Why, for so long, was there no theory of the firm?

The theory of the firm is one of the more recent innovations in economics having only really started around 1970. This is strange since we have been producing stuff since humans become human. The question is therefore why did it take so long for anyone one to ask questions about the institutional organization of production. I will argue there are at least two parts to the answer to this question.

The first is that microeconomics in general is a relatively new area of research having really only taken off with the neoclassical revolution of the 1870s. Before then most discussion of economic issues was about what we would now call macroeconomic questions. The mercantilists, the physiocrats and the classical economists, for example, emphasised macroeconomic inquiries.

There were at times, in the mercantilist literature, much discussion of firms but it was a limited discussion. Limited in the sense that it dealt not with issues to do with firms per se but with the effects of firms on more macro issues such as recession, bullion and the balance of trade. In addition it gave occasion for the crystallization of protectionist doctrine. It was also limited in that it largely dealt only with the regulated companies and the opposition to their monopolies.

Foss and Klein (2006: 7-8) note that 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”.

O’Brien (2004: 63) makes the same basic point by noting the differences in emphasis between classical and neoclassical economics:

“[t]he core of neo-Classical economics is the theory of microeconomic allocation, to which students are introduced in their first year in an elementary and largely intuitive form, and which receives increasingly sophisticated statements during succeeding years of study. On top of this, as a sort of icing on the cake, comes the macroeconomics theory of income determination, with, in little attached boxes so to speak, theories of growth and trade appended. But the approach of the classical economists was the very reverse of this. For them the central propositions of economics concerned macroeconomic problems. Their focus above all was on the problem of growth, and the macroeconomic distribution conclusions which followed from their view of growth. On the one hand, international trade, at least for Smith, was inextricably bound up with all this: on the other, the microeconomic problems of value and microdistribution took their place as subsets of the greater whole”.

Thus the firm wasn’t examined because microeconomic questions in general weren’t examined.

The second part of the answer is that firms weren’t for a long time of much importance to the economy as a whole. For much of human history production and consumption were very closely interconnected. Production for those outside of the production unit was largely unknown. That is, there was little production for trade. The production and consumption units were, by and large, the same. This point is important since some form of trade is a necessary, if not sufficient, condition for a firm to exist since without trade consumption and production must coincide, that is, the objectives of the producer and consumer will be the same. The coincidence of consumption and production in a world without trade, or at least a world with little trade, was noted as a potential problem by McDonald and Snooks (1986) in their analysis of manorial production in Domesday England:

“In the absence of trade, all the goods produced on the manor will be consumed on the manor. Such a situation makes it difficult to interpret the results of our production function estimates, because it becomes difficult to draw a distinction between the manor as a unit of production and as a unit of consumption: manorial production behaviour will be inextricably combined with the lord’s consumption preferences (or utility function). The underlying reason is that the implicit prices of output reflect both the production and the consumption behaviour of the manor, rather than just the costs of manorial production” (McDonald and Snooks 1986: 99).

So for the firm to become a major player in the economy, the market had to grow to the point where trade, both national and international, was large enough to allow the division of labour to develop and for specialised production units to be able to develop and survive. It is only then that production can be separated from consumption and firms can become separate from households.

It is only when self-sufficiency makes way for specialisation and trade that a discussion of firms becomes relevant.

The Consequences of Keynes

is the title of a new essay by Peter J. Boettke (George Mason University - Department of Economics) and Patrick Newman (George Mason University).

The abstract reads:

This paper discusses the consequences of John Maynard Keynes for the science of political economy, or the fields of economics, economic policy, and politics. It argues that the consequences of Keynes in all three fields were negative and resulted in a significant retrogression. For economics, a macroeconomic theory of an unstable capitalist economy supplanted the theory of the market process which concentrated on the individual actions of entrepreneurs and their effects on relative prices and production. For economic policy, activist tinkering on behalf of policy advisors replaced the theory of limited and hands off governments. For politics, unrestricted politicians and continual deficits and inflation replaced restrained politicians who adhered to balanced budgets and sound money.

I'm guessing not a paper that will be to everyone's taste!

Professor Benjamin Powell on sweatshops

This video was recorded at the Mises Institute in Auburn, Alabama, on 26 July 2016.

Peter Klein on entrepreneurs and firms

In a recent article Peter Klein talks about Why entrepreneurs need firms, and the theory of the firm needs entrepreneurship theory. He writes,

And yet, there is much less work in this tradition explaining the emergence of the firm. Where do firms come from? Most are established by entrepreneurs, and indeed, the most common definition of “entrepreneur” for academics and practitioners is “one who forms a new business organization.” One would then think that entrepreneurship theory would be part of the theory of the firm. Put differently, entrepreneurs are individuals who establish, operate, reconfigure, dissolve, and otherwise work through firms; hence economic theories of the firm – as well as theories of the firm drawn from psychology, sociology, operations research, and so on – might be considered applications of entrepreneurship theory. Alas, neither is true; for the entrepreneurship field has its own research literature, largely divorced from the literatures on firm organization and firm strategy. The entrepreneurship literature focuses mostly on individuals, not organizations, and on firm creation, not firm operation.

There is much truth in what Klein says. The standard theory of the firm literature looks at three basic questions to do with Why firms exist, What the boundaries of firms are and What determines the internal organisation of firms. What it, by and large, doesn't consider is where firms come from. This is where the role of the entrepreneur is important.

But all is not lost. In Walker (forthcoming) I briefly discuss two recent attempts to integrate the theories of the firms and entrepreneurship, including work by Klein himself. These attempts are Spulber (2009) and Foss and Klein (2012). The Foss and Klein approach to the firm, like that of Spulber but unlike the more standard approaches, emphasises the role of the entrepreneur. Foss and Klein wish to explain the formation of, determination of the boundaries of and the internal organisation of the firm. The things that set Foss and Klein apart from the mainstream are the importance given in their theory to the entrepreneur and they develop their theory utilising a combination of Knightian uncertainty and Austrian capital theory. Spulber seeks to explain why firms exist, how firms are established, and what firms contribute to the economy. He sets out to create an approach to microeconomics in which entrepreneurs, firms, markets, and organisations are all endogenous. An even more recent contribution in this area is Bylund (2015). This paper attempts to explain how firm emerge and the role of firms in the market structure using the productive power of specialisation. The basic idea is that emergence is based on productivity efficiencies developed through technological specialisation. This approach leads an to understanding of the firm's function to the entrepreneur and its internal organisation and capabilities.

The Bylund, Foss and Klein and Spulber contributions open important new lines of inquiry for the theory of the firm since Hamlet really does need the Prince of Denmark.

Refs.:

• Bylund, P.L. (2015). "Explaining firm emergence: Specialization, transaction costs, and the integration process", Managerial and Decision Economics, 36(4): 221-38.
• Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm, Cambridge: Cambridge University Press.
• Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations, Cambridge: Cambridge University Press.

Inequality v's crony capitlism

At his Stumbling and Mumbling blog, everybody's third favourite Marxist, Chris Dillow says Yes, Inequality Matters. Dillow writes,

A free market society in which high incomes arise from the free choices of consenting adults – as in Robert Nozick’s Wilt Chamberlain parable – might have the same Gini coefficient as a crony capitalist society. But they are two different things. A good reason to be worried about current inequality – even if it hasn’t changed – is that it is a symptom of market failures such as corporate welfare, regulatory capture or the implicit subsidy to banks.

Here I think Dillow is right .... and wrong. He is right that crony capitalist societies are bad, but he wrong to tie this to inequality.

The reasons for disliking crony capitalism is the inefficiencies, via things like rent seeking, corporate welfare, subsidies to favoured industries etc, that such a system invariably results in. But these outcomes are independent of the level of inequality.

Even if inequality was low under a crony capitalist system, that system would still be in need of change and if a (truly) free market society has greater inequality it would not justify the transformation that the crony capitalist system would. Inequality is not the reason for worrying about crony capitalism, there are many other, better, justifications for doing so.

Not everything that is thought wrong in this world is due to inequality, no matter what some people will tell you.

The beginning of British economics?

An interesting comment from Beer (1938: 86-7):

In 1581, a certain W.S., into the personality of which it is irrelevant to inquire, brought out a quarto volume under the tide A Briefe Conceipte of Inglish Policie, which may be regarded as the beginning of British political economy: The treatise was reprinted in 1751, 1808, 1813. 1876 by various publishers, one of whom thought to have discovered under the letters W.S. the name of William Shakespeare. In 1893 it was edited under the title A Discourse of the Commonweal of this Realm of England, by Miss Elizabeth Lamond. The editing may serve as a model for such literary ventures, though not easily imitated or duplicated. She sent the book out with an introduction-the product of vast researches-proving with a certainty which is all but absolute that it was John Hales (a member of Parliament in 1548, a member of the Commission on Enclosures in I 549, a promoter of learning, a reformer imbued with warm sympathy for the dispossessed peasantry) who wrote it in 1549 (Emphasis added).

I must say its the first time I have seen such a claim. I don't recall any other historian of economic thought arguing that it is the start of British economics. That said, no lesser historian of thought than Lionel Robbins does say that it is "highly readable" and that it contains the first statement of the quantity theory of money. Robbins also argues that it is unlikely that John Hales is the author of the work. He argues that the author is Sir Thomas Smith (Robbins 1998: 42-3).

Refs.:

• Beer, M. (1938). Early British Economics: From the Thirteenth to the Middle of the Eighteenth Century, London: George Allen and Unwin Ltd.
• Robbins, Lionel (1998). A History of Economic Thought: The LSE Lectures, Princeton: Princeton University Press.

How mandatory shareholder voting prevents bad corporate acquisitions

In a new column at VoxEU.org Marco Becht, Andrea Polo and Stefano Rossi argue that many corporate acquirers impose losses on their shareholders. Conflicted or overconfident CEOs and boards embark on acquisitions that are not in the best interest of the owners of the firm. They go onto argue that the governance tool of shareholder voting can represent a potential solution. Their column shows that in the UK, where bids for relatively large targets require mandatory shareholder approval, shareholders gain when the transaction is conditional on a vote and lose when it is not. The evidence suggests that the vote puts a constraint on the amount the CEO can offer for the target.

This does raise the question that if this is true, why do we not see more shareholder activism on this issue? Also if this is true and activism is low, ie "voice" is not used, then why do we not see more "exit" occurring? That is, why do we not see disgruntled shareholders selling their shares?

Becht, Polo and Rossi write,

One of the most striking empirical regularities in finance is that many acquirer shareholders earn negative abnormal returns (Andrade et al. 2001, Bouwman et al. 2009), and that the losses from the worst performing deals are very large (Moeller et al. 2005). Why is this the case?

The finance literature has pointed to two non-mutually exclusive explanations. First, in line with the traditional ‘separation of ownership and control’ problem, managers who control widely held corporations may have private goals – such as empire building – that conflict with those of shareholders, particularly in the case of acquisitions (Morck et al. 1990). According to this view, managers know what they are doing and deliberately take excessive risks. Second, managers may be overconfident or suffer from ‘hubris’, thereby paying too much relative to rational managers (Roll 1986, Malmendier and Tate 2008).

Can shareholders address these issues and prevent negative abnormal returns in acquisitions from materialising in the future? In principle, shareholder voting can provide a potential solution in both of the cases described above. Rational shareholders can veto actions driven by overconfidence, while vigilant or active shareholders can halt transactions motivated solely by empire building or private benefit purposes. If shareholder voting is effective in deterring CEOs’ behavior, CEOs will not overpay relative to the median shareholder and will not propose projects the shareholders are unlikely to support. As a result, in equilibrium all acquisition proposals will be approved.

In the conclusion Becht, Polo and Rossi ask, given the above results, why is mandatory voting on relatively large acquisitions not adopted more widely among issuers? In their answer to their own question they write,

Acquirer shareholders could be better off by writing a mandatory voting provision into the corporate charter. In some jurisdictions this might be difficult because the board and the management can get in the way and want to guard their autonomy. Under Delaware law in the US, for example, shareholders could potentially make the necessary charter amendment but this would require the approval of the board. The same frictions that explain the large value destruction in acquisitions - self-dealing and overconfidence - might explain why we do not see such charter amendments. In other countries company law and listing rules simply do not foresee the possibility of mandatory voting on acquisitions. Acquirer shareholders would have to lobby more effectively to get the tools that would allow them to protect their wealth.

How well does GDP measure the digital economy?

A question asked by Timothy Taylor at his Conversable Economist blog. Taylor writes,

Digital technologies aren't just changing the way existing companies communicate and keep records, but are creating new kinds of companies (think Uber, AirBnB, or Amazon) and products (think and "free" products like email and websearch or an app like Pokemon Go). Can the old-style methods of measuring GDP keep up? Nadim Ahmad and Paul Schreyer of the OECD tackle this question in "Are GDP and Productivity Measures Up to the Challenges of the Digital Economy?" which appears in the Spring 2016 issue of International Productivity Monitor, which in turn is published by the Ontario-based Centre for the Study of Living Standards. Perhaps a little surprisingly, their overall message is upbeat. Here's the abstract:

"Recent years have seen a rapid emergence of disruptive technologies with new forms of intermediation, service provision and consumption, with digitalization being a common characteristic. These include new platforms that facilitate peer-to-peer transactions, such as AirBnB and Uber, new activities such as crowd sourcing, a growing category of the ‘occasional self-employed’ and prevalence of ‘free’ media services, funded by advertising and ‘Big data’. Against a backdrop of slowing rates of measured productivity growth, this has raised questions about the conceptual basis of GDP, and whether current compilation methods are adequate. This article frames the discussion under an umbrella of the Digitalized Economy, covering also statistical challenges where digitalization is a complicating feature such as the measurement of international transactions and knowledge based assets. It delineates between conceptual and compilation issues and highlights areas where further investigations are merited. The overall conclusion is that, on balance, the accounting framework for GDP looks to be up to the challenges posed by digitalization. Many practical measurement issues remain, however, in particular concerning price changes and where digitalization meets internationalization."

Contrary to this "upbeat" assessment I would argue that there are reason to think that GDP, as we know it, does not capture much of what happens within the digital/knowledge/information economy, call it what you will. There are substantial challenges to be overcome in any attempt to measure the such an economy. These are at both the theoretical and the method level.

To begin with, a more consistent set of definitions are required as are more robust measures that are derived from theory rather than from whatever data is currently or conveniently available. In order to identify the size and composition of the knowledge based economy one inevitably faces the issue of quantifying its extent and composition. Economists and national statistical organisations are naturally drawn to the workhorse of the ‘System of National Accounts’ as a source of such data. Introduced during World War II as a measure of wartime production capacity, the change in (real) Gross Domestic Product (GDP) has become widely used as a measure of economic growth. However, GDP has significant difficulties in interpretation and usage (especially as a measure of well being) which has led to the development of both ‘satellite accounts’ - additions to the original system to handle issues such as the ‘tourism sector’; ‘transitional economies’ and the ‘not-for-profit sector’ - and alternative measures, for example, the Human Development Indicator and Gross National Happiness. GDP is simply a gross tally of products and services bought and sold, with no distinctions between transactions that add to well being, and those that diminish it. It assumes that every monetary transaction adds to well being, by definition. Organisations like the Australian Bureau of Statistics and the OECD have adopted certain implicit/explicit definitions, typically of the Information Economy-type, and mapped these ideas into a strong emphasis on impacts and consequences of ICTs. The website (http://www.oecd.org/sti/information-economy) for the OECD’s Information Economy Unit states that it:

“[...] examines the economic and social implications of the development, diffusion and use of ICTs, the Internet and e-business. It analyses ICT policy frameworks shaping economic growth productivity, employment and business performance. In particular, the Working Party on the Information Economy (WPIE) focuses on digital content, ICT diffusion to business, global value chains, ICT-enabled off shoring, ICT skills and employment and the publication of the OECD Information Technology Outlook.”

Furthermore, the OECD’s Working Party on Indicators for the Information Society has

“[...] agreed on a number of standards for measuring ICT. They cover the definition of industries producing ICT goods and services (the “ICT sector”), a classification for ICT goods, the definitions of electronic commerce and Internet transactions, and model questionnaires and methodologies for measuring ICT use and e-commerce by businesses, households and individuals. All the standards have been brought together in the 2005 publication, Guide to Measuring the Information Society [ . . . ]” (http://www.oecd.org/document/22/0,3343,en_2649_201185_34508886_1_1_1_1,00.html).

The whole emphasis is on ICTs. For example, the OECD’s “Guide to Measuring the Information Society” has chapter headings that show that their major concern is with ICTs. Chapter 2 covers ICT products; Chapter 3 deals with ICT infrastructure; Chapter 4 concerns ICT supply; Chapter 5 looks at ICT demand by businesses; while Chapter 6 covers ICT demand by households and individuals.

As will be shown below several authors have discussed the requirements for, and problems with, the measurement of the knowledge/information economy. As noted above most of the data on which the measures of the knowledge economy are based comes from the national accounts of the various countries involved. This does raise the question as to whether or not the said accounts are suitably designed for this purpose. There are a number of authors who suggest that in fact the national accounts are not the appropriate vehicle for this task. Peter Howitt argues that:

“[...] the theoretical foundation on which national income accounting is based is one in which knowledge is fixed and common, where only prices and quantities of commodities need to be measured. Likewise, we have no generally accepted empirical measures of such key theoretical concepts as the stock of technological knowledge, human capital, the resource cost of knowledge acquisition, the rate of innovation or the rate of obsolescence of old knowledge.” (Howitt 1996: 10).

Howitt goes on to make the case that because we can not measure correctly the input to and the output of, the creation and use of knowledge, our traditional measure of GDP and productivity give a misleading picture of the state of the economy. Howitt further claims that the failure to develop a separate investment account for knowledge, in much the same manner as we do for physical capital, results in much of the economy’s output being missed by the national income accounts.

In Carter (1996) six problems in measuring the knowledge economy are identified:

1. The properties of knowledge itself make measuring it difficult,
2. Qualitative changes in conventional goods: the knowledge component of a good or service can change making it difficult to evaluate their ‘levels of output’ over time,
3. Changing boundaries of producing units: for firms within a knowledge economy, the boundaries between firms and markets are becoming harder to distinguish,
4. Changing externalities and the externalities of change: spillovers are increasingly important in an knowledge economy
5. Distinguishing ‘meta-investments’ from the current account: some investments are general purpose investments in the sense that they allow all employees to be more efficient
6. Creative destruction and the ‘useful life’ of capital: knowledge can become obsolete very quickly and as it does so the value of the old stock drops to zero.

Carter argues that these issues result in it being problematic to measure knowledge at the level of the individual firm. This results in it being difficult to measure knowledge at the national level as well since the individual firms’ accounts are the basis for the aggregate statistics and thus any inaccuracies in the firms’ accounts will compromise the national accounts.

Haltiwanger and Jarmin (2000) examine the data requirements for the better measurement of the information economy. They point out that changes are needed in the statistical accounts which countries use if we are to deal with the information/knowledge economy. They begin by noting that improved measurement of many “traditional” items in the national accounts is crucial if we are to understand fully Information Technology’s (IT’s) impact on the economy. It is only by relating changes in traditional measures such as productivity and wages to the quality and use of IT that a comprehensive assessment of IT’s economic impact can be made. For them, three main areas related to the information economy require attention:

The investigation of the impact of IT on key indicators of aggregate activity, such as productivity and living standards,

1. The impact of IT on labour markets and income distribution and
2. The impact of IT on firm and on industry structures.

Haltiwanger and Jarmin outline five areas where good data are needed:

1. Measures of the IT infrastructure,
2. Measures of e-commerce,
3. Measures of firm and industry organisation,
4. Demographic and labour market characteristics of individuals using IT, and
5. Price behaviour.

In Moulton (2000) the question is asked as to what improvements we can make to the measurement of the information economy. In Moulton’s view additional effort is needed on price indices and better concepts and measures of output are needed for financial and insurance services and other “hard-to-measure” services. Just as serious are the problems of measuring changes in real output and prices of the industries that intensively use computer services. In some cases output, even if defined, is not directly priced and sold but takes the form of implicit services which at best have to be indirectly measured and valued. How to do so is not obvious. In the information economy, additional problems arise. The provision of information is a service which in some situations is provided at little or no cost via media such as the web. Thus on the web there may be less of a connection between information provision and business sales. The dividing line between goods and services becomes fuzzier in the case of e-commerce. When Internet prices differ from those of brick-and-mortar stores do we need different price indices for the different outlets? Also the information economy may affect the growth of Business-to-Consumer sales, new business formation and in cross-border trade. Standard government surveys may not fully capture these phenomena. Meanwhile the availability of IT hardware and software results in the variety and nature of products being provided changing rapidly. Moulton also argues that the measures of the capital stock used need to be strengthened, especially for high-tech equipment. He notes that one issue with measuring the effects of IT on the economy is that IT enters the production process often in the form of capital equipment. Much of the data entering inventory and cost calculations are rather meagre and needs to be expanded to improve capital stock estimates. Yet another issue with the capital stock measure is that a number of the components of capital are not completely captured by current methods, an obvious example being intellectual property. Also research and development and other intellectual property should be treated as capital investment though they currently are not. In addition to all this Moulton argues that the increased importance of electronic commerce means that the economic surveys used to capture its effects need to be expanded and updated.

In Peter Howitt’s view there are four main measurement problems for the knowledge economy:

1. The “knowledge-input problem”. That is, the resources devoted to the creation of knowledge are underestimated by standard measures.
2. The “knowledge-investment problem”. The output of knowledge resulting from formal and informal R&D activities is typically not measured.
3. The “quality improvement problem”. Quality improvements go unmeasured.
4. The “obsolescence problem”. No account is taken of the depreciation of the stock of knowledge (and physical capital) due to the creation of new knowledge.

To deal with these problems Howitt makes a call for better data. But it’s not clear that better data alone is the answer, to both Howitt’s problems and the other issues outlined here. Without a better theory of what the “knowledge economy” is and the use of this theory to guide changes to the whole national accounting framework, it is far from obvious that much improvement can be expected in the current situation.

One simple, theoretical, question is, To which industry or industries and/or sector or sectors of the economy can we tie knowledge/information production? When considering this question several problems arise. One is that the “technology” of information creation, transmission and communication pervades all human activities so cannot fit easily into the national accounts categories. It is language, art, shared thought, and so on. It is not just production of a given quantifiable commodity. Another issue is that because ICT exists along several different quantitative and qualitative dimensions production can not be added up. In addition if much of the knowledge in society is tacit, known only to individuals, then it may not be possible to measure in any meaningful way. Also if knowledge is embedded in an organisation via organisational routines then again it may not be measurable. Organisational routines may allow the knowledge of individual agents to be efficiently aggregated, much like markets aggregate information, even though no one person has a detailed understanding of the entire operation. In this sense, the organisation “possesses” knowledge which may not exist at the level of the individual member of the organisation. Indeed if, as Hayek can be interpreted as saying, much of the individual knowledge used by the organisation is tacit, it may not even be possible for one person to obtain the knowledge embodied in a large corporation.

As noted above Carter (1996) emphasises that it is problematic to measure knowledge at the national level in part because it is difficult to measure knowledge at the level of the individual firm. Part of the reason for this is that none of the orthodox theories of the firm offer us a theory of the “knowledge firm” which is needed to to guide our measurement.

Thus many of the measurement problems of the "knowledge economy" are rooted in the fact that we don't have a good theory of the "knowledge economy" or the "knowledge firm". Without such theories calls for better data are wasted, they miss the point. "Better" data collection alone is not going to improve the measurement of the "digital/knowledge/information economy".

Mercantilism and the firm

As is well known the classical economists had no serious theory of the firm. For them economics was more orientated towards marcoeconomic issues than microeconomic ones such as the firm. This situation is one they largely inherited from the mercantilists.

There were at times, in the mercantilist literature, much discussion of firms but it was a limited discussion. Limited in the sense that it dealt not with issues to do with firms per se but with the effects of firms on more macro issues such as the balance of trade. It was also limited in that it largely dealt only with the regulated companies and their monopolies.

When discussing the period 1640-1690, Magnusson (1994) argues that several mercantilist writes attacked the regulated companies. Some authors argued for the adoption of measures to end the monopoly position that regulated companies such as the Merchant Adventurers, the Russian Company, the Levant Company and the East India Company held. There were also debates about the effects of companies like the East India Company on the balance of trade. Gerrad Malynes, for example, argued that the East India Company was exporting money “beyond the seas” and thus hurting England’s balance of trade.

But other voices where added to the chorus against the regulated companies as the seventeenth century progressed. In 1645, for example, an anonymous writer, in a pamphlet entitled “A Discourse Consisting of Motives for the Enlargement and Freedome of Trade”, attacked the Merchant Adventurers. The author argued that there is nothing more “ … pernicious and destructive to any Kingdom or Common-wealth than Monopolies”.

But regulated companies also had their defenders. In 1602 John Wheeler defended the Merchant Adventurers saying that its traffic in cloth led to that “ … a number of labouring men are set to work and gain much monie, besides that which the Merchant gaineth”. That is, what’s good for the Adventurers is good for the country! In 1641 Lewell Roberts recommended that more regulated companies should be set up. He was of the opinion that “ … joyn one with another in a corporation and Company, and not to kase their Traffike by themselves asunder, or apart” would lead to increased strength and maximum benefits for a trading nation. In addition, Thomas Mun, Edward Misselden and Sir Josiah Child had all defended the East India Company from attack at different times.

It should be noted, however, that much of these debates were partisan rent seeking with each side just dressing up their position in terms of the public good. But as Magnusson notes for " ... at least one scholar, Thomas, the controversies around this company [The East India Company] was an overall  important factor propelling the economic discussion as such during most of this century".

Importantly for our purposes such a discussion is more policy orientated than economics orientated. One point is that although such arguments involve firms they do not require a theory of the firm. Just accepting that the firms do exist is enough for policy evaluation, there is no need for an explanation of what a firm is, what its boundaries are or what its internal organisation is.

So what we see here is much like the situation with the classical economists, a largely macroeconomic originated outlook with no need for a serious theory of the firm.

Ref.:

• Magnusson, Lars (1994). Mercantlitism: The Shaping of an Economic Language, London: Routledge.

David Friedman on "Future Imperfect"

Professor David Friedman delivers the THINK 2016 keynote address on the "Future Imperfect".

What kinds of transformative technologies are likely or possible in the near future? How will they affect us and our relations with government? Will they enhance and extend individual freedom or threaten it – or may they do both? What are the implications for politics and government of some of the things that are happening, that we can foresee and can realistically imagine?

An empirical analysis of racial differences in police use of force

A timely new NBER working paper.

An Empirical Analysis of Racial Differences in Police Use of Force
Roland G. Fryer, Jr
NBER Working Paper No. 22399
Issued in July 2016
NBER Program(s): LE LS POL The abstract reads:

This paper explores racial differences in police use of force. On non-lethal uses of force, blacks and Hispanics are more than fifty percent more likely to experience some form of force in interactions with police. Adding controls that account for important context and civilian behavior reduces, but cannot fully explain, these disparities. On the most extreme use of force – officer-involved shootings – we find no racial differences in either the raw data or when contextual factors are taken into account. We argue that the patterns in the data are consistent with a model in which police officers are utility maximizers, a fraction of which have a preference for discrimination, who incur relatively high expected costs of officer-involved shootings.

In the introduction to the paper Fryer writes,

The results obtained using these data are informative and, in some cases, startling. Using data on NYC’s Stop and Frisk program, we demonstrate that on non-lethal uses of force – putting hands on civilians (which includes slapping or grabbing) or pushing individuals into a wall or onto the ground, there are large racial differences. In the raw data, blacks and Hispanics are more than fifty percent more likely to have an interaction with police which involves any use of force. Accounting for baseline demographics such as age and gender, encounter characteristics such as whether individuals supplied identification or whether the interaction occurred in a high- or low crime area, or civilian behaviors does little to alter the race coefficient. Adding precinct and year fixed effects, which estimates racial differences in police use of force by restricting to variation within a given police precinct in a given year reduces the black coefficient by 19.4 percent and the Hispanic coefficient by 26 percent, though both are still statistically larger than zero. Including more than 125 controls available in the data, the odds-ratio on black (resp. Hispanic) is 1.173 (resp. 1.120).

Interestingly, as the intensity of force increases (e.g. handcuffing civilians without arrest, drawing or pointing a weapon, or using pepper spray or a baton), the probability that any civilian is subjected to such treatment is small, but the racial difference remains surprisingly constant. For instance, 0.26 percent of interactions between police and civilians involve an officer drawing a weapon; 0.02 percent involve using a baton. These are rare events. Yet, the results indicate that they are significantly more rare for whites than blacks. In the raw data, blacks are 21.3 percent more likely to be involved in an interaction with police in which at least a weapon is drawn than whites and the difference is statistically significant. Adding our full set of controls reduces the racial difference to 19.4 percent. Across all non-lethal uses of force, the odds-ratio of the black coefficient ranges from 1.163 (0.036) to 1.249 (0.129).

Data from the Police-Public Contact Survey are qualitatively similar to the results from Stop and Frisk data, both in terms of whether or not any force is used and the intensity of force, though the estimated racial differences is larger. In the raw data, blacks and Hispanics are approximately two percentage points more likely than whites to report any use of force in a police interaction. The white mean is 0.8 percent. Thus, the odds ratio is 3.335 for blacks and 2.584 for Hispanics. As the use of force increases, the racial difference remains roughly constant. Adding controls for civilian demographics, civilian behavior, contact and officer characteristics, or year does little to alter the results. The coefficients are virtually unchanged and are all highly significant with the exception of the highest uses of force for which data is sparse.

There are several potential explanations for the quantitative differences between our estimates using Stop and Frisk data and those using PPCS data. First, we estimate odds-ratios and the baseline probability of force in each of the datasets is substantially different. Second, the PPCS is a nationally representative sample of a broad set of police-civilian interactions. Stop and Frisk data is from a particularly aggressive form of policing in a dense urban area. Third, the PPCS is gleaned from the civilian perspective. Finally, granular controls for location are particularly important in the Stop and Frisk data and unavailable in PPCS. In the end, the “Truth” is likely somewhere in the middle and, importantly, both bounds are statistically and economically important.

In stark contrast to non-lethal uses of force, we find no racial differences in officer-involved shootings on either the extensive or intensive margins. Using data from Houston, Texas – where we have both officer-involved shootings and a randomly chosen set of potential interactions with police where lethal force may have been justified – we find, in the raw data, that blacks are 23.8 percent less likely to be shot at by police relative to whites. Hispanics are 8.5 percent less likely. Both coefficients are statistically insignificant. Adding controls for civilian demographics, officer demographics, encounter characteristics, type of weapon civilian was carrying, and year fixed effects, the black (resp. Hispanic) coefficient is 0.924 (0.417) (resp. 1.256 (0.595)). These coefficients are remarkably robust across alternative empirical specifications and subsets of the data. Partitioning the data in myriad ways, we find no evidence of racial discrimination in officer-involved shootings. Investigating the intensive margin – the timing of shootings or how many bullets were discharged in the endeavor – there are no detectable racial differences.

Why is Fat Bastard fat?

Apart from the obvious point that Mike Myers created the character that way.

In a recent column at VoxEU.org Rachel Griffith and Melanie Lührmann argue that its because he doesn't exercise as much we used to.

Griffith and Lührmann start by arguing that the rise in obesity we see around the world has largely been attributed to an increase in calorie consumption. They then set out to investigate this claim by examining the evolving consumption and lifestyles of English households over the 30 year period between 1980 and 2013. While there has been an increase in calories from restaurants, fast food, soft drinks, and confectionery, there has been an overall decrease in total calories purchased. This decline in calories can be partially rationalised with weight gain by the decline in the strenuousness of work and daily life, and increasingly sedentary lifestyles.

Overall, we see that declines in physical activity at market work and in other activities has largely counteracted the reduction in calories. As well as going some way toward explaining the rise in obesity, our research indicates that market work might also influence the types of foods we eat. Households that spend more time in market work buy more market-produced foods. They eat more often in restaurants and fast food outlets, and eat more takeaway. Market-produced foods are on the whole more expensive than home-produced foods, and this means that trends in expenditure do not necessarily mirror trends in calories.

So its not that we consume more calories, its more that we don't use up as many calories as we used to. Thus its not so much that Fat Bastard is tucking into more haggis, its more that he not chasing and cubing as many Englishmen as he used to.

Virginia School of Political Economy

In these videos Jayme Lemke interviews Professor Donald Boudreaux of George Mason University on the Virginia School of Political Economy. In this discussion, Lemke and Boudreaux discuss the core insights of public choice economics.

Virginia School of Political Economy I: An Introduction to Public Choice


Virginia School of Political Economy II: The Continuing Relevance of Public Choice

Are cooperatives more productive than investor-owned firrms?

An often asked, if not often answered question. Well now there is an article that sets out to answer the question, at least for the case of Portugal.

Natália P. Monteiro and Odd Rune Straume have a new working paper, "Are cooperatives more productive than investor-owned firms? Cross-industry evidence from Portugal".

And the answer is that cooperatives are less productive than investor-owned firms.

The abstract reads:

We analyse empirically whether cooperatives and investor-owned firms differ in terms of productive efficiency. Using rich Portuguese panel data covering a wide range of industries, we apply two different empirical approaches to estimate potential differences in total factor productivity between the two groups of  firms. The results from our benchmark random-effects model show that cooperatives are significantly less productive, on average, than investor-owned firms. This conclusion is to a large extent confirmed by the results from System-GMM estimations. The lower productivity of cooperatives applies to a wide spectrum of industries. In six out of thirteen industries, cooperatives are outperformed by investor-owned firms in all empirical specifications considered, while there is no industry in which cooperatives are consistently found to be the more productive type of firm.

Of course it has been argued that an investor-owned firm is a particular type of producer cooperative; a capital (or lenders’) cooperative.

In their analysis Monteiro and Straume combine all forms of cooperatives but the basic results don't change when they look at particular types of cooperatives within a given industry. That is, productive efficiency of cooperatives versus investor-owned firms is not particularly related to cooperative type.

A South Island Initiative

Given the success of Brexit and the likely breakup of the UK when Scotland leaves the union, is it time for a renewed look at independence for the mainland. Is it time to ride ourselves of the tyranny of the North, and its think tanks. Time to get decisions about the South made in the South.

This does raise the question of whether the southern economy would survive on its own. I can't see why not. Given that Australia isn't that much further away than the North Island, a free trade deal with the West Island would make up for any losses in exports and imports from the North. The South Island could become a free trade mecca for the Pacific. We could embrace free trade, low taxes, free banking, the free movement of people, and personal responsibility and freedom, without the interference of Wellington and JAFAs.

And given the Crusaders and the Highlanders we would still have a damn good rugby team. First thing we need, however, is a referendum on breaking away from the North.

Time to drum up support for Southern independence!

Economic calculation and the theory of the firm

Ludwig von Mises is famous for pointing out that even in theory socialism cannot work. Checkout the current state of the Soviet Union and Eastern Europe or Cuba or Venezuela for empirical evidence on this matter, if you need it. Mises’s argument on ‘economic calculation’ can be summarised as follows (Boettke 1998):

“1 Without private property in the means of production, there will be no market for the means of production.
2 Without a market for a means of production, there will be no monetary prices established for the means of production.
3 Without monetary prices, reflecting the relative scarcity of capital goods, economic decision-makers will be unable to rationally calculate the alternative use of capital goods.”

In short, to be able to rationally decide on how to allocate scare capital resources among the many possible uses they can be put to, market prices are a necessary informational input. That is, entrepreneurs need prices to decide what to produce and how to produce it. Without prices an entrepreneur cannot compare the many possible goods to produce and the multitude of ways to produce them.

This shows us that any institutional regime, eg socialism, which attempts to abolish private ownership of the means of production cannot work. While it is clear that this is so for the economy as a whole, it is not so clear that the argument has important implications for institutions that are just part of the economy, in particular firms. Or it has at least two important implications for the theory of the firm.

First it highlights the need to include the entrepreneur into models of the firm. A point to keep in mind is that the neoclassical model is one in which Mises’s argument is effectively sidestepped. The model has market prices but without (real) ownership of the means of production. This is why the market socialists could use the model in response to Mises. This point is particularly relevant for the textbook, neoclassical, theory of the firm. An implication of Mises’s argument is that models that without genuine markets for the means of production, the model has no role for the entrepreneur. The entrepreneur is the one who carries out the economic calculations, she is the one who combines the factors of production together in such a way as to satisfy consumers’ current or future demands. It is also the entrepreneur who forms firms (and via them markets (Spulber 2009)). In models with ‘passive’ markets for inputs there is no genuine role for an entrepreneur. The neoclassical model in such a framework. In it the firms (and markets) are simply assumed into existence, there is no explanation for where it comes from or who forms it or why it is necessary to have it. There is no consideration of the role of the entrepreneur since there is no need of one. Inputs are simply combined via the market by the owners of the means of production responding to market prices and interaction via elaborate complete contracts.

More than 40 years ago William Baumol noted that the entrepreneur has no place in formal neoclassical theory.

“Contrast all this with the entrepreneur’s place in the formal theory. Look for him in the index of some of the most noted of recent writings on value theory, in neoclassical or activity analysis models of the firm. The references are scanty and more often they are totally absent. The theoretical firm is entrepreneurless−the Prince of Denmark has been expunged from the discussion of Hamlet” (Baumol 1968: 66).

Baumol notes that the reasons for this are not hard to find. Within the formal model the ‘firm’ is a production function or production possibilities set, it is simply a means of creating outputs from inputs. Given input prices, technology and demand, the firm maximises profits subject to its production plan being technologically feasible. The firm is modelled as a single agent who faces a set of relatively uncomplicated decisions, e.g. what level of output to produce, how much of each input to utilise etc. Such ‘decisions’ are not decisions at all, they are simple mathematical calculations, implicit in the given conditions. The ‘firm’ can be seen as a set of cost curves and the ‘theory of the firm’ as little more than a calculus problem. In such a world there is a role for a ‘decision maker’ (manager) but no role for an entrepreneur.

Market socialists could utilise this model when responding to Mises’s attack since in the neoclassical model, given it is a zero transaction cost world of complete contracts, there is no role for ownership as contracts cover every state of the world. There is no situation to be faced or decision to be made that is not included in the terms of the contract and thus there is nothing for an owner to do, the contract does it all. This is as true of the markets for the factors of production as for output markets and so such markets react passively to prices without the need of serious decision making by an entrepreneur. The manager just sets marginal benefits equal to marginal costs in both input and output markets. In fact, the model can be seen as one without entrepreneurs or firms.

As there is no role for ownership in such a world and any organisational structure can mimic any other, it’s not hard to see that a centrally planned economy can mimic a market economy, which was basically the market socialists’ claim. The market socialist argument works, in part, because the neoclassical model suppresses the role of the entrepreneur.

What this highlights is the need for the inclusion of the entrepreneur into economic theory and, in particular, the integration of the entrepreneur with the theory of the firm. This is a process that has started within mainstream economics with works such as Spulber (2009) and Foss and Klein (2012).
In his essay “Ludwig von Mises and Economic Calculation Under Socialism” Murray N. Rothbard make a second point about how Mises’s argument is relevant to the theory of the firm. Rothbard argues that Mises's point about the impossibility of socialism can be applied to the problem of the size of firms. Rothbard writes that

“There is one vital but neglected area where the Mises analysis of economic calculation needs to be expanded. For in a profound sense, the theory is not about socialism at all! Instead, it applies to any situation where one group has acquired control of the means of production over a large area - or, in a strict sense, throughout the world. On this particular aspect of socialism, it doesn't matter whether this unitary control has come about through the coercive expropriation brought about by socialism or by voluntary processes on the free market”.

In other words, it can apply to a firm.

Rothbard continues

“[ … ] Mises analysis also supplies us the answer to the age-old criticism leveled at the unhampered, unregulated free-market economy: what if all firms banded together into one big firm that would exercise a monopoly over the economy equivalent to socialism? The answer would be that such a firm could not calculate because of the absence of a market, and therefore that it would suffer grave losses and dislocations. Hence, while a Socialist Planning Board need not worry about losses that would be made up by the taxpayer, One Big Firm would soon find itself suffering severe losses and would therefore disintegrate under this pressure. We might extend this analysis even further. For it seems to follow that, as we approach One Big Firm on the market, as mergers begin to eliminate capital goods markets in industry after industry, these calculation problems will begin to appear, albeit not as catastrophically as under full monopoly. In the same way the Soviet Union suffers calculation problems, albeit not so severe as would be the case were the entire world to be absorbed into the Soviet Union with the disappearance of the world market. If, then, calculation problems begin to arise as markets disappear, this places a free-market limit, not simply on One Big Firm, but even on partial monopolies that eradicate markets. Hence, the free market contains within itself a built-in mechanism limiting the relative size of firms in order to preserve markets throughout the economy”.

Rothbard then notes that this argument is related to Coase's argument about the size of firms.

“This point also serves to extend the notable analysis of Professor Coase on the market determinants of the size of the firm, or of the relative extent of corporate planning within the firm as against the use of exchange and the price mechanism. Coase pointed out that there are diminishing benefits and increasing costs to each of these two alternatives, resulting, as he put it, in ah " 'optimum' amount of planning" in the free market system. Our thesis adds that the costs of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear, so that the free market optimum will always stop well short not only of One Big Firm throughout the world market but also of any disappearance of specific markets and hence of economic calculation in that product or resource. Coase stated that the important difference between planning under socialism and within business firms on the free market is that the former "is imposed on industry while firms arise voluntarily because they represent a more efficient method of organizing production." if our view is correct, then, this optimal free-market degree of planning also contains within itself a built-in safeguard against eliminating markets, which are so vital to economic calculation”.

So we can think of Mises’s argument as giving an upper bound to the size of firms.

Refs.:

• Baumol, William J. (1968). ‘Entrepreneurship in Economic Theory’, American Economic Review, 58(2) May: 64–71.
• Boettke, P. J. (1998). “Economic Calculation: The Austrian Contribution to Political Economy,” Advances in Austrian Economics 5: 131–58.
• Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm, Cambridge: Cambridge University Press.
• Rothbard, Murray N. (1976). "Ludwig von Mises and Economic Calculation Under Socialism," in Lawrence Moss, The Economics of Ludwig won Mises, pp. 67–77.
• Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations, Cambridge: Cambridge University Press.

Coase and central planning

Ronald Coase famously pointed out that the reason we have firms is that there are costs to using the market, transaction costs as we call them now. The existence of transaction costs means that firms can carry out some activities at a lower cost than if we were to transact across the market. But this raises an obvious question, If firms are so great why are there markets? Or, in other words, why isn't everything done in one huge firm with no recourse to markets?

Coase's answer to this question is that there are organisational costs as well as transaction costs. In his 1937 paper Coase asked the question as to why, if by creating a firm, the costs of production can be reduced, are there are any market transactions at all? “Why is not all production carried on by one big firm?” (Coase 1937: 394). The answer according to Coase is, first, that as a firm gets bigger there may be decreasing returns to entrepreneurial activity. That is, the cost of an additional transaction being organised within the firm may rise. Second, as the number of transactions which are organised in-house increases, the entrepreneur may fail to place the factors of production in the uses where their value is maximised. This means that the entrepreneur fails to make the best use of the available factors of production. Finally, the supply price of one or more of inputs to production may increase because the ‘other advantages’ of a small firm are greater than those of a large firm. As a result of these factors a firm will grow to the point where the costs of organising an additional transaction within the firm become equal to either the costs of carrying out the same transaction via the market or the cost of organising the transaction in another firm (Coase 1937: 395).

In more modern terms it would be argued that firms have to cope with, for example, problems such as shirking, which can be covered up in situations of team production; informational complexity and asymmetries; monetary calculation, as the socialist calculation debate made clear; rent seeking and an increase in principal-agent problems.

As firms get larger, teams get bigger and monitoring costs go up. As teams get larger the possibility of shirking increases as the monitor has increased difficulty in detecting that shirking is occurring and who is doing it when it does. When a firm does more in-house appropriable quasi-rents are likely to grow making rent seeking more profitable and more likely. While rent seeking is "personally" profitable it is "socially" destructive and thus decreases the efficiency of an organisation. The larger the is organisation, the larger the asymmetries in information are and therefore the costlier it is to provide the correct incentives for mangers and workers to use their knowledge efficiently and the harder it is to design hierarchies so that the right people get the information they need and have the expertise to use it and to get people to share their information. The costs of communicating, the number of communication channels, delays in information transmission etc all raise as the firm gets bigger. As an organisation become larger with a greater number of levels of management there is an increase in the principal-agent problems that arise. More incentive mechanisms have to be developed, implemented, and monitored, in an effort to ensure that an efficiently working organisation will be created. Ultimately firms will be limited in size by the fact that as they grow and do more in-house they eliminate capital goods and this increases the costs of internal corporate planning and the eventually such costs become prohibitive. This is essential an application of the arguments in the socialist calculation debate to the firm.

So Coase gave us a framework, albeit one that he didn't develop as far as we may have wished, which can be utilised to explain why central planning is limited in the range over which it will work. Central planning only works over a limited range in terms of a firm's size. A firm can only ever be so big. The market will at some point be a cheaper way to manage transactions.

Ref.:
Coase, Ronald Harry (1937). ‘The Nature of the Firm’, Economica, n.s. 4(16) November: 386–405.