So what's "moral" funding?

From the New Zealand Herald comes this gem,

Research funding from the dairying and soft drink industries could be declined on ethical grounds under proposals being worked through by the University of Canterbury.

The university is in the midst of a wide-ranging debate about ethical research funding - who academics should and shouldn't accept money from, and for what research purpose.

Currently, research funding from the tobacco and armaments industries could be declined.

Some academics have argued that should extend to certain industry-funded alcohol, gambling, dairying, mining and soft drink research.

Who the hell cares who funds research? Surely the issue is the quality of the research, not who funds it. If research is able to be published in peer-reviews journals or books hasn't it meet the standards required of academic research? After all if someone thinks you have said or done something wrong in your paper they can write a response to your work pointing out the error. Such a thing is not unusual.

Others believed there should be no prohibition and that the acceptance of funding should be left to individual moral judgements.

Some sanity after all.

Later we are told,

Professor Sally Casswell, a Massey University public health researcher with a particular focus on alcohol, said she strongly believed research funding should not be accepted from the alcohol industry.

But let me guess, she has no problems whatsoever about researchers taking money from anti-alcohol groups.

Such funding was an attempt by the industry to position itself as a partner in policy research, Professor Casswell said, but only industry-friendly policies were supported.

And of course the anti-alcohol groups support all research on alcohol not just industry-unfriendly work. You may not like the conclusions reached by some research but you should play the ball not the man.

Eric Crampton makes good sense on this issue:

However, Dr Eric Crampton, head of research at the NZ Initiative think-tank, said industry-funded research could be extremely valuable, so long as funding arrangements were disclosed and unethical behaviour could be censured.

Dr Crampton previously worked at the University of Canterbury's economics department and was frequently critical of research on the societal harm from alcohol.

He maintains an adjunct senior fellow position with the department.

One-fifth of his university position was funded through a grant from the Brewers Association of Australia and New Zealand, he said, "and everything that I did was totally up for anybody to look at or comment on, or censure me if I was behaving badly".

"It is distortionary to automatically believe that industry funding is bad and evil and that government money comes with no strings and no agenda."

Yes indeed. All research money comes with strings attached, that's why you judge research not on the source of funding but on the quality of the output produced. Unless, of course, you want to make sure your views are the only ones heard.

The Economics of World War I. 4

Another in the series of posts from The Economics of World War I at VoxEU.org

Endowments for war in 1914
Avner Offer 19 September 2014
Victory in World War I relied on three types of energy: renewable energy for food and fodder, fossil energy, and high explosive. This column argues that the Allies had a clear advantage in manpower, coal, and agriculture, but not enough for a quick decision. Mobilisation in continental economies curtailed food production, occasionally to a critical level. Technical competition was a matter of capacity for innovation, not of particular breakthroughs. Coercive military service and rationing of scarce energy and food had egalitarian consequences that continued after the war.

EconTalk this week

Elizabeth Green, author of the new book Building a Better Teacher: How Teaching Works (and How to Teach it to Anyone), talks with EconTalk host Russ Roberts about the art of teaching and the history of various reforms, mostly failed, trying to improve teaching in America. Specific topics include the theoretical focus of undergraduate education programs and various techniques being used in charter schools and elsewhere to improve teaching performance.

A direct link to the audio is available here.

This is simply a bad idea: Labour's asset buying fund.

From the Stuff website comes this news:

Labour is promising to create a new national asset buying fund, giving at least $100 million a year to help raise local ownership.

In the last major policy announcement before Saturday's election, leader David Cunliffe revealed the details of his planned sovereign wealth fund, NZ Inc.

and

Although Cunliffe said the fund would target strategic assets - such as port infrastructure or dairy processing plants - or invest in renewable energy companies, he agreed it could also buy farms or shares in privatised electricity companies.

Labour has said it would not rule out buying back the state assets partially sold in the current term, and the fund appears to be an attempt to court New Zealand First leader Winston Peters into coalition.

Peters has named foreign ownership as a key priority for coalition talks, promising a "buy back" programme of farmland during a speech in Tauranga this week.

While there are problems with the National government's partial "privatisation" policy (more on this below) the answer to these problems isn't to buy back the bits of the firms sold but rather to sell 100% of those SOEs. Also the government is very bad at picking winners to invest in. In addition xenophobia isn't a basis for determining what to invest in.

Why do we want  government ownership? If foreign ownership means a more efficient use of an asset then we want that asset to be in foreign hands. We get a more efficient, and wealthier, economy. If, on the other hand, "local ownership" is more efficient then local private investors will be able to buy and utilise the asset. to our advantage Thus there are either good efficiency reasons for foreign ownership or local ownership will occur without government ownership being necessary. Either way its not clear why we want government ownership.

The fundamental question to be asked is Where is the boundary between what activities the government should carryout and those the private sector should carryout? Insight into this question is provided in Hart, Shleifer and Vishny (1997). Here the issue examined is when should the government carryout production "in-house" and when should it contract out the production of a good or service. In this paper information problems are not the driving force of the analysis of contracting out. The provider of a service, either public or private, can invest his time in improving the quality of the service or reducing the cost of the service. Here quality has a broad interpretation. It can stand for how well prisons treat prisoners, how clean utilities keep the water, how well schools educate their pupils, how long it takes for a letter to reach a remote area or how innovative car makers are etc. The important assumption is that investments in cost reduction have negative effects on quality. Investments are non-contractible ex ante. For the case where the provider is a government employee he must obtain approval from the government to implement any innovation he has created. Given that the government has residual rights the employee will gain only a fraction of return on his investment. This gives him weak incentives to innovate. If the service provider in an independent contractor, i.e. the service has been contracted out, then he will have stronger incentives to both cut costs and improve quality. This is because he keeps the returns to his investment. The downside to private provision is that the incentives to cut costs are strong and the provider does not fully internalise the negative effects on quality of the reductions in cost. With public provision the incentive for excessive cost cutting are reduced as are the incentive for innovation and quality improvements. Costs are always lower under private ownership but quality may be higher or lower under a private owner. Hart, Shleifer and Vishny argue that the case for public provision is generally stronger when (i) non-contractible cost reductions have large deleterious effects on quality; (ii) quality innovations are unimportant; (iii) corruption in government procurement is a severe problem. On the other hand their argument suggests that the case for privatisation is stronger when (i) quality-reducing cost reductions can be controlled through contract or competition; (ii) quality innovations are important; (iii) patronage and powerful unions are a severe problem inside the government.

Hart, Shleifer and Vishny apply this analysis to several government activities using the available evidence on the importance of various factors. They conclude that the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for privatisation is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools.

So what assets does Labour think are "strategic"and thus should be used to produce in-house? And what is a "strategic asset" anyway? The term has no meaning within economics.

Its not clear that the government's past interventions have been in areas where the Hart, Shleifer and Vishny arguments would suggest the government should be involved. Banking, for example, is not a area where cost reduction come at the expense of quality, where innovation is unimportant or where there are any problem with government procurement. So why have the government owning a bank? Also government involvement in Air New Zealand is hard to justify on these grounds. As noted above, the case for private sector provision is stronger when quality reducing cost reduction can be controlled through competition, and the airline industry is very competitive, when quality innovations are important, and we want a high quality and innovative airline industry, and when patronage and powerful unions are a severe problem inside the government, which are things we wish to avoid with an airline. Here private provision makes sense.

So what will be invested in, and how will the assets be picked? And why should the government be involved in these businesses in the first place?

And what of governments, or their agents, picking winners? Some years ago economist Tim Harford had a piece up at Forbes.com in which he tries to unravel why governments so unerringly back losers. Harford points out that "[i]f you want to dismay an economist, just mention the phrase "national champion."" On hearing such a phrase economists automatically think of "wheezing corporate behemoths protected from domestic competition, propped up with generous government subsidies and shielded behind trade barriers." I suspect that the expression "strategic asset" would have much the same affect on economists. Not a pretty picture, it has loser written all over it. So, asks Harford, if governments want to back winners, Why are they so good at backing losers?. He answers,

Partly, it's because picking the winners is inherently a difficult job. Left alone, the market does a great job of rewarding the very best and cutting the rest down to size. Any corporation that gets big and stays big in a competitive environment is likely to be very good at what it does. A corporation that stays big only because of government backing probably won't be.

He then goes on to explain that government favouritism may have a somewhat more sinister logic behind it,

Namely, firms in emerging, competitive industries have virtually no incentive to lobby for government hand-outs, while firms in aging, shrinking industries have the most to gain.

The reason for this is simple he says,

Firms in an open, competitive, growing young industry have little to gain from government support. More government funding for, say, biotechnology, is going to mean more biotechnology companies, more competition and (perhaps) more innovation. That might be good for America, but probably not much good for any single biotech company. Sure, they'll all enjoy the government help, but each must weigh that assistance against the swarm of new competitors attracted by the handouts. No one firm would choose to hire top lobbyists and send them to D.C. to bring back the pork.

By contrast, firms in aging, shrinking, capital-intensive industries have everything to gain from government support. Because the industry is shrinking and it's expensive to enter--think steel mills--the government subsidies and tax breaks are probably not going to attract new competitors. If there are no new competitors, the old guard gets to pocket all the money.

D R Myddelton looked at a related question in his recent book They Meant Well: Government Project Disasters. In this work, published by the Institute of Economic Affairs in London, Myddelton asks How is it that so many major, government-sponsored projects can lose so much money? He points out that the the answer to this question does not lie with malign intentions on behalf of their promoters in government. On the contrary the supporters within government of such projects only have the best of motives, so why do these projects go so wrong?

Myddelton considers six projects covering a period of 80 years to find answers. He looks at The R. 101 airship, the groundnut scheme, nuclear power, Concorde, the channel tunnel and the infamous Millennium Dome. A recurring rationale for these grandiose projects has been to boost "national prestige", but this concept has little real value.

Myddelton's explanation for the continual failure of such projects is that failure results from mismanagement, lack of clear lines of responsibility and lack of accountability. The point is made that

[n]one of the six projects was well managed and many of the failures were down to politicians: installing inadequate or over-complex organisations, appointing incompetent managers, or insisting on excessive secrecy.

These problems have their roots in the wider economic problems of undertaking quasi-commercial ventures in the public, rather than in the private, sector. This results, argues Myddelton, in well-meaning politicians and government officials wasting huge sums of taxpayers' money.

The arguments of both Harford and Myddelton should make us apprehensive when governments start talking of "national champions" or "strategic assets" and starting want to back these notions with our money. Odds are things will end badly.

Folsom and Folsom (2014) looks at the history of government investments in the U.S. covering everything from beaver pelts to railroads to green energy, and again things ended badly.

In short, there are good reasons for thinking the government, or its agents, will pick losers rather than winners.

To return to the point made at the beginning that there are problems with the current government's policy of selling 49% of SOEs. To see the problems note that most of the privatisation programmes enacted around the world - including New Zealand, as well as the general political debates that have surrounded the sale of state assets, have taken place with little or no reference to the economic theory of privatisation. Taking a look at the literature on the contemporary incomplete contracts approach to privatisation we can conclude a number of things several of which are directly applicable to the 49% sale programme of the New Zealand government.

First, one of the most important results is what can be interpreted as ``existence results" that show that even in a world of totally benevolent governments privatisation can still be optimal. Secondly, it can be reasonably argued that the practice of selling less than 51% of an SOE does not constitute privatisation. Under such a plan the state remains the primary force responsible for deciding the outputs (and possibly the inputs) of the firm, rather than the market. This means that programmes such as the recent policy by the New Zealand government of selling just 49% of SOEs is not genuine privatisation. The results flowing from the papers utilising the British definition of privatisation implicitly assume that full control is transferred to the private sector. Thirdly some of the results above suggest that the government is involved in areas of the economy where private provision is more efficient. Sectors of the economy like banking, mining and airlines are examples of areas where innovation is likely to be important and competition can deal with any deleterious effects on quality, which suggests that public provision is less likely to be welfare enhancing. See the discussion of the Hart, Shleifer and Vishny paper above. Fourthly, a firm's ownership can depend on its investment requirements since different ownership structures result in different patterns of investment and thus depending on the desired nature of investments different forms of ownership can be optimal. Fifthly, an important driver of several of the results presented above is the degree to which politicians can interfere, ex post, with the operations of the firm. The lower the cost of interference the greater the likelihood of firms being induced to serve political rather than economic ends. This highlights the importance of post-privatisation regulation, and competition, to the outcome of an asset sales programme. Sixth there is an implicit assumption in the literature discussed above that economic efficiency is a major objective of privatisation but the, ex ante, conditions sometimes imposed by governments on the sale of assets often serve political rather than economic ends. Examples of such conditions are things like the New Zealand governments restrictions on foreign ownership and the desire to sell to ``Mums and Dads" which restricts the number of possible bidders. Such conditions also result in fragmented ownership making it difficult for owners to coordinate their efforts to effect the firm's behaviour. In addition given that each ``Mum or Dad" will own only a very small share of any of the firms, they have little incentive to become informed on the firm's activities since they will only capture a very small amount of any improvement in performance they could bring about. These factors suggest that in practice little will change in terms of the behaviour of the SOEs, they will remain, for all intents and purposes, government controlled entities. This contradicts the very reason for privatising SOEs in the first place.

The answer to the problems with the National government's asset sales programme is not a buy-back plan like that being suggested by Labour but rather the opposite: the sale of 100% of the SOEs in question.

Ref:

• Folsom Jr., Burton W. and Anita Folsoms (2014). Uncle Sam Can't Count: A History of Failed Government Investments, from Beaver Pelts to Green Energy, New York: Broadside Books.
• Hart, Oliver D., Andrei Shleifer and Robert W. Vishny (1997). `The Proper Scope of Government: Theory and an Application to Prisons', Quarterly Journal of Economics, 112(4) November: 1127-61.

How did the west get so rich?

In this audio Deirdre McCloskey is interviewed on the Tom Woods Show. Deirdre McCloskey, author of The Bourgeois Virtues, among many other books, discusses the real reason for why west got rich and why the traditional explanations fail.

A research agenda on NZ's productivity

One of the most discussed issues to do with the New Zealand economy is New Zealand's less than stellar history of productivity growth. We do OK for a couple of years every now and then, but we can't keep it up. Trying to explain this history is a complex and difficult task but one which the "Productivity Hub" - a part of Government Economic Network - was set up to help coordinate.

Patrick Nolan has a paper in Policy Quarterly - vol. 10 no. 2 May 2014 - outlining the development by the Productivity Hub of a "Forward Looking Agenda of Research" or FLARE. Yes you do have to wonder if they couldn't have come up with a better name.

Nolan writes,

The objective of FLARE is to provide a list of relevant research projects which would advance understanding of New Zealand's productivity issues and ultimately improve policy. A short-list of proposed projects for the next two years is shown in Figure 2.

Figure 2 is

One thing with regard to point 1 in Figure 2 is that the theory of firm-level productivity isn't based on the theory of the firm. It is based on the theory of production - think what you were taught about production in 2nd year micro, for a book length discussion see Rasmussen (2013). For a survey of the contemporary theory of the firm see Walker (forthcoming). The theories are very different and are useful for examining different aspects of the productivity puzzle. This bring me to a related point that Nolan makes,

Although these are largely descriptive questions, they are nonetheless important, as clearly identifying what you are dealing with is a useful starting point for analysis. Further, this descriptive analysis will provide a basis for an improved understanding of how changes take place at the level of the firm.

To fully understand such changes requires recourse to the boarder area of organisational economics (see Gibbons and Roberts 2013) rather than just an emphasis on the theory of the firm or on production economics. Looking in side the firm to see how changes in management, in corporate culture, incentives within the firm, internal labour markets etc alter productivity seems important.

Nolan goes on to say,

As Sautet (2000) noted, many currently accepted theories of the firm cannot provide insights into important market phenomena such as entrepreneurship.

While there is truth to Sautet's comment, this is an area in which progress is being made. Two recent examples are Spulber (2009) and Foss and Klein (2012) - for a quick summary of these works see sections 3.2 and 3.3 of Walker (forthcoming).

Nolan also notes, correctly, the importance of understand the data utilised in empirical studies.

This approach should also help to contribute to efforts to improve measures of productivity and understanding of their limits, including the differences between firm-based and economy-wide (macro) measures.

This point about difference in micro and macro measure highlighted by the debate over the so-called "Solow Paradox"- Robert Solow famously quipped in a 1987 review of the book “Manufacturing Matters: The Myth of the Post-Industrial Economy” that: “[y]ou can see the computer everywhere but in the productivity statistics”, a remark that has given rise to what is often called the “Solow productivity paradox”. It turns out that the paradox is a paradox only at the macro data level, micro-level data provides little evidence in support of Solow’s paradox. Pilat (2004: 11) explains “[s]tudies with firm-level data often find the strongest evidence for economic impacts of ICT.” Recent research on the productivity paradox based on firm-level data suggests that ICT use is beneficial to firm performance and productivity, even for industries and countries where there is no evidence at the more aggregate levels. This result holds for all countries in which micro-level studies have been carried out. For example, studies have found that ICT capital deepening increased labour productivity in services firms in Germany and the Netherlands. A close correlation between labour productivity and ICT use was found for Swiss firms. Another study looked at ICT use in Finland and concluded there are productivity-enhancing effects associated with ICTs. Yet more work found that greater use of ICTs was associated with higher labour productivity growth in the nineties for Canada. Another paper analysed U.K. data and found a positive effect on labour productivity and multi-factor productivity associated with the exploration of computer networks for trading. U.S. data was used to demonstrate that average labour productivity was higher in plants with computer networks with labour productivity being around 5 percent higher for such plants.

Serious thinking about the data used in empirical studies is not given enough emphasis.

There are  many other interesting and important issues raised in  Nolan's paper which if you are interested in New Zealand's productivity performance is well worth reading.

Refs.:

• Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm. Cambridge: Cambridge University Press.
• Gibbons, Robert and John Roberts (2013). The Handbook of Organizational Economics, Princeton: Princeton University Press.
• Pilat, Dirk (2004). ‘Introduction and Summary’. In OECD, The Economic Impact of ICT − Measurement, Evidence and Implications, Paris: Organisation for Economic Cooperation and Development.
• Rasmussen, Svend (2013). Production economics: The Basic Theory of Production Optimisation, Berlin: Springer-Verlag.
• Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations. Cambridge: Cambridge University Press.
• Walker, Paul (forthcoming). "Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective". Journal of Economic Surveys.

Mixed messages

From the back of a packet of throat lozenges I saw in the supermarket:

[...] Lozenges have been formulated to give effective and rapid relief from painful and inflamed sore throats. Their dual action formula contains a local anaesthetic to numb the throat while the two antibacterial agents help kill the bacteria which can cause sore throats and mouth infections.

followed by

The efficacy of an antibacterial agent in lozenges in reducing the severity or duration of throat infections has not been clinically established.

Now doesn't the second bit kinda undermine the first bit?!

The advantages of beer drinking

.... at least in Russia.

Understanding consumer behaviour is crucial for many economic questions. A new column - The persistence of consumption habits by Lorenz Kueng and Evgeny Yakovlev - at VoxEU.org looks at the persistence of consumer habits towards alcohol among Russian males. Beer sales expanded rapidly after the collapse of the Soviet Union both in levels and relative to vodka sales, driven mainly by the beer consumption of cohorts born in the 1980s and 1990s. The authors estimate that this trend will reduce the male mortality rate in Russia by one quarter in the next 20 years.

The conclusion of the paper is,

We study the implications of our results for the evolution of life expectancy of working age males, taking into account the persistent habits we uncovered. It is important to note that of the 40% alcohol-related deaths each year, only about 7% are due to alcohol poisoning. Over 30% are due to external causes related to alcohol intoxication, including vehicular and other accidents and homicides, and hence are also unrelated to long-run consequences of alcohol consumption, such as liver cirrhosis. To proceed with the analysis, we estimate a hazard model of death as a function of the share of alcohol consumed, controlling for many individual characteristics, in particular the level of total alcohol intake. The estimates show that consuming the same level of alcohol but doing so by using more vodka rather than beer is associated with a significantly higher mortality rate, both statistically and economically.

Using our results, we estimate that male mortality in Russia will decrease by one quarter within 20 years even under the status quo, that is, under the current set of policies and current levels of relative prices of alcoholic beverages. This will happen simply because new generations will be more accustomed to beer and will replace older generations with strong preferences for vodka. Since much of the gap in male life expectancy is due to occasional binge drinking (even holding fixed the average level of alcohol intake), which in turn is more likely to occur for males who prefer vodka, this shift in consumption habits toward beer has strong effects on life expectancy. Hence, this reduction in the male mortality rate will be the result of changes that occurred several decades ago.

So drinking beer rather than vodka has its positives.

I am confused about Coase and the division of labour

An intersting new working paper by Per L. Bylund considers Signifying Williamson's Contribution to Coase's Transaction Cost Approach: An Agent-Based Simulation of Transaction Costs and Specialization. The abstract reads,

This paper simulates Ronald Coase's transaction cost approach to firm organizing using agent-based modeling, and contextualizes and contrasts it with the earlier division-of-labor/specialization theory of the firm that Coase challenged and sought to replace. The simulation tests firm emergence by targeting the difference between the theories, especially Coase’s rejection of specialization as an explanation for integration in the firm. The results show little support for, and suggest a shortcoming to, Coase’s transaction cost theory. These findings indicate a potential relationship between the pre-Coasean theory and Williamson’s Transaction Cost Economics, which can help shed light on the latter’s significant influence in the theory of the firm. (Emphasis added).

It is the idea in bold that confuses me. Consider the following from an interview with Coase:

Wang: Microeconomics is about demand and supply. Compared with classical economics, marginal analysis clearly offers a deeper understanding of consumer choice. But I don’t think it is equally powerful in explicating production, the supply side of the economy.

Coase: To understand production, we have to go back to Adam Smith’s division of labor. It serves well as a starting point, even though the modern economy today has become far more complicated.

Wang: This must be Smith’s most undeserving failure. Modern economics is built on Smith’s framework of the “invisible hand”. But it leaves no room for the division of labor.

Coase: Modern economics shows little interest in production. I am not sure production function tells us anything about production in the economy.

Wang: Adam Smith used the pin factory as an example to develop his analysis of the division of labor. Today, to investigate the division of labor, we can no longer afford to confine our focus to a single firm. Instead, we have to study the organizational structure of production.

Coase: That’s right. The firm remains the cell of the economy, but the intricate relations and constant interactions among the cells determine economic dynamism.

Is this really a man challenging the division of labour?

Also consider this piece from Coase and Wang (2011):

Price theory is primarily concerned with resource allocation, with little to say about production and innovation. The study of the industrial structure of production offers a research program to bring the division of labor back to the center of economics, with direct implications for the study of innovation and entrepreneurship.

Again, does this sound like a man trying to replace the division as an explanation for production, rather the opposite I would think. Coase seems to be saying we need to emphasise the division of labour.

Ref.:

• Coase, Ronald H. and Wang, Ning (2011) 'The Industrial Structure of Production: A Research Agenda for Innovation in an Entrepreneurial Economy', Entrepreneurship Research Journal, 1(2): Article 1.

A "pretense of knowledge" problem? 2

In the comments section to my previous post on this topic Donal Curtin makes the point that

However, unfortunately but unavoidably, it is the job of regulators to set some prices in situations where important markets aren't functioning competitively. I'd prefer if it wasn't, and personally I'd fire the price regulation gun only as a last resort if all other more market-friendly options were exhausted. But that said, even generally pro-market governments find themselves setting some prices. I agree that the process is imperfect, and there are multiple methodology and other choices to make along the way each of which introduces room for error. But sometimes it has to be done, and as well as you can manage, and preferably (as ComCom tends to do) with investment-friendly "err on the high side" numbers, to keep investment flowing into the regulated sector. The opportunity cost point is fine, but I wonder if in practice it's addressed (albeit in some rough and ready fashion) when regulators set a rate of return equal to that earned by "similar" sorts of activity, given that they're likely to be the sorts of activities the regulated company would otherwise have pursued?

My point here would be, and let me go all Coaseian for a moment, that comparative institutional analysis is needed. The first thing the regulators have to show is that their "wrong solution" is likely to be better than the market "wrong solution". It is possible that the regulated outcome is worse that the unregulated one. As Coase said in an interview with Reason magazine in 1997:

Reason: You said you're not a libertarian. What do you consider your politics to be?

Coase: I really don't know. I don't reject any policy without considering what its results are. If someone says there's going to be regulation, I don't say that regulation will be bad. Let's see. What we discover is that most regulation does produce, or has produced in recent times, a worse result. But I wouldn't like to say that all regulation would have this effect because one can think of circumstances in which it doesn't.

Reason: Can you give us an example of what you consider to be a good regulation and then an example of what you consider to be a not-so-good regulation?

Coase: This is a very interesting question because one can't give an answer to it. When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies--perhaps all the studies--suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been. I was not willing to accept the view that all regulation was bound to produce these results. Therefore, what was my explanation for the results we had? I argued that the most probable explanation was that the government now operates on such a massive scale that it had reached the stage of what economists call negative marginal returns. Anything additional it does, it messes up. But that doesn't mean that if we reduce the size of government considerably, we wouldn't find then that there were some activities it did well. Until we reduce the size of government, we won't know what they are.

My issue is that regulators don't seem to think like this, they just seem to assume that whatever they do will be better than what it occurring without their intervention. And I just want them to show that their regulated outcome is likely to be better than the current, albeit imperfect, market situation.

How to misunderstand the Coase theorem 5

Someone else get it! James Johnson at the Monkey Cage gets the point that the Coase Theorem doesn't apply to the reclining seats in airplanes issue. He writes,

In a recent post Josh Barro provides an example by misinterpreting one theoretical argument commonly known as “the Coase Theorem.”

Barro is commenting on a fracas aboard United Airlines flight 1462 last week. One passenger attached an apparatus to the seat in front of him preventing the woman occupying that seat from activating its recline function. When asked by a flight attendant to remove the apparatus the man refused. This caused mayhem that resulted in the pilot diverting the flight so that both passengers could be removed from the plane and reported to the authorities.

Barro declares himself a frequent flier and unrepentant recliner. He seems genuinely perplexed by the animus toward people like himself, reflected in media commentary, this fracas reveals. In his defense Barro invokes the “Coase Theorem” which, he believes, provides useful advice for how to avoid situations like the one that erupted on United 1462. He poses this question: “If sitting behind my reclined seat was such misery, if recliners like me are ‘monsters,’ as Mark Hemingway of The Weekly Standard puts it, why is nobody willing to pay me to stop?” Unfortunately for Barro, the Coase Theorem does not support the conclusion he draws. If we consider what the Coase Theorem actually says, we won’t be surprised either by the events on United 1462 or by the fact that no one offers Barro money to change his reclining ways.

and

Coase’s argument appears to generalize the virtues of decentralized market exchange, namely voluntary action generating efficient outcomes, to situations of strategic interdependence where markets tend to function poorly, if at all. For it to work, however, two conditions must hold. First, the initial distribution of property rights must be well defined. Second, transaction costs must be zero. This is where Barro goes astray. In the dispute between recliners and reclined upon, neither condition obtains.

Barro recognizes the first condition. He insists that, having purchased a seat with a recline option, passengers “own the right to recline.” Consequently, by installing an apparatus on the seatback in front of him, the man on United 1462, “usurped his fellow passenger’s property rights.” This claim is contestable. What is at issue is increasingly limited space and access to it. And if crew member instructions provide any indication, passengers “own the right” to the space under the seat in front of them where they are told to place their carry-on items. Recliners limit the reclined-upon passenger’s access to that space and any belongings stowed there. Moreover, passengers purchase a seat with a tray table and arguably “own the right” to use it for a variety of purposes. Reclining often interferes with that right as well. The airlines and the government treat recline function and tray tables as equivalent in their safety instructions: “In preparation for landing please make sure your tray table is stowed and your seat back is in the upright and locked position.” Despite his confident assertion, Barro is mistaken to assert that property rights to space for airline passengers are well-defined.

Even if you accept Barro’s view of property rights, what about transaction costs? Here Barro is sloppy. He depicts the dispute between recliners and reclined upon as one where “transaction costs are low.” Coase, however, insists that for his argument to work, transaction costs must be zero. Not low. Zero. Yet the reclined upon face substantial transaction costs. Most obviously, information problems abound, even beyond the ambiguous distribution of property rights. It would be costly to discern which type of person they might be bargaining with. Are they sitting behind an inveterate recliner and who might turn belligerent if asked not to recline, even for a price? Is the passenger in front of them a moralist who will take offense at the very suggestion of treating one another as bargaining partners rather than relying on norms of decency and respect? Other such possibilities are plentiful. Barro simply dismisses such problems because it suits his claim that, if only they would try, the reclined upon could easily buy off recliners like himself.

That property rights to the space around a seat are not well defined is the point I made in my first post on this issue. I am not so sure about Johnson's second point. I would say that transactions are low in that you know who you are bargaining with and its simple to bargaining with them, they are just in front of you. This doesn't mean that bargaining will not be hard. I don't see anything in the Coase Theorem that says bargaining must be easy, it just says whoever values the property right most will end up with it. May be only after some tough negotiations.

How not to run a company

At the Offsetting Behaviour blog Eric Crampton reminds us of one of the great stories about the inefficiency of the old Eastern Block. Eric writes,

Remember the story of the West German auto exec who, after touring the Trabant plant, wept because the value of the steel and other inputs going in exceeded the value of the car coming out? The Trabant plant was destroying value.

For those who don't know it, the story comes from a World Bank publication, Transition: a newsletter of the World Bank, Number 5-6, May-June 1996, page 15:

With a view to corporate takeover Volkswagen AG sent a Herr Heuss to Zwickau to find out how the Trabant (relatively cheap, East German cars) were made there. He emerged shocked from the huge plant, babbling "My God!" The Trabant operation was value-subtracting: valuable material, labor, and capital inputs went in at one end; shabby Trabies came out at the other, their bodies made from compacted trash. The final output was worth less than the sum of the inputs. What was not fully understood at the time was that East Germany's whole economy was value-subtracting and cost-unconscious.

I still can't get my head round the idea that "production" is value decreasing! But its something to keep in mind when there are those who would have the government take a much greater role in running the economy and owning firms. It doesn't doesn't always end well.

A "pretense of knowledge" problem?

Over at the, ever interesting, Economics New Zealand blog Donal Curtin writes,

Chorus got bowled like ninepins this morning by the Court of Appeal, having earlier been skittled by the High Court.

The cases were about the Commerce Commission proposing a big reduction in the price Chorus could charge for UBA, or as it is formally defined, "the additional UBA service component, which allowed access seekers to supply broadband services over Telecom’s copper access lines without investing in their own equipment or software". In other words, the bits and bobs that carry broadband traffic across the gap between the copper line from your place and the start of an ISP's network.

The reduction (roughly halving the price) had been based on a benchmarking exercise, where the Commission (as required by the Telecommunications Act) looked at the prices overseas for UBA as a quick and dirty proxy for what it might well cost here. There's lots more about the exact details of the benchmarking comparability exercise, but that's the gist of it.

and

So now on we go to the Commission's final word on the UBA price, which will be determined by modelling the actual costs of an efficient provider in New Zealand (Chorus had exercised its right to object to the benchmark stab at the price and to have local costs estimated explicitly).

So what's my problem here? In short, it isn't the job of courts or regulators to determine costs or prices. About the only thing you can say about outcomes determined by such procedures is that they are wrong. As I noted in a post a couple of days ago, Dixit on costs, Avinash Dixit writes that,

In other words, opportunity costs are the correct measure. But these are based on expectations and calculations done within firms, and are not available in reported data.

If we accept this, then its not clear what basis the regulator or the courts have for determining costs and thus prices. At best these bodies have to deal with "reported data" but as noted such data misses some of the most important determines of opportunity costs. Without measures of theses how can a regulator or court arrive at any sensible view on what costs are?

Looks like there is a bit of the "pretense of knowledge" problem here.

Innovation, exports and technical efficiency

What are the effects of the size of the market in which a firm operates on the efficiency and productivity of the firm? According to a new working paper by M. Ángeles Díaz-Mayans and Rosario Sánchez-Pérez those Spanish firms involved in exporting, and thus facing a market much larger than just the local market, are more efficient and productive.

The abstract of the paper reads,

This paper analyses the relationship between exports, innovative activities and size and their effect over firms’ technical efficiency and then over their productivity. The analysis takes, also, into account other variables that could affect productivity as industrial sector, or firms’ financial conditions. We use a micro panel data set of Spanish manufacturing firms, during the period 2004–2009, to simultaneously estimate a stochastic frontier production function and the inefficiency determinants. The data source is published in the Spanish Industrial Survey on Business Strategies (Encuesta sobre Estrategias Empresariales, ESEE), collected by Fundación SEPI. Our results show that exporting firms are more efficient than non-exporting firms; and that small and medium-sized firms’ tent to be more efficient when they focus on international markets.

An obvious question this gives raise to is, Why? From the conclusion of the paper,

The inefficiency determinants can be due to environmental or firm specific factors. Here we focus on these firms specific factors to provide an explanation to the differences in technical inefficiency across Spanish manufacturing firms. Inefficiency tends to be smaller for firms with a higher ratio of gross investment over capital. Firms that account for this kind of investment become more competitive as a consequence of having a higher efficiency in their production process.

Also, we found that exporting firms are closer to the stochastic frontier. They have to be more competitive to sell in international markets. Only the most efficient firms survive in the highly competitive international market.

Size is another determinant of technical efficiency. Even though the impact of size in technical efficiency is not clearly determined in empirical and theoretical frameworks, here we obtain a positive and significant effect over efficiency. What it means that large firms are closer to the efficient frontier.

In addition, efficiency tends to be smaller for those firms with a higher proportion of external funds over value added.

None of these results seem counter-intuitive but you may ask about causation in some cases. For example does size help determine efficiency or does efficiency help determine size? That is, it is the more efficient firms that grow?

Anyway, more reasons for supporting free trade.

EconTalk this week

Paul Pfleiderer, C.O.G. Miller Distinguished Professor of Finance at the Graduate School of Business at Stanford University, talks with EconTalk host Russ Roberts about his recent paper critiquing what Pfleiderer calls "Chameleon Models," economic models that are thought to explain the real world with little analysis of the accuracy of their assumptions. Also discussed are Akerlof's market for lemons model, Friedman's idea that assumptions do not have to be reasonable as long as the model predicts what happens in the real world, and the dangers of leaping from a model's results to making policy recommendations.

A direct link to the audio is available here.

Innovation, inequality and economics: Edmund Phelps is interviewed by Mark Thoma

From VoxEU.org comes this video in which Edmund Phelps and Mark Thoma discuss a number of topics including Phelps's argument that a loss of dynamism in the western world is stalling innovation thereby reducing productivity growth and threatening future prosperity, graduate economics education, inequality and austerity.

EconTalk last week

Nathan Blecharczyk, co-founder and chief technology officer of Airbnb, talks with EconTalk host Russ Roberts about Airbnb, one of the earliest companies to use technology to allow individuals to share underused resources, and in the case of Airbnb, housing. Blecharczyk and Roberts discuss how a design conference and the Democratic National Convention got Airbnb started, how the company aligns incentives to overcome the trust problem of house-sharing, and the rise of technology and online social networks to make a new business model possible. Along the way, Blecharczyk gives his take on the role of luck vs. skill in entrepreneurial success and how Airbnb plans to expand its product offerings in the future.

A direct link to the audio is available here.

Dixit on costs

From Avinash Dixit's new book, Microeconomics: A Very Short Introduction, comes this discussion of costs and the supply curve. Dixit is discussing an example of calculating a short-run supply curve for crude oil.

Although this example makes the idea of a supply curve stand out vividly, it is merely illustrative. First, data are not available for all countries; for example Russia and China are omitted for want of cost data. Second, countries or regions are not the right unit of analysis. Ideally we should have data on lifting costs and capacities for all the thousands of individual wells. These differ greatly within a country; they would generate a smooth supply curve instead of the large steps shown. Finally and most importantly, lifting costs are not correct short-run marginal costs. Firms that operate the wells have the choice of leaving oil in the ground, thus producing at less than full capacity, if they believe that prices will rise in the future. In other words, opportunity costs are the correct measure. But these are based on expectations and calculations done within firms, and are not available in reported data. Therefore this example can be used to improve understanding of the ideas, but should not be taken literally (Emphasis added).

One implication of the bit in bold is that, at best, without detailed firm level data you cannot estimate a supply curve. But as expectations are subjective, at least to some degree, it may be impossible to get data on the opportunity costs at all. The expectations held by members of the firm will differ depending on the particular person being asked. Also even if that person can detail their expectations well enough to be part of a quantifiable data set, the data will change person by person. Thus the whole idea of an objective cost function that can be estimated from "the data" becomes untenable.

Now there's a thought that could ruin an econometrician's day.

You know your economy is in even more trouble when ......

This from the Economist magazine:

Venezuela is in trouble. Such trouble, in fact, that the central bank (BCV) has not published GDP figures since the beginning of the year and is two months behind with inflation figures. Leaks from inside the BCV suggest annual inflation is now well over 60% and that GDP fell by almost 5% in the first half of 2014. Shortages of food, medicines and other basic goods, including spare parts and tyres for vehicles, have reached critical levels. Representatives of private health clinics say more than half have suspended elective surgery for lack of crucial supplies and parts for medical equipment. The government plans to address shortages by fingerprinting customers to prevent them from buying extra goods to sell on the black market.

Dependent on oil revenues for 97 out of every hundred dollars in foreign earnings, and on imports for a large part of what it consumes, the country is heavily in debt to foreign suppliers, many of whom have cut off credit. But instead of adopting an adjustment plan, the government has continued to print money and introduce ever more stringent price and exchange controls. Massive price differentials with neighbouring Colombia have fuelled the contraband trade, to which the authorities have responded by closing the border at night.

You can't help but think that this can't end well.