on Suicide and Property Rights in India by Siwan Anderson and Garance Genicot. The abstract reads,

This paper studies the impact of female property rights on male and female suicide rates in India. Using state level variation in legal changes to women's property rights, we show that better property rights for women are associated with a decrease in the difference between female and male suicide rates, but an increase in both male and female suicides. We conjecture that increasing female property rights increased conflict within household and this increased conflict resulted in more suicides among both men and women in India. Using individual level data on domestic violence we find evidence that increased property rights for women did increase the incidence of wife beating in India. A model of intra-household bargaining with asymmetric information and costly conflict is consistent with these findings.

Increasing property rights for women is a good thing but increasing the suicide rate for both men and women is the bad thing. An increase in domestic violence is also, clearly, a bad thing. How to deal with the trade-offs here is not obvious. As Anderson and Genicot write,

To be sure, this paper is not suggesting that improving female property rights is undesirable. Until recently, women have been excluded from land rights in many societies and their ability to inherit property has largely been restricted. A growing body of empirical evidence shows that improving women’s asset ownership, relative income, or ability to control land impacts the intra-household allocation of resources towards children (among others Lundberg et al. 1997, Duflo and Udry 2004, Bobonis 2009). That improvements in women’s relative position in the household can be desirable, not only on equity, but also on efficiency grounds is a frequent justification for policies targeting women, such as microcredit and conditional cash transfers. Moreover, there is evidence that making inheritance laws more egalitarian between sons and daughters has had desirable consequences in India. For example, Roy (2010) and Deininger, Goyal, and Nagarajan (2013) show that the legal changes to women’s property rights that we consider here increased daughters’ likelihood to inherit land, women’s age at marriage and the educational attainment of daughters.

Our model predicts that women’s expected welfare rises due to increased female property rights. When wives contribute a greater proportion of the total family wealth, they do no longer accept any allocation offered by their husbands. Women expect, and are more likely to get, a more equitable share of consumption. However, as a consequence of these higher expectations, conflict within the household can rise and result in higher suicide rates for both men and women.

When considering the policy implications of their results Anderson and Genicot note that they are certainly not recommending that inheritance rights be kept unequal between men and women. Clearly their paper highlights some of the negative implications of women empowerment but they also point out that they do expect that women are made ex-ante better off by more equitable property rights. Anderson and Genicot suggest that other policies should be enacted to help deal with the negative aspects of the increase in female property rights. They suggest that policies that decrease the cost of conflict by easing separations for example can help. Referring to US evidence Anderson and Genicot point out that that states that adopted more liberal laws permitting "unilateral divorce" reported a 8 to 16 percent decline in female suicide and roughly a 30 percent decline in domestic violence for both men and women, and a 10 percent decline in females murdered by their partners. Anderson and Genicot note that in India, the Marriage Laws (Amendment) Bill in 2012 made divorce proceedings for unhappy couples easier and women-friendly, but stigma as well as norms in terms of child custody and alimony still make separation extremely hard in practise.

Armen Alchian, behavioural economics and the firm

There is a new working paper out by Geoffrey A. Manne and Todd J. Zywicki on Uncertainty, Evolution, and Behavioral Economic Theory. The abstract for the paper is,

Armen Alchian was one of the great economists of the twentieth century, and his 1950 paper, Uncertainty, Evolution, and Economic Theory, one of the most important contributions to the economic literature. Anticipating modern behavioral economics, Alchian explains that firms most decidedly do not – cannot – actually operate as rational profit maximizers. Nevertheless, economists can make useful predictions even in a world of uncertainty and incomplete information because market environments “adopt” those firms that best fit their environments, permitting them to be modeled as if they behave rationally. This insight has important and under-appreciated implications for the debate today over the usefulness of behavioral economics.

Alchian’s explanation of the role of market forces in shaping outcomes poses a serious challenge to behavioralists’ claims. While Alchian’s (and our) conclusions are borne out of the same realization that uncertainty pervades economic decision making that preoccupies the behavioralists, his work suggests a very different conclusion: The evolutionary pressures identified by Alchian may have led to seemingly inefficient firms and other institutions that, in actuality, constrain the effects of bias by market participants. In other words, the very “defects” of profitable firms — from conservatism to excessive bureaucracy to agency costs — may actually support their relative efficiency and effectiveness, even if they appear problematic, costly or inefficient. In fact, their very persistence argues strongly for that conclusion.

In Part I, we offer a short summary of Uncertainty, Evolution, and Economic Theory. In Part II, we explain the implications of Alchian’s paper for behavioral economics. Part III looks at some findings from experimental economics, and the banking industry in particular, to demonstrate how biases are constrained by firms and other institutions – in ways often misunderstood by behavioral economists. In Part IV, we consider what Alchian’s model means for government regulation (with special emphasis on antitrust and consumer protection regulation).

Some behavioural economists have argued that models which assume rationality and self-interest on behalf of market participants are of little value when it comes to predicting future behaviour. The Manne and Zywicki paper argues against this conclusion. Manne and Zywicki point out that Armen Alchian's model, detailed in Uncertainty, Evolution, and Economic Theory, helps to explain why this is so: evolutionary pressures of the marketplace select those most fit for survival under given conditions, which often means those best at constraining the behavioural biases behavioural economics love so much. Manne and Zywicki also note that this implies that seemingly inefficient market and firm structures may exist to ameliorate these biases and thus confer unappreciated efficiency. They then argue that with this point in mind, regulators should be wary of making the leap from diagnosing biases in a laboratory to intervening in the marketplace.

Government size and economic growth

The theoretical literature on economic growth offers support for both positive and negative effects of government size on economic growth. There are core areas of government which are said to help growth - e.g. provision of public goods such as infrastructure, rule of law, and protection of property rights - while there are also arguments outlining detrimental effects for growth arsing from the size of government. These occur via mechanisms such as the distortionary effects of high taxes and public borrowing, diminishing returns to public capital, rent-seeking activities and bureaucratic inefficiencies. Such negative effects are said to become more prevalent as the size of government increases.

Such ideas have been formalised in the endogenous growth literature as a non-monotonic relationship between growth and the increasingly distortionary effect of the rising tax rates which are required to fund ever larger government expenditure. In one such model, due to Robert Barro, when government is relatively small growth rises with increases in productive government services, as the positive effects of more public goods dominates, but beyond some critical point the disincentive effects of higher taxes on savings and investment reduce the growth rate. If the non-linear hypothesis is valid and the effect of government spending on long-run economic growth does vary with its size this would offer clearer guidelines on the appropriate fiscal policy prescription for a country of a particular government size. Furthermore, implicit in the non-linear hypothesis is the existence of some optimal size of government which would maximise economic growth.

There is a new paper - The Effect of Government Spending on Economic Growth: Testing the Non-Linear Hypothesis by Tamoya Christie - in the Bulletin of Economic Research which examines the relationship between government size and long-run economic growth. The paper explicitly accounts for the likelihood of a non-linear effect. It contributes to the literature in a number of ways.

First, in terms of methodology, the paper makes improvements to previous empirical studies by applying threshold analysis (Hansen, 2000) to a panel of countries. This technique has been widely used as the preferred method to identify threshold effects (Khan and Senhadji, 2001; Adam and Bevan, 2005; Chen and Lee, 2005; Falvey et al., 2006; Haque and Kneller, 2009), particularly when the variable of interest is observable, but the position of the threshold is not known. The methodology uses a sample-splitting framework and follows an objective strategy for identifying and testing changes in the slope. One important advantage of threshold analysis is that it avoids the ad hoc, subjective pre-selection of threshold values – a major critique of previous studies. In addition, the generalized method of moments (GMM) dynamic panel technique is applied to address potential endogeneity of government expenditure, which is measured as a share of GDP. Second, with respect to data, the study employs an updated dataset with a broad cross-section of countries over a long time span. Pulling data from the IMF's Government Finance Statistics (GFS), the sample contains 136 countries over the period 1971–2005. Most important, this data source offers a more comprehensive measure of government size by using total government expenditure (excluding interest payments) as opposed to government consumption expenditure as the proxy. The consumption measure, though widely used in empirical studies, does not include public capital formation and so cannot fully capture the productivity-enhancing effects of government services. Moreover, the GFS data contain sectoral decompositions of government spending, which facilitates isolating productive elements of government spending from the total.

Likely the most interesting result of the paper is that it finds evidence in support of Barro's non-linear hypothesis. For total government spending above 33 percent of GDP, there is a strong negative effect on growth. However for governments of a size less than this level the negative effects are much smaller and even becomes positive when productive government spending is singled out. The paper's findings also suggest that the level of economic development and the quality of government present additional sources of potential non-linearities.

Incentives matter: colonisation file

From A Licence to Trade: A History of the English Chartered Companies by Percival Griffiths, London: Ernest Benn Limited, 1974, p.215.

It is interesting to note that the two Companies organized initially by philanthropists rather than businessmen-the Sierra Leone Company and the New Zealand Company-were badly managed and were a financial failure though they served a useful purpose. The other two companies were efficiently run on business methods.

Winston Peters attacks property rights ...... again

From The Press,

Restoration of the Christ Church Cathedral could be a condition of any post-election coalition deal, New Zealand First leader Winston Peters says.

But Winston you don't own the Cathedral. The decision about restoration of it is up to its owners, the Anglican Church, not you. The control rights over the Cathedral are in the hands of the Anglican Church, that's what ownership means.

Peters, who was visiting Christchurch yesterday, called for government intervention and funding for the restoration of the earthquake-damaged landmark.

There is not basis for government intervention. There is no "market failure" requiring government intervention here, its not a public good, there are no externality issues. In short there is no problem that requires government intervention to "fix".

And Winston why should the New Zealand taxpayer have their money wasted on a vote buying scheme for you? The government has better things to do with taxpayer money than buy you a few votes from the anti-property rights, anti-demolition crowd.

The Press continues,

I am seriously committed to this project. It means much more than just the cathedral."

Peters was "very, very confident" a deal could be reached.

Well no. The Anglican Church has made its decision and as they are the owners it is their decision to make, not yours.

Later in the article it says,

Peters said the Government should intervene to restore the cathedral because it was such a significant building.

No, what the government should be doing is supporting property rights and staying out of the whole issues as its nothing to do with them.

This is a huge icon building and critical as a statement of central government belief in the city. We should be intervening because it can be restored and it should be restored.

Who's "we" Batman? "We" should just let the owners of the building decide what they want to do with their property.

The article goes on to quote Peters as saying,

"[The] Government can find all sorts of money for all sorts of projects, including $45 million for the Novopay debacle. This present Government is prepared to put $42m a year into Auckland casino. The cathedral would be less money for far less time."

So the fact that a government does one really stupid thing means it should do lots of really stupid things! Great logic.

Still later the article notes that an

Anglican church spokesman Jayson Rhodes said Peters' comments suggested "the cathedral be taken off the Anglican church".

Exactly! Peters wants to usurp the Church's property rights over the Cathedral.

A thing of very great practical utility

In his 1902 Presidential Address to Section F of the British Association Edwin Cannan argued that economic theory is "a thing of very great practical utility". But what did he mean? Utility to whom, doing what? He said that

I do not mean to argue that a knowledge of economic theory will enable a man to conduct his private business with success. [...] But economic theory does not tell a man the exact moment to leave off the production of one thing and begin that of another; it does not tell him the precise moment when prices have reached the bottom or the top. It is, perhaps, rather likely to make him expect the inevitable to arrive far sooner than it actually does, and to make him underrate, not the foresight, but the want of foresight of the rest of the world.

The practical usefulness of economic theory is not in private business but in politics, and I for one regret the disappearance of the old name " political economy," in which that truth was recognised.

Such views would leave Cannon very confused and depressed if he was to return to New Zealand today. For a start given that economic theory is of little use to business he would be confused as to why most economics departments in this country are in business schools or the like. I'm sure he would expect them to be in with the other social sciences as it is with the LSE at which he taught for 30 years.

As to the usefulness of economics in politics I feel he would be depressed by the use of economics by politicians. Or more correctly the misuse of economics in politics.The relationship between economics and politics seems to amount to little more than the simple fact that good economics is bad politics. No matter what your favoured policies are they will be unpopular with enough voters to make sure they are never implemented. Which raises the question if all "good economic policies" are unpopular can we ever get anyone's version of good policy implemented? Does politics gut all economic policy, no matter whether "left" or "right", of all serious content? Are we doomed by the populist nature of politics to get crap economic policy no matter how we define good policy?

Also given that we are, unfortunately, in an election year, we need to take notice of the fact that whoever wins the next election the ability for them to be able to comprise on policies just to get a coalition together so that they can govern may be good politics, but it can also lead to to some very bad economics. Coordination of different areas of economic policy is important if they are not to end up working at odds with each other. Which means trading off one aspect of economic policy against another leads to bad policy. Unfortunately bad politics always beats good economics.Which I'm sure what not what Cannan would have hoped for.

Who didn't see this coming?

From the Irish Times

Philosophy but no economics

Can this be right?

When discussing the contribution to economics of the ancient Greek philosophers Edwin Cannan writes,

The fact that these ancient philosophers were not and could not be economists in our sense of persons who are interested in and think and perhaps talk or write about the material welfare of mankind. They professed to be concerned with higher things, and if they were not always so in fact, it was because they thought of themselves rather than because they thought of their fellowmen. Their State, of which they made so much, covered a contemptible little district with one small town in it and a population of which the great majority were not citizens but slaves. It is impossible for economics to develop in such an environment.

Is it really impossible? Even within such an environment there are questions to do with resource allocation, questions to do with the hows and whys of production and distribution, problems to do with the supply of public goods, issues to do with the supply of money and the fiscal behaviour of the, albeit small, state, questions to do with international trade and so on. Can't such problems give rise to economics? And if not then what are the prerequisites for economic thought to develop?

Rent controls are efficient

Or so says Cameron Murray at the Fresh Economic Thinking blog. And whats more he claims to have 17 million reasons for it being so! Well I have only one reason for him being wrong, a below equilibrium price. Given that at such a price you have an excess demand, its hard to see how this can be called efficient.

Murray points to a situation in the US where one Herbert Sukenik was paid US$17million in 2005 to leave his rent-controlled NYC apartment by a developer who wanted to redevelop the Mayflower Hotel, in which Sukenik lived, adjacent to Central Park. The building was occupied by many long-term tenants under New York’s rent-control laws. This meant that tenants could only be evicted upon mutual agreement. Most tenants accepted offers ranging from $650,000 to $1million to leave but Sukenik held out for a US$17million lump sum payment, in addition to the developers offering him another apartment to live in for the rest of his life for a peppercorn rent of $1 per month.

What I don't get this how this shows rent control is efficient. Or says anything much about rent control at all. To me what this shows is that in low transaction situations where bargaining is between just a few people the Coase theorem holds. If one party, the developer, values an asset more highly than the current holder of the asset, the tenant, then the higher valuing party can buy the property rights to the asset from the lower valuing party. The price paid is just a transfer between the parties with no implications for efficiency.

The question that economists  would ask is, Should there be rent control in the first place? No this question most, more than 90% of economists according to surveys, would have grave doubts. Economist Assar Lindbeck went so far as to say, “In many cases rent control appears to be the most efficient technique presently known to destroy a city—except for bombing.” In fact those apossed to rent control range from Milton Friedman and Friedrich Hayek to Gunnar Myrdal. Myrdal stated, “Rent control has in certain Western countries constituted, maybe, the worst example of poor planning by governments lacking courage and vision.” And its not often you get Friedman, Hayek and Myrdal agreeing!!

Walter Bock outlines some of the issues economists have with rent control,

Economists have shown that rent control diverts new investment, which would otherwise have gone to rental housing, toward greener pastures—greener in terms of consumer need. They have demonstrated that it leads to housing deterioration, fewer repairs, and less maintenance. For example, Paul Niebanck found that 29 percent of rent-controlled housing in the United States was deteriorated, but only 8 percent of the uncontrolled units were in such a state of disrepair. Joel Brenner and Herbert Franklin cited similar statistics for England and France.

The economic reasons are straightforward. One effect of government oversight is to retard investment in residential rental units. Imagine that you have five million dollars to invest and can place the funds in any industry you wish. In most businesses, governments will place only limited controls and taxes on your enterprise. But if you entrust your money to rental housing, you must pass one additional hurdle: the rent-control authority, with its hearings, red tape, and rent ceilings. Under these conditions is it any wonder that you are less likely to build or purchase rental housing?

This line of reasoning holds not just for you, but for everyone else as well. As a result, the quantity of apartments for rent will be far smaller than otherwise. And not so amazingly, the preceding analysis holds true not only for the case where rent controls are in place, but even where they are only threatened. The mere anticipation of controls is enough to have a chilling effect on such investment. Instead, everything else under the sun in the real estate market has been built: condominiums, office towers, hotels, warehouses, commercial space. Why? Because such investments have never been subject to rent controls, and no one fears that they ever will be. It is no accident that these facilities boast healthy vacancy rates and relatively slowly increasing rental rates, while residential space suffers from a virtual zero vacancy rate in the controlled sector and skyrocketing prices in the uncontrolled sector.

Although many rent-control ordinances specifically exempt new rental units from coverage, investors are too cautious (perhaps too smart) to put their faith in rental housing. In numerous cases housing units supposedly exempt forever from controls were nevertheless brought under the provisions of this law due to some “emergency” or other. New York City’s government, for example, has three times broken its promise to exempt new or vacant units from control. So prevalent is this practice of rent-control authorities that a new term has been invented to describe it: “recapture.”

Rent control has destroyed entire sections of sound housing in New York’s South Bronx and has led to decay and abandonment throughout the entire five boroughs of the city. Although hard statistics on abandonments are not available, William Tucker estimates that about 30,000 New York apartments were abandoned annually from 1972 to 1982, a loss of almost a third of a million units in this eleven-year period. Thanks to rent control, and to potential investors’ all-too-rational fear that rent control will become even more stringent, no sensible investor will build rental housing unsubsidized by government.

So the landlord may have a tough time of it but what about the effects on the tenants, it has to be good for them, right?

Existing rental units fare poorly under rent control. Even with the best will in the world, the landlord sometimes cannot afford to pay his escalating fuel, labor, and materials bills, to say nothing of refinancing his mortgage, out of the rent increase he can legally charge. And under rent controls he lacks the best will; the incentive he had under free-market conditions to supply tenant services is severely reduced.

The sitting tenant is “protected” by rent control but, in many cases, receives no real rental bargain because of improper maintenance, poor repairs and painting, and grudging provision of services. The enjoyment he can derive out of his dwelling space ultimately tends to be reduced to a level commensurate with his controlled rent. This may take decades, though, and meanwhile he benefits from rent control.

And then there is the "old lady effect".

Consider the case of a two-parent, four-child family that has occupied a ten-room rental dwelling. One by one the children grow up, marry, and move elsewhere. The husband dies. Now the lady is left with a gigantic apartment. She uses only two or three of the rooms and, to save on heating and cleaning, closes off the remainder. Without rent control she would move to a smaller accommodation. But rent control makes that option unattractive. Needless to say, these practices further exacerbate the housing crisis. Repeal of rent control would free up thousands of such rooms very quickly, dampening the impetus toward vastly higher rents.

So some tenants gain from rent controls  while others lose, what determines who wins and who doesn't?

If the building in which he lives is in a good neighborhood where rents would rise appreciably if rent control were repealed, then the landlord has an incentive to maintain the building against the prospect of that happy day. This incentive is enhanced if there are many decontrolled units in the building (due to “vacancy decontrol” when tenants move out) or privately owned condominiums for which the landlord must provide adequate services. Then the tenant who pays the scandalously low rent may “free ride” on his neighbors. But in the more typical case the quality of housing services tends to reflect rental payments.

If local or central government thinks that some high social end is served by allowing tenants to sit on someone else's property in perpetuity at below market rents, then it should use public funds, after proper democratic deliberation, to buy or lease the premises for market value which it can then lease out to people they believe are in need. Or they could use public funds to supplement these people's income. Tax increase would at least get across to voters the idea that low cost housing does indeed cost rather than hiding that cost by forcing it upon a subset of society, landlords.

EconTalk this week

Richard Epstein, of New York University and Stanford University's Hoover Institution, talks with EconTalk host Russ Roberts about the differences between classical liberalism and hard-line libertarianism. What is the proper role of the state? Topics discussed include the Constitution, prudent regulation, contract enforcement, intellectual property, and the Supreme Court case, Lochner vs. New York.

A direct link to the audio is available here.

This is an interesting interview, take as an example Epstein's view on the difference between libertarians and classical liberals.

Epstein: Well, first of all there is really a terminological gulf, and this is what I think is the fundamental ambiguity. There are many issues in which there are subsets--that classical liberals and the hard-line libertarians are in agreement. And therefore the differences between them simply disappear when you start to take on many progressive policies. The grounds on they may be opposed will differ from group to group, but the fact of the opposition is going to be very strong. So, for example, there is neither the classical liberal nor the libertarian believes that the government ought to support or prop up [?] any monopoly institutions where it is possible to have a competitive industry. And so, at that particular point, both are in favor of a smaller government. The classical liberal says: Monopoly has changed output for the worse so therefore when the government spends money to create a worse situation, it's a clear no-starter. The libertarian says: The government is using force to interfere with advantageous relationships; we don't care about the consequences; don't give me all this fancy economics stuff; we're just against it. So, one of them tends to be more consequentialist--that's the classical liberal--the other tends to be more deontological--that turns out to be the hard-line libertarian. [...] The term libertarian covers both of these things when you are dealing with these external debates. But when you start to get a little bit more philosophical, trying to figure out how small the small government ought to be, how the government ought to be put together, the difference between the deontological approach to the hard-line libertarian, and, it turns out, the relatively consequentialist approach of the classical liberal lead to some serious differences over a wide range of issues. I'll just mention--for example, the hard-line libertarian says: You guys want to get together to restrict output? It turns out that that's a contract like any other contract. You enforce contracts, you enforce that contract. The common law took the position these contracts are contracts in restraint of trade, and its preferred [?] was not to enforce those contracts, even though it did not impose criminal sanctions on the parties who entered into it. The modern antitrust guy says: You know what? We have the Sherman Act, and we are going to punish this civilly and criminally, because we think these cartels can endure longer that might otherwise be the case, even if the agreements turn out to be unenforceable in terms of the legal system. So what happens is, you have three kinds of approaches there. The libertarian, who just doesn't think of this as a problem and whose basic attitude is: we've got free entry, that will take care of itself. And the classical liberal says: I really like unenforceability because it will tend to increase the decay. And then some of the hard-line modern economists come along and say: The Sherman Act is a pretty good thing on this stuff. To which some classical liberals like myself will say: You really have to worry about the probable enforcement with the antitrust laws; increase in the size of government. Are you really sure you need this thing, and if so, are you going to do it correctly? And I think the answer is, if you get the right people running the system of the antitrust law, it's fine; if you get the wrong people running the system of the antitrust law, it's horrible. And then there is a very difficult political judgment as to whether you think good guys or bad guys are going to be running the system. So the [?] it seemed with the people like Bob Bork, is they really did focus this field on the cartel-like activities of various [?] departments, which reduced the error rate. The danger, of course, is that you will get some other administration that will believe that predation is the dominant offense, so when people start getting better products at lower prices, this now becomes ruinous competition, and then you are right back into the Progressive mode because the ruinous competition theme is one that is very dominant in their work. So there are profound differences in methodology. There are profound differences with respect to the actual consequences of the difference between these two systems.

Austrian and mainstream approaches to the theory of the firm

Are the Austrian and mainstream approaches to the firm incompatible?

While thinking about issues arising from my previous post on The firm in classical economics I reread the paper "Austrian Economics and the Transaction Cost Approach to the Firm" by Nicolai J. Foss and Peter G. Klein. The transactions cost approach to the theory of the firm is one of main contemporary theories of the firm and has developed out of Coase's 1937 paper on "The Nature of the Firm". In fact Coase won the 1992 Nobel Prize in economics for "For his discovery and clarification of the significance of transaction costs and property rights for the traditional structure and functioning of the economy".

When discussing the importance of dynamics to the economic theory of organisations Foss and Klein write,

One way to interpret this Austrian insight is that absent change there are no transaction and information costs; that is, in the absence of the knowledge and appraisement problems introduced by economic change there would be no costs of identifying contractual partners, drafting and executing contracts, monitoring production, constructing contractual safeguards, judging quality, and so on. In the absence of transaction costs the choice between price-mediated market transactions and firm hierarchies is indeterminate.

Thus in a world of zero transaction costs there is no need for firms. This point is highlighted by the zero transaction cost neoclassical approach to the firm. As Nicolai Foss has noted elsewhere

With perfect and costless contracting [due to zero transaction costs], it is hard to see room for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and wouldn't need the services of the intermediaries known as firms.

In terms of the standard neoclassical approach Peter Klein puts it this way,

In neoclassical economic theory, the firm as such does not exist at all. The “firm” is a production function or production possibilities set, a means of transforming inputs into outputs. Given the available technology, a vector of input prices, and a demand schedule, the firm maximizes money profits subject to the constraint that its production plans must be technologically feasible. That is all there is to it. The firm is modeled as a single actor, facing a series of relatively uncomplicated decisions: what level of output to produce, how much of each factor to hire, and so on. These “decisions,” of course, are not really decisions at all; they are trivial mathematical calculations, implicit in the underlying data. In the long run, the firm may also choose an optimal size and output mix, but even these are determined by the characteristics of the production function (economies of scale, scope, and sequence). In short: the firm is a set of cost curves, and the “theory of the firm” is a calculus problem.

When thinking terms of general equilibrium theory Foss, Lando and Thomsen write,

[t]he pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist.

All this suggests the importance of positive transaction costs to a theory of the firm.

Foss and Klein go on to say that their argument indicates a link between Austrian insights from the socialist calculation debate and Coasian insights in economic organisation. In their view it is only with this kind of dynamic economic reality inherent in Austrian economics that Coase's argument acquires its full force.

Later Foss and Klein admit that there is debate about the compatibility between Austrian economics and the Coasian based contractual perspective on the firm but they argue that there are two Coasian traditions, one of which is, they claim, consistent with Austrian ideas.

There is some debate within the Austrian literature about the basic Coasian approach and its compatibility with the Austrian perspective. O’Driscoll and Rizzo (1985, p. 124), while acknowledging Coase’s approach as an “excellent static conceptualization of the problem,” argue that a more evolutionary framework is needed to understand how firms respond to change. Some Austrian economists have suggested that the Coasian framework may be too narrow, too squarely in the general-equilibrium tradition to deal adequately with Austrian concerns (Boudreaux and Holcombe, 1989; Langlois, 1994). However, as Foss (1993) has pointed out, there are “two Coasian traditions.” One tradition, the moral-hazard or agency-theoretic branch associated with Alchian and Demsetz (1972), studies the design of ex ante mechanisms to limit shirking when supervision is costly. Here the emphasis is on monitoring and incentives in an (exogenously determined) agency relationship. The above criticisms may apply to this branch of the modern literature, but they do not apply to the other tradition, the governance or asset-specificity branch, especially in Williamson’s more heterodox formulation. Williamson’s transaction cost framework incorporates non-maximising behaviour (bounded rationality); true, “structural” uncertainty or genuine surprise (complete contracts are held not to be feasible, meaning that all ex post contingencies cannot be contracted upon ex ante); and process or adaptation over time (trading relationships develop over time, typically undergoing a “fundamental transformation” that changes the terms of trade). In short,

at least some modern theories of the firm do not at all presuppose the “closed” economic universe—with all relevant inputs and outputs being given, human action conceptualized as maximization, etc.—that [some critics] claim are underneath the contemporary theory of the firm (Foss, 1993, p. 274).

Stated differently, one can adopt an essentially Coasian perspective without abandoning the Misesian view of the entrepreneur as an uncertainty-bearing, innovating decision maker.

One of the positives of the Austrian approach to the firm is the importance given to the entrepreneur in the theory of the firm. In the Coasian world there is a manager who runs the firm but he does act as a true entrepreneur, in that he does not form the firm. The Austrians - e.g. Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm, Cambridge: Cambridge University Press - and some other approaches to the firm - e.g. Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations, Cambridge: Cambridge University Press -  are starting to develop genuine theories of entrepreneurial activity.

The Foss and Klein (2012) book shows that Austrian and the mainstream approaches to the firm are not completely incompatible. While the basis of their theory, a combination of Knightian uncertainty and Austrian capital theory, places their work outside the conventional theory of the firm, Foss and Klein are not completely opposed to the standard theory. In fact they see themselves “not as radical, hostile critics, but as friendly insiders”.

When discussing the multi-person firm Foss and Klein argue that the need for experimentation with regard to production methods is the underlying reason for the existence of the firm. Given that assets have many dimensions or attributes that only become apparent via use, discovering the best uses for assets or the best combination of assets requires experimenting with the uses of the assets involved. Thus entrepreneurs seek out the least-cost institutional arrangement for experimentation. Using a market contract to coordinate collaborators leaves the entrepreneur open to hold-up, collaborators can threaten to veto any changes in the experimental set-up unless they are granted a greater proportion of the quasi-rents generated by the project. By forming a firm and making the collaborators employees, the entrepreneur gains the right to redefine and reallocate decision rights among the collaborators and to sanction those who do not utilise their rights effectively. This means that the entrepreneur can avoid the haggling and redrafting costs involved in the renegotiation of market contracts. This can make a firm the least-cost institutional arrangement for experimentation. The notions of hold-up over quasi-rents and the importance of the allocation of decision rights and their use to avoid haggling costs are features of more standard theories of the firm like the transaction cost based theory of Oliver Williamson and the incomplete contracts theory of Grossman-Hart-Moore.

The takeaway message from all of this is that the Austrian approach and the mainstream approaches to the theory of the firm are not necessarily incompatible. There are areas of overlap and thus gains from trade arising from interaction between them. They can learn from each other.

Utku Unver and Tayfun Sonmez talk about kidney exchange

In this short video Boston College economists Tayfun Sönmez and Utku Ünver talk about the development of kidney exchanges.

The firm in classical economics

On twitter Per Bylund wrote:

I'm increasingly convinced that the social sciences need to be reintegrated. Its universal framework should be based on classical economics.
— Per Bylund (@PerBylund) March 7, 2014

This is an interesting idea but I would ask Per, as theory of the firm man, what the theory of the firm would look like if it is to be based on classical economics. Mark Blaug when so far as to write that the classical economists "had no theory of the firm". Micheal H. Best writes, "Adam Smith did not elaborate a theory of the firm." Smith famously opens The Wealth of Nations with a discussion of the division of labour at the microeconomic (pin factory) level but quickly moves the analysis to the market level. When discussing Smith's approach to the division of labour McNulty comments,

“[h]aving conceptualized division of labor in terms of the organization of work within the enterprise, however, Smith subsequently failed to develop or even to pursue systematically that line of analysis. His ideas on the division of labor could, for example, have led him toward an analysis of task assignment, management, or organization. Such an intra-firm approach would have foreshadowed the much later−indeed, quite recent−efforts in this direction by Herbert Simon, Oliver Williamson, Harvey Leibenstein, and others, a body of work which Leibenstein calls “micro-microeconomics”. [ ...] But, instead, Smith quickly turned his attention away from the internal organization of the enterprise, and outward toward the market and the realm of exchange, perhaps because he found therein both the source of division of labor, in the “propensity in human nature ...to truck, barter and exchange” and its effective limits”

A quick search of the second edition of Edwin Cannan's "History of the Theories of Production and Distribution in English Political Economy from 1776 to 1848" showed that the only time the word firm appears is when Cannan says that an author "would have been on firm ground". The use of the world company or corporation seems to only appear when Cannan is talking about the meaning of the word capital as being the "funds of a trader, company, or corporation".

What this suggests to me is that Blaug is right. As Foss and Klein have noted classical economics was largely carried out at the aggregate level with microeconomic analysis acting as little more than a handmaiden to the macro-level investigation,

“[e]conomics began to a large extent in an aggregative mode, as witness, for example, the “Political Arithmetick” of Sir William Petty, and the dominant interest of most of the classical economists in distribution issues. Analysis of pricing, that is to say, analysis of a phenomenon on a lower level of analysis than distributional analysis, was to a large extent only a means to an end, namely to analyze the functional income distribution”.

With no real emphasis on microeconomics how can a theory of the firm develop? Thus it is not clear what a theory of the firm would look like if based on classical economics.

What are the effects of offshoring?

Not what you may think.

The Economist's blog Free Exchange has a posting that looks at research on the effects of offshoring and its results may well not be what you expected.

The Free Exchange posting looks at new research that draws on a U.S. pilot study utilising the 2010 National Organisations Survey (NOS). The NOS collected data on the sourcing practises of American firms, and did so according to eight standardised business functions: primary business function (i.e., the company’s core activity), R&D, sales and marketing, logistics, customer service, administration, information technology (IT) and facilities. This enabled the researchers to see precisely which functions were being offshored—and what impact such shifts had back home.

Although 23% of American companies undertook some offshoring, when it came to their primary business functions—which account for two-thirds of domestic employment—an average of only 4% by cost was offshored. For large goods-producing companies the figure was much higher, at 10.5%. Because the products those manufacturers make tend to be highly visible (e.g., smartphones, clothing), this increases the impression that masses of American jobs are being exported. As co-author Tim Sturgeon of MIT points out, the researchers found “a tale of two economies”: large manufacturers, and everyone else. “Services, health care, public agencies and small firms of all kinds tend to be very domestically oriented,” he notes. And these types of organisation account for about 80% of America’s employment.

The second surprise was that the majority of offshoring (57% by cost) was to locations with costs that were the same as or higher than America, such as Canada and Western Europe, rather than to low-cost developing countries (29%)—the ones typically suspected of gobbling up American work. By way of explanation, the researchers note that Western Europe and Canada are America’s largest and oldest trading partners, and point to a long history of foreign direct investment by American firms in these regions. Presumably, at least some of this investment and sourcing is reciprocated, though it will fall to future studies to determine how much. Interestingly, mid-cost emerging economies were almost entirely out of the mix, caught in what Mr Sturgeon calls the “middle income trap”—they are neither sufficiently attractive markets in their own right nor sources of cheap labour.

In terms of jobs, the researchers found that the more companies offshored a particular function, the fewer low-paid jobs they had in the same function at home. An obvious reason for this could be that offshoring is siphoning away low-paid jobs. It is possible, however, that cost-reductions enabled by offshoring raise overall demand for firms' products, and therefore increase the demand for skilled workers in tasks that haven't been outsources.

Perhaps the most interesting points in the quote are the point about the small manufacturing and service sectors being "domestically oriented" - remembering the large contribution these sectors make to local employment - and the point about the substitution of low-paid jobs for high-paid jobs. Fewer low-paid jobs is what many people would expect offshoring to lead to but the increase in high-paid jobs is more unexpected.

"The Tyranny of Experts" book launch

This short video is just a few selected clips from the launch of Bill Easterly's great new book The Tyranny of Experts: Economists, Dictators, and the Forgotten Rights of the Poor. Buy it, read it and learn, among other things, about the New Zealand economist John Bell Condliffe. The guy at the beginning of the video is Paul Romer.


The Tyranny of Experts Book Launch from NYU Devt Research Institute on Vimeo.

Unemployment and qualifications

Previously I have noted papers that deal with the effects of long-term unemployment on re-employment, see here, here and here. These papers show that being unemployed for a long period of time lowers your probability of get a another job. Do does long term unemployment affect different levels of qualification differently?

There is a paper, by Alexander Mosthaf, forthcoming in the Scottish Journal of Political Economy which asks Do Scarring Effects of Low-Wage Employment and Non-Employment Differ BETWEEN Levels of Qualification? The paper finds that for those with low-qualifications being in a low-wage job incurs a lower risk of future unemployment when compared to being unemployed. But for those with higher qualifications the risk of unemployment is no different given that you are in low-paid worker or unemployed.

The idea underlying the results is that if employers interpret the job search behaviour of workers as a signal for their future productivity - more job search implies lower productivity, if you were high productivity you would have gotten a job quickly - taking up a low-paid interim job as well as being unemployed is associated with negative signalling effects. As the incidence of unemployment and low-wage employment is more typical for workers with lower qualifications, the paper argues that negative signals may be lower for workers with low qualifications and stronger for workers with high levels of qualification.

The paper's abstract reads:

This study investigates how the effects of low-wage employment and non-employment on wage prospects vary depending on qualification. Based on theories on signalling effects, human capital and job search, we discuss why there may be heterogeneity in state dependence in both labour market states. We find that episodes of low-wage employment incur a significantly lower risk of future non-employment than episodes of non-employment for low-qualified workers. In contrast, for workers with a middle or high level of qualification the risk of non-employment is not significantly different when being low-paid instead of not employed.

Behavioural economics: a short run phenomena?

Peter Klein at the Organizations and Markets blog points us to a paper which looked at an Indian tea plantation that changed its employment contract in such a way as to weaken the pay-for-performance incentives and found a substantial increase in output ... at least in the beginning.

In the one month following the contract change, output increased by a factor between 30-60%, the exact number depending on the choice of counterfactual and the set of controls applied. This large and contrarian response to a flattening of marginal incentives is at odds with the standard model, including one that incorporates dynamic incentives, and it can only be partly accounted for by higher supervisory effort. We conclude that the increase is a “behavioral” response.

So the behavioural economists will be happy.

But,

Yet in subsequent months, the increase is comprehensively reversed. In fact, an entirely standard model with no behavioral or dynamic features that we estimate off the pre-change data, fits the observations four months after the contract change remarkably well.

So standard incentive theory strikes back.

The findings of the paper suggest that the behavioural responses may be transitory, especially in employment contexts in which the baseline relationship is delineated by financial considerations in the first place. This change over time does not sit well with the behavioral economics models. The paper's results also suggest that when considering an empirical strategy for looking at changes in contracts it is better to examine responses to the change over an extended period of time.

Cannan on Plato on trade

An interesting quote from Edwin Cannan's "A Review of Economic Theory", London: P. S. King and Son, Ltd. 1929.

In relation to foreign commerce, he [Plato] says of his citizens, "What they produce at home must be not only enough for themselves, but such that both in quantity and quality as to accommodate those from whom their wants are supplied," which shows appreciation of the fact that the real purpose of exports is to procure imports. (p.2).

Now if only many contemporary people had as much insight into trade as Plato. How often do we have some commentator or journalist or politician tell us that we must increase exports, as if exporting per se is a good thing and thus an end in and of itself? Or how often do we hear calls to import less without the commentator seemingly able to grasp the fact that this means exporting less as well? Plato at least got the point that it is importing that makes us better off, not exporting. We only export to pay for our imports.

Interesting blog bits

1. Matt Ridley asks Do people mind more about inequality than poverty?

   Few people know that global inequality is falling and so is poverty.

2. Kevin Vallier on Reasonable Libertarian Worries about Nudging
   

   This is part of a series of replies to “Human Freedom and the Art of Nudging,” written by Charles Mathewes and Christina McRorie, religious studies professors at the University of Virginia. I think their piece is, quite honestly, bad. It attacks libertarian criticisms of nudging based on a host of straw men.

3. Peter Boettke on Science/Scholarship and Academics

   Joe Salerno publically called me out to explain my position on how a scientific/scholarly discipline advances and the role that private funding plays. He also asks me to contemplate a counter-factual of my own career if there was no private funding available.

4. Donal Curtin shouts Wrong, wrong, wrong, wrong, wrong

   I do want to comment, though, on the substance of some potential telco policy ideas that were apparently leaked from Clare Curran's office. And yes, you get it, he thinks the policy is wrong.

5. Tim Worstall explains A most wonderful example of cause and effect

   A number of studies have been done over the years trying to work out whether people are insider trading given the specialist knowledge that they have. For example, one such showed that Senators were getting a 12% annual return on their stock portfolios. The conclusion was that yes, they were indeed using their inside information about what laws were likely to be written and how. No prosecutions of course because this wasn't actually illegal but it was pretty clear that the activity was going on. Using very much the same techniques researchers have had a look at the stock investments of the policemen of that world, the folks at the SEC.

6. Tim Worstall says Those 'Communists' At The IMF Do Indeed Say That Redistribution Harms Growth

   There’s been a recent paper issued by economists at the IMF looking at whether and how redistribution harms economic growth. There’s been a number of gleeful headlines insisting that what they’ve actually said is that redistribution does not harm economic growth at all, all of us right wing neoliberal free market types are just wrong. Sadly, this isn’t actually what the paper says.

7. Angus Deaton and Arthur Stone ask What good are children?

   Study after study has shown that those who live with children are less satisfied with their lives than those who do not. Is there something wrong with these empirical analyses? Or is it that happiness measures are unreliable? This column argues that the results are correct but that comparisons of the wellbeing of parents and non-parents are of no help at all for people trying to decide whether to have children.

8. Stefano DellaVigna, John List, Ulrike Malmendier and Gautam Rao on Voting to tell others

   The question of why people vote has intrigued social scientists for decades. This column discusses a model of voting due to social image motivations and presents empirical tests based on it. In this model, an individual would be motivated to vote because of an anticipation of being asked after the election. The results of a conducted field experiment suggest that the anticipation of being asked provides a large motivation to vote. In fact, the motivation is as large as being paid $5-15 to vote. Applying this methodology to other elections would provide more rigorous evidence about the validity of the proposed model.