Timeless words of wisdom?

A quote from Greg Mankiw's blog

I don't care who writes a nation's laws, or crafts its advanced treaties, if I can write its economics textbooks.
-- Paul A. Samuelson

Samuelson did of course write the nation's economic textbooks, for many, many years. His first year economics text has gone through at least 19 editions. It was first published back in 1948. But what I wonder is how much damage has been done by having him do so. In particular with regard to macroeconomics.

Maija Halonen-Akatwijuka on "Oliver Hart, Nobel laureate"

Maija Halonen-Akatwijuka writes on Oliver Hart, Nobel laureate at VoxEU.org. As is well known by now Oliver Hart has been jointly awarded the 2016 Nobel Prize in Economic Sciences with Bengt Holmstrom "for their contributions to contract theory". Halonen-Akatwijuka looks at Hart's contribution to contract theory. In particular incomplete contracts.

Halonen-Akatwijuka opens her discussion by noting,

The cornerstone of Hart’s contribution to incomplete contracts theory is his 1986 paper with Sandy Grossman on the costs and benefits of ownership. In this paper, they develop the formal theory of incomplete contracts and with it introduce the notions of control and power that have had great impact in many fields beyond the theory of the firm (see Aghion et al 2016).

Even in market economies, a significant proportion of transactions do not take place in the market but within firms. Grossman and Hart (1986) build on the foundations laid by previous Nobel laureates Ronald Coase and Oliver Williamson in asking what determines whether a transaction occurs inside the firm or in the market – that is, whether there is vertical integration or non-integration.

Coase’s (1937) answer was that both market and internal transactions have their costs and they are organised so that the transaction costs are minimised. Williamson (1975, 1985) emphasised a particular cost of transacting in the market: the hold-up problem. When a productive relationship requires an investment that has much lower value in other uses, the investor may only make the investment if the relationship is within the firm, since in the market, such relationship-specific investment is vulnerable to expropriation in bargaining when contracts are incomplete. Williamson was less clear about the costs of integration, which, in his view, related to bureaucratic decision-making.

Grossman and Hart (1986) formalised the analysis of the boundaries of the firm and provided a rationale not just for the benefits but also for the costs of vertical integration. When contracts are incomplete, a trading relationship can be governed by allocating the control rights – or power – to a party. Ownership of an asset brings with it control rights as the owner has the right to refuse to trade with a supplier/buyer (unless a prior contract is in place). The question then arises of not just whether the assets should be integrated or not, but also who should be the owner.

Ownership gives power to an agent in the sense that his default payoff is increased. If buyer B owns the asset that supplier S works with — and therefore S becomes B’s employee — B can get a higher share of the surplus in bargaining. The benefit of integration is that B’s incentives in relationship-specific investments are stronger. But the hold-up problem does not disappear inside the firm as he still needs to bargain with his employee to complete the production.

The cost of integration is the other side of the coin: S as an employee has weaker incentives than as an independent supplier. Given this trade-off, if one of the parties is a key investor, then it is optimal for him to become the owner of the integrated firm. That guarantees the best incentives for the key investment while the cost of weaker incentives for the party with less important investment is not significant.

Hart’s 1990 paper with John Moore developed the theory for a multi-asset and multi-party setting. Ownership – or power – is distributed among the parties to maximise their investment incentives. Hart and Moore show that complementarities between the assets and the parties have important implications. If the assets are so complementary that they are productive only when used together, they should have a single owner. Separating such complementary assets does not give power to anybody, while when the assets have a single owner, the owner has power and improved incentives.

A point to note here is that this ideas of having a single owner for complementary assets helps explain by we most often see control rights and income right being bundled together. Income rights give people an incentive to use assets efficiently while control rights give them the ability to do so. Income and control rights are complementary.

Furthermore, if there are such strong complementarities between an asset and a party that the asset is productive only with that party, then this indispensable party should own the asset. Ownership of the asset would not give power to anybody else and the incentive effect would be wasted.

This theory of the firm is now known as Grossman-Hart-Moore (GHM) property rights theory. It has been applied in various fields, including corporate finance, public economics, political economy and international trade.

I would, of course, recommend reading pages 98-107 of Walker (2016) for a brief introduction to the Grossman-Hart-Moore approach to the theory of the firm.

One of the applications of the Grossman-Hart-Moore theory that Hart has written on is to privatisation. The reason for this application is that there is a close relationship between the theory of the firm and the theory of privatisation. As Hart himself has written,

Let me begin by discussing the very close parallel between the theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms,A and B. A might be a car manufacturer and B might supply car-body parts. Suppose that there is some reason for A and B to have a long-term relationship (e.g., A or B must make a relationship-specific investment). Then there are two principal ways in which this relationship can be conducted. A and B can have an arms-length contract, but remain as independent firms; or A and B can merge and carry out the transaction within a single firm. The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents a firm supplying the government or society with some service. B could be an electricity company (supplying consumers) or a prison (incarcerating criminals).Then again, there are two principal ways in which this relationship can be conducted. A and B can have a contract, with B remaining as a private firm, or the government can buy (nationalise) B.

Also,

[...] the issues of vertical integration and privatisation have much more in common than not. Both are concerned with whether it is better to regulate a relationship via an arms-length contract or via a transfer of ownership.

Thus, we can think about the nationalisation/privatisation decision of the government in a similar way to the integration/spin-off decision of the private firm, conceptually both decisions are about determining the boundaries of an organisation.

Halonen-Akatwijuka points out that,

Hart’s 1997 paper with Andrei Shleifer and Robert Vishny applies the property rights theory to privatisation of tax-funded welfare services, such as schools, prisons and refuse collection. Government contracts with a service provider but the contract is incomplete, particularly regarding the quality of the service. The provider can invest in cost reduction but the owner has the control rights to decide whether the cost innovation will be implemented.

Under privatisation, the provider has the control rights and will implement cost innovation even if it damages the quality of the service. Since the provider gets the full benefit from cost-cutting and ignores the quality-reducing effect, his incentives for cost reduction are too strong.

Under public ownership, the provider needs government approval for any innovations, and therefore a quality-damaging innovation would not go ahead. This means that the provider will take into account the quality-reducing effect but has generally weak incentives to reduce costs.

Privatisation is therefore not desirable for services where cost reduction can damage quality. Hart and his co-authors argue that prisons meet this condition reasonably well. Federal authorities in the US are indeed ending the use of private prisons partly because of quality issues.

In contrast, privatisation works well for services where the quality-reducing effect is likely to be trivial, such as refuse collection. Finally, for some welfare services such as schools, competition can discipline quality-damaging cost-cutting, and therefore there is a reasonably valid case for privatisation.

When she turns to Hart's more recent work Halonen-Akatwijuka writes about what is now referred to as the "reference points" approach to contracts,

In recent work, Hart has introduced the theory of contracts as reference points (Hart and Moore 2008). The basic idea is that the role of a contract is to shape the parties’ expectations and to get them ‘on the same page’ to avoid future misunderstandings. Misunderstandings cause parties to feel aggrieved and lead to shading in ex post performance, causing deadweight losses.

The benefit of a rigid contract is that it fixes expectations, avoiding arguments. But it may not perform well when there is uncertainty. A flexible contract can adjust to the state of nature, but there is also room for arguments.

This approach has yet to get much attention in  economics textbooks, but see pages 113-117 of Walker (2016) for more.

Given this lack of discussion I will take a quick look the model given in Hart (2008) which presents a simple, intuitive, reference points model and applies it to the theory of the firm. What is presented below is a slightly modified version of Hart's model. I hope that you can tell the difference between the zero's and the theta's below.

Hart assumes that a seller, S, can provide a good, costing 10, to a buyer, B, who is willing to pay 20. Let us assume that we are talking about a public lecture on some aspect of microeconomics which B is organising and which B wants S to give. A successful lecture is worth 20 to B and it costs 10 for S to give the lecture.

At this stage Hart ignores the fact that B could engage other economists or that S could give lectures elsewhere. While trade could proceed smoothly, it is also possible that it will not. We will assume that B and S each have some discretion over the ‘quality’ of performance. For example, S could give a witty, lively, entertaining lecture or a very boring one. B on the other hand could treat S well, give her a nice dinner and pay quickly, or treat her badly.

In the language of Hart and Moore (2008) each party is able to provide basic (perfunctory) or exemplary (consummate) performance. It is further assumed that only the basic (perfunctory) level of performance can be legally enforced: exemplary (consummate) performance is entirely discretionary. It is assumed that each party is more or less indifferent between providing each level of performance − exemplary performance costs only a little more than basic or may even be slightly more pleasurable − and will provide exemplary performance if they feel they are being 'well treated' but not if they feel they are being 'badly treated'. Cutting back on exemplary performance is called ‘shading’. Such behaviour cannot be observed or punished by an outsider. Shading hurts the other party.

Hart emphasises that each party will feel 'well treated' if they receive what they think they are entitled to; that a contract between the parties is a reference point for perceived entitlements; and that should there be no reference point, then entitlements can diverge, wildly in some cases.

To return to the example above. First, we will add a time line. The time line tells us that B and S will write a contract some months before the lecture is given, at date 0, rather than at the last minute, date 1. One reason for this is that each party has more options earlier on. In fact it is assumed that there is a competitive market for sellers, at date 0.

Assume, further, that although B and S sign a contract at date 0, they leave the question of how much B will pay S open until the night before the lecture, date 1. This may seem a bad idea, and later it will be shown that it is. If no price is specified, then any p between 10 and 20 is possible. What might each party feel entitled to?

Hart and Moore (2008) take the view that entitlements can diverge. S may feel that the whole success of the talk will be due to her giving it and thus she feels entitled to p = 20. On the other hand B may have a somewhat different view of S’s abilities and likely contribution and thus feel that S is worth much less, say, p = 10.

Even though they disagree as to what p should be, they are rational enough to arrive at a compromise, say p = 15. According to Hart and Moore (2008) each party will feel short-changed and therefore aggrieved. Since B is aggrieved by 5, (15-10), B shades to the point where S’s payoff falls by 5θ, where θ is the constant of proportionality. And since S is also aggrieved by 5, (20-15), S shades to the point where the payoff for B falls by 5θ.

The end result of this is that if S and B leave the determination of the price until the night before the lecture, there will be a deadweight loss of 10θ due to the shading activities of each party. This reduces the value of the relationship between S and B from 10 to 10−10θ = 10(1−θ).

Next Hart asks the question: Can anything be done to avoid this deadweight loss? His answer is yes. But first note an answer that doesn’t do the job. Ex post Coasian bargaining at date 1 doesn’t work. The reason is that shading is not contractible and thus an agreement not to shade is not enforceable. Or to put this another way, if B offers to pay S more to reduce her shading, say B offers to pay p = 16 to S rather than 15, then this will indeed reduce S’s shading, from 5θ to 4θ, since S will now feel less aggrieved, but it will also increase B’s shading from 5θ to 6θ, since he now feels more aggrieved. Total deadweight loss does not change, it remains at 10θ. However there is a simple solution; the parties just put the price in the contract at date 0. Since it has been assumed that the market for lectures is competitive at date 0, B will be able to hire S for a price p = 10. With this price specified in the contract, there is nothing for B and S to disagree about at date 1. The fact that B and S may disagree about the contribution that S makes to the success of the lecture no longer matters. B and S have agreed that B will pay S 10, and neither B nor S will be disappointed or aggrieved when that happens. Importantly, agreeing in advance, at date 0, to a payment of 10 eliminates ex post argument and aggrievement, and thus both parties will be willing to provide exemplary performance. Here we have the first best being achieved and zero deadweight losses as a result. This does raise an obvious question: What changes between dates 0 and 1? Why does a date 0 contract that fixes p avoid aggrievement, whereas a date 1 contract that fixes p does not? The crucial point here is the role of the ex ante market at date 0. This market gives an objective measure of what B and S bring to the relationship. Given the assumption of a competitive date 0 market, there are many sellers willing to supply at p = 10 and thus S accepts that she cannot expect to receive more than 10, while B understands that he can’t expect to pay less, as no one would be willing to give the lecture for less. Thus, neither party is aggrieved by p = 10. This gives us a model of the contractual relationship between B and S, but, as Hart explains, we need one further ingredient to create a theory of the firm.

Now let us add a little more realism by assuming that not all of the details of the lecture can be anticipated at date 0. To keep things simple we will assume that two different lectures can be given.

Lecture 1 - say, a theory of the firm lecture - is the same as above, with a value of 20 and costs of 10. Lecture 2 - say, a microeconometrics lecture - yields value of 14 and costs of 8. Note that lecture 1 is more efficient in that it generates a greater surplus - 10 v's 6. Assume that the lectures can not be specified in the date 0 contract, since thinking about econometrics is sooooo boring that no one can stay awake long enough to write the contract! At date 1, however, the choice between them becomes clear.

Now we have to compare two organisational forms: an employment contract and an independent contractor. First, let B and S fix the price of the good at date 0, at say 10, and let B and S agree at date 0 that S will be an independent contractor. This is, in other words, a market exchange between two separate economics agents. Independent contractor means here that S gets to pick which lecture to give.

Hart then asks, What will S do? Given that the price has been fixed by the date 0 contract, S will pick lecture 2, since it is cheaper for her. But note this is inefficient. B will be aggrieved because S didn’t choose lecture 1, which B feels entitled to; B is short-changed by 6 (20-14), and he will therefore shade enough to reduce S’s payoff by 6θ. Total surplus in this case will be 6 − 6θ.

The second organisation form to be considered is an employment contract. B and S agree at date 0 that S is an employee of B. This we take to mean that S will work for B at a fixed wage, again assume 10. B, being the employer, has the right to decide on which lecture is to be given. As the wage is fixed B will choose lecture 1, as this gives him the greater value. This is efficient. S will be aggrieved since lecture 2 wan’t chosen, but S’s aggrievement is only 2. This induces S to shade by enough to reduce B’s payoff by 2θ. Total surplus is therefore 10 − 2θ.

Under the conditions specified, the employment contract is better. This is true for two related reasons. First, the lecture matters more to B than to S. B will lose 20 − 14 = 6 if his favoured lecture is not chosen while S only loses 10 − 8 = 2 if her favoured lecture is not chosen. This means it is efficient for B to choose the lecture. Second, and related, S’s aggrievement is low since she doesn’t care very much.

Hart now changes the numbers. Keep lecture 1 as it is, but change lecture 2 so while it still yields 14, it now costs only 2. Lecture 2 is now the more efficient (12 v’s 10). Under employment, lecture 1 will be chosen, yielding a total surplus of 10−8θ. If S is an independent contractor, lecture 2 will be chosen resulting in a total surplus of 12 − 6θ.

What this suggests is that employment is good if the lecture matters more to B than to S, while independent contracting is good if the lecture matters more to S than to B.

Hart goes on to say,

[o]ne point worth emphasizing is that in neither of the above examples is the following contract optimal: to leave the choice of price and method until date 1, i.e. to rely on unconstrained Coasian bargaining. This would always yield the efficient method, but the aggrievement costs would be high. In [Table not shown] the parties would agree on method 1; however, since there are 10 dollars of surplus to argue over, shading costs equal 10θ: net surplus = 10(1 − θ), which is less than that obtained under the employment contract. In [Table 171.1] there are 12 dollars of surplus to argue over and net surplus = 12(1 − θ), which is less than that obtained under independent contracting.

Clearly the examples above are toy ones, but Hart argues they contain the basic ingredients of a theory of the firm in that they consider the choice between carrying out a transaction in the market, using an independent contractor, and 'inside the firm', via an employment contract. This was the trade-off at the heart of Coase (1937).

Halonen-Akatwijuka also notes that this reference point theory shifts the focus from ex ante investment incentives, as in the Grossman-Hart-Morre theory, to ex post inefficiencies caused by shading and, importantly, this approach is not subject to the Maskin and Tirole (1999) critique (see pages 110-113 of Walker (2016) for more on the critique and why it is a problem for the Grossman-Hart-Moore theory).

The basic ingredients of the reference point approach to contracts have been applied to the theory of the firm more fully in papers by Hart and Moore (2007), Hart (2009) and Hart and Holmstrom (2010). For more on these papers see Walker (2013).

Halonen-Akatwijuka and Hart (2016) have also applied the contracts as reference point approach continuing contracts.

Refs.

• Aghion, P, M Dewatripont, P Legros and L Zingales (eds) (2016), The Impact of Incomplete Contracts on Economics, Oxford University Press.
• Coase, Ronald Harry (1937). ‘The Nature of the Firm’, Economica, n.s. 4(16) November: 386–405.
• Grossman, Sanford J. and Oliver D. Hart (1986). ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy, 94(4): 691–719.
• Halonen-Akatwijuka, M and O Hart (2016), ‘Continuing Contracts’, mimeo.
• Hart, Oliver D. (2008). ‘Economica Coase Lecture: Reference Points and the Theory of the Firm’, Economica, 75(299) August: 404–11.
• Hart, Oliver D. (2009). ‘Hold-up, Asset Ownership, and Reference Points’, Quarterly Journal of Economics, 124(1) February: 267–300.
• Hart, Oliver D. and Bengt Holmstrom (2010). ‘A Theory of Firm Scope’, Quarterly Journal of Economics, 125(2) May: 483–513.
• Hart, Oliver D. and John Moore (1990). ‘Property Rights and the Nature of the Firm’, Journal of Political Economy, 98(6): 1119–58.
• Hart, Oliver D. and John Moore (2007). ‘Incomplete Contracts and Ownership: Some New Thoughts, American Economic Review, 97(2) May: 182–6.
• Hart, Oliver D. and John Moore (2008). ‘Contracts as Reference Points’ Quarterly Journal of Economics, 123(1) February: 1–48.
• Hart, O, A Shleifer and R Vishny (1997), ‘The Proper Scope of Government: Theory and an Application to Prisons’, Quarterly Journal of Economics 112(4): 1127-61.
• Walker, Paul (2013). ‘The ‘Reference Point’ Approach to the Theory of the Firm: An Introduction’, Journal of Economic Surveys, 27(4) September: 670–95.
• Williamson, Oliver (1975), Markets and Hierarchies, Free Press.
• Williamson, Oliver (1985), The Economic Institutions of Capitalism, Free Press.

Trump vs Friedman - trade policy debate

Import tariffs v. free trade, argued by Donald Trump and Milton Friedman.


One of these two guys knows about economics ..... and the other is Donald Trump.

Sam Richardson weighs in on economics of Parker bout

From Morning Report this morning. A specialist in sports event economics, Dr Sam Richardson of Massey University, says the economic argument for Duco to get Major Events funding for Joseph Parker's forthcoming world heavyweight boxing fight is "not particularly strong".

See here for the interview.

Analysing the extent and effects of occupational regulation in New Zealand

A new paper, by Simon James Greenwood and Andrea Kutinova Menclova, has been published online for New Zealand Economic Papers on the above topic.

The abstract reads,

This study is the first to our knowledge to document the extent and correlates of occupational regulation in New Zealand. Using data from the Census and the Survey of Working Life, we estimate that 28% of workers’ primary jobs are affected by occupational regulation. This is lower than the 35% reported for the US but identical to UK estimates of 28%. Furthermore, we find that holding observable factors constant, occupational regulation is associated with a wage premium of 5%. This is lower than the 18% licensing premium found for the US but within the range of estimates for the UK.

I would love to see evidence on the distribution of the wage premium since I'm sure there are groups out there getting a hell of a lot more than a 5% premium! The other side of this coin is that there must be groups for whom occupational regulation results in little of the way of a premium. Does the form of regulation play a role here?

Funding the fight ... low blow or a knockout?

That question is asked by Sam Richardson at his Fair Play and Forward Passes blog. His view is much like that of Eric Crampton (see previous posting).

Sam writes

I can only really add to this discussion with a few points of my own:

• A matter of a week or so ago, Auckland was widely considered the host. Now we are told that there is only a 20-30 percent chance of the fight being staged in Auckland. What is the situation that has caused this uncertainty? This, to me, is the key question. Why is the government funding needed? Could it be that promoters in the US are proposing to spend more on attracting the fight than Duco, and are therefore being considered as a safer (read: more lucrative to the WBO) bet than hosting a title fight here? Government funding has been used the world over to try to trump others in hosting events ... with questionable returns.

• Indeed, there is little to no evidence from the independent research looking at the realised economic impacts of mega sporting events that said events will generate tangible economic impacts. The winners from such arrangements tend to be the governing sporting bodies, followed by the event organisers - with taxpayers a distant last.

• What are the benefits that New Zealanders will enjoy from hosting the fight? Benefits will accrue largely to those who watch the fight - and you can bet that it will not be anywhere in the plan for such an event to be broadcast live free-to-air. Part of what makes the fight commercially lucrative is the ability of broadcasters to charge for people to watch it. If government funding was contingent on it being broadcast free-to-air, it would undermine the commercial viability of hosting it here. So it should be a given that people will have to pay to watch the fight with or without government funding. These prices will be much more expensive than any previous fight given its title status, so one would reasonably expect the promoters to capture a much greater share of the event's benefits in the form of ticket sales and pay-per-view sales from Sky. 

• The economic benefits are (unfortunately) synonymous with economic impacts - which doesn't help the case for the fight to be publicly funded. If you look at past events funded by the Major Events Development Fund (MEDF), they've tended to be events with longer than a single day's duration - which means that their ability to attract visitors and spending is much greater than a one-day event. Any economic impacts from the event are also highly likely to be concentrated in Auckland - hence there may well be a stronger case for Auckland Council (via ATEED, one assumes) to be a major backer of the event. I understand that ATEED is already involved, but it doesn't appear to be enough to get the deal over the line. 

• There is also a matter of consistency and transparency regarding the treatment of the application for the MEDF - any (perceived or otherwise) favouritism will not go down well with people who have missed out in the application stage. One assumes that the application will include an estimate of economic impacts attributable to the event? To support these impacts, it is useful to consider what would happen in Auckland (and New Zealand) if the event did not take place. In most cases, projections of economic impact assume that the counterfactual is that there would be no spending at all in the absence of the event - an assumption that overstates the likely economic impact.

• One must also factor in the opportunity cost of public funding into such an equation. Scarce government funds could be spent elsewhere - and no doubt there are plenty of alternative uses for an as-yet unknown amount of public money that may generate greater longer-term impacts than funding a one-off event like this.

• From what we have heard (at least via the media) the good people at Duco are pointing to the feel-good factor as being an important reason why we should consider funding the fight. If so, ask yourself this - will you feel any worse than you already do if the fight was to go offshore? And if so, what is this "feel-bad" worth to you? In several studies from overseas that have attempted to quantify (among other things) the feel-good effect, intangible benefits are almost always smaller than the economic impacts and are certainly not large enough on their own or in tandem with tangible benefits to justify subsidies given to sports events, facilities or franchises. 

• And what about the precedent a favourable fast-tracked decision would set? 

The good news is that Sam is blogging again. There are many sports related questions that need good economic analysis.

You must be punch-drunk if you support public funding for a boxing match

There is much stupid talked when it comes to taxpayer funding of sporting events. But sometimes some good sense is also talked. One such example is Eric Crampton's discussion of the idea that the government should put taxpayer money put into Joseph Parker's next fight.

At his Offsetting Behaviour blog Eric offers a quick summary of what he said on Jim Mora's Panel at Radio NZ yesterday (Eric comes in at approx 2:45). He writes:

I covered a few points:

1. A boxing match is a commercial endeavour. If investors thought it would be more profitable here than it would be hosted elsewhere, they’d be putting in private money in anticipation of that return. 
2. Government funding to bring it here then only makes sense if:
   1. It would not have happened here unless it were funded (likely); but more critically,
   2. There is a real benefit to New Zealand in hosting the match here that would not be enjoyed were it hosted elsewhere; and, further,
   3. That this benefit, relative to the government’s outlay, is bigger than the government can get from spending the money elsewhere, or from leaving it in taxpayers’ pockets in the first place.
3. Governments love subsidising big sporting events. They talk a lot about the extra spending that tourists coming to events bring with them, but the kinds of studies backing these things up are usually pretty flawed. 
   1. First, they’ll count spending by visitors rather than profits on spending by visitors. Where there are costs involved in providing services to visitors, those need to be brought into the analysis.
   2. Second, they’ll assume that the visits would not have happened but for the event, and that the visits that do happen do not displace other visits. Both of these are often wrong. People who had always planned on visiting New Zealand and who like the event might shift the timing of a visit to coincide with the event. And other people who could only visit New Zealand during the time of the event might be put off: hotels get booked out for big events, for example, and rental caravans can be hard to find during things like the Lions’ tour. Just looking at the spike of visits during a big international event isn’t enough. You also have to account for displacement.
   3. Finally, none of this much enters into the picture for a boxing match which would draw fewer tourists in than a big sporting tour anyway.
4. Minister Joyce noted that he’d hope that the government might be paid back if the match turned a profit. If I were operating under that kind of contract, I’d be pretty sure to pay myself and staff bonuses big enough to make sure there weren’t profits, or to buy my supplies from a related company at inflated prices to make sure there weren’t profits to pay back. But maybe the companies with whom the government strikes these kinds of deals are more publicly spirited.

What we have to keep in mind is that the economics of funding sporting events, be they boxing matches, the rugby world cup, the Olympics, the America's Cup or whatever, are generally bad. The returns from such funding do not justify spending taxpayer money on such events, no matter what some ministers may claim.

Charity begins at the profit function

When firms offer up a percentage of their revenue to charity, is this a purely altruistic act? Adriaan Soetevent explains how, given a high enough offer, companies can actually make more money out of the higher sales caused by the arrangement. Filmed at the European Economic Association's 2016 Congress in Geneva.

The invisible hand in action? Firms gain but charities also gain. A win-win for society.

Testing the general validity of the Heckscher-Ohlin theorem

The Heckscher–Ohlin theorem is one of the four critical theorems of the Heckscher–Ohlin model. Simply put it states that a country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively. In the two-factor case, it states:"A capital-abundant country will export the capital-intensive good, while the labour-abundant country will export the labor-intensive good".

In the current issue of the American Economic Journal: Microeconomics (8(4), November 2016: 54–90) Daniel M. Bernhofen and John C. Brown have a paper which aims at Testing the General Validity of the Heckscher-Ohlin Theorem. The abstract reads:

We exploit Japan’s mid-nineteenth century transition from autarky to open trade to test Alan Deardorff’s (1982) seminal and parsimonious autarky price formulation of the Heckscher-Ohlin theorem. Factor price data from Japan’s late autarky period impose a refutable restriction on Japan’s factor content of trade. Our data are constructed from many historical sources, including a major Japanese survey of agricultural techniques and a rich set of nineteenth century comparative cost studies. Evaluating Japan’s factor content of trade during 1865–1876 under alternative theoretical assumptions about technology, we provide robust evidence in favor of the Heckscher-Ohlin hypothesis

The paper's conclusion states,

The Heckscher-Ohlin theorem is one of the central general equilibrium propositions in economics. It predicts that the direction of trade is explained by differences in countries’ relative factor scarcity. In Bertil Ohlin’s (1933) original formulation, relative factor scarcity is measured by countries’ autarky factor prices. A long line of research that applies comparative statics methodology to international trade has shown that Ohlin’s (1933) conjecture on the relationship between autarky factor prices and the pattern of international trade can be formulated as a refutable hypothesis. This was initially accomplished for the two-country, two-factor, wo-commodity world familiar from undergraduate textbooks in international trade. Subsequent research by Deardorff (1982) and Neary and Schweinberger (1986) has formulated a refutable Heckscher-Ohlin proposition for a single economy that holds under general conditions regarding dimensionality and assumptions about the economy’s trading partners.

We argue that Japan’s economy before and after its nineteenth century move from autarky to free trade conformed to the critical assumptions of this autarky price formulation of Heckscher-Ohlin. The historical sources allowed us to construct technology matrices based on disaggregated data of input requirements for traded goods at the location of production. Combining these data with matching commodity trade flows and autarky factor prices enabled us to test the general validity of the Heckscher-Ohlin hypothesis. We were not able to reject the hypothesis in any of the sample years. This is certainly good news for the neoclassical trade model and for those who have contributed to its formulation since Ohlin.

So one up for traditional trade theory.

There is a lot of stupid in JAFAland

It is often said that economists don't agree on anything, well that's not quite true. One thing they do agree on is that building sports stadiums is just not worth it.

As Adam M. Zaretsky has put it,

When studying this issue, almost all economists and development specialists (at least those who work independently and not for a chamber of commerce or similar organization) conclude that the rate of return a city or metropolitan area receives for its investment [in stadiums] is generally below that of alternative projects. In addition, evidence suggests that cities and metro areas that have invested heavily in sports stadiums and arenas have, on average, experienced slower income growth than those that have not.

From Suff comes this bit of information:

Auckland Mayor Phil Goff is being praised by his Dunedin counterpart for being "realistic" about a billion dollar replacement for Eden Park stadium.

Goff has said that he would rather build a whole new stadium, on Ngati Whatua land next to Vector Arena, than invest an estimated $250 million more on upgrading Eden Park over the next 15 years.

As I have argued many on this blog the economics of sports stadiums are just awful and if Phil Goff really wants to be "realistic" about a new stadium - or an upgrade to Eden Park - he should just say no. The history of Dunedin's controversial Forsyth Barr stadium should act as a case study of the dangers of building stadiums. That stadium has cost Dunedin's ratepayer millions. Auckland has much more important problems to fix, eg the local housing market, than any issues over a sports stadium. Goff would better serve the ratepayers of Auckland by concentrating on such major and real problems than wasting time and money on stadiums.

Kevin Bryan on Bengt Holmstrom and the black box of the firm

Kevin Bryan writes at VoxEU.org on the key contributions of Bengt Holmstrom to the theory of contracts and its application to the theory of the firm. Bryan opens by saying,

Holmström’s contribution lies most centrally in the area of formal contract design. Imagine that you want someone – an employee, a child, a subordinate division, an aid contractor or, more generally, an ‘agent’ – to perform a task. How should you induce them to do this?

If the task is ‘simple’ – meaning that the agent’s effort and knowledge about how to perform the task most efficiently is known and observable – you can simply pay a wage, cutting off payment if effort is not being exerted. When only the outcome of work can be observed, if there is no uncertainty in how effort is transformed into outcomes, knowing the outcome is equivalent to knowing effort, and hence optimal effort can be achieved via a bonus payment made on the basis of outcomes.

All straightforward so far. The trickier situations, which Holmström and his co-authors have analysed at great length, are when neither effort nor outcomes are directly observable.

Consider paying a surgeon. You want to reward the doctor for competent, safe work.

Perhaps a real world example of such a contract may help illustrate that is happening here. Below are details of the contract for surgeons on the ships that transported colonists to the province of Canterbury in New Zealand in the 1850s.

So real people where into incentives contracts long before economists started formal investigation of them!!!

The British economist Edwin Chadwick was also thinking about  about such issues in the mid-1800s. Chadwick pondered the question of incentives for the transportation of prisoners from the UK to Australia. Chadwick noted:

​[I]n the first instance, a capitation payment was made on embarkation, and this resulted in the loss of half the conve​cts put on board ; by degrees that loss was reduced to one-third ; but when, under the auspices of a new colonial administration, the system was altered to a capitation payment for all the convicts that were landed at their destination, the contrast was ​very​ ​ striking indeed, and tho owners of the vessels carried surgeons, and the best means were devised for landing the largest possible number at the port for which they were bound.

But as Byran notes that Holmstrom was aware that in general, in the modern case, it is very difficult to observe perfectly what the surgeon is doing at all times, and basing pay on outcomes has a number of problems:

1. First, the patient outcome depends on the effort of not just one surgeon, but on others in the operating room and prep table. Team incentives must be provided.
2. Second, the doctor has many ways to shift the balance of effort between reducing costs to the hospital, increasing patient comfort, increasing the quality of the medical outcome, and mentoring young assistant surgeons. So paying on the basis of one or two tasks may distort effort away from other harder-to-measure tasks. There is a multitasking problem.
3. Third, the number of medical mistakes, or the cost of surgery, that a hospital ought to expect from a competent surgeon depends on changes in training and technology that are hard to know, and hence a contract may want to adjust payments for its surgeons on the performance of surgeons elsewhere. Contracts ought to take advantage of relevant information when it is informative about the task being incentivised.
4. Fourth, since surgeons will dislike risk in their salary, the fact that some negative patient outcomes are just bad luck means that you will need to pay the surgeon very high bonuses to overcome their risk aversion. When outcome measures involve uncertainty, optimal contracts will weigh ‘high-powered’ bonuses against ‘low-powered’ insurance against risk.
5. Fifth, the surgeon can be incentivised either by payments today or by keeping their job tomorrow, and worse, these career concerns may cause the surgeon to waste the hospital’s money on tasks that matter to the surgeon’s career beyond the hospital.

Holmström wrote the canonical paper on each of these topics. His 1979 paper shows that any information that reduces the uncertainty about what an agent actually did should feature in a contract, since by reducing uncertainty, you reduce the risk premium needed to incentivize the agent to accept the contract.

It might seem strange that contracts in many cases do not satisfy this ‘informativeness principle’. For example, CEO bonuses are often not indexed to the performance of firms in the same industry. If oil prices rise, essentially all oil firms will be very profitable, and this is true whether or not a particular CEO is a good one. Bertrand and Mullainathan (2001) argue that this is because many firms with diverse shareholders are poorly governed.

Bryan continues,

Much of Holmström’s work in the 1980s and 1990s tried to square the gap between theory and empirics by finding justifications for the simplicity of many real world contracts that can be rationally justified.

Written jointly with Paul Milgrom, the famous ‘multitasking’ paper published in 1991 notes that contracts shift incentives across different tasks in addition to serving as risk-sharing mechanisms and as methods for inducing effort. Since bonuses on task A will cause agents to shift effort away from hard-to-measure task B, it may be optimal to avoid strong incentives at all (just pay teachers a salary rather than a bonus based only on test performance) or to split job tasks (pay bonuses to teacher A who is told to focus only on mathematics test scores, and pay salary to teacher B who is meant to serve as a mentor).

That outcomes are generated by teams also motivates simpler contracts. Holmström’s 1982 article on incentives in teams points out that if both my effort and yours is required to produce a good outcome, then the marginal product of our efforts are both equal to the entire value of what is produced, hence there is not enough output to pay each of us our marginal product. What can be done?

Alchian and Demsetz had noticed this problem in 1972, arguing that firms exist to monitor the effort of individuals working in teams. With perfect knowledge of who does what, you can simply pay the workers a wage sufficient to make the optimal effort, then collect the residual as profit.

Holmström notes that the monitoring isn’t the important bit; rather, even shareholder-controlled firms where shareholders do no monitoring at all are useful. The reason is that shareholders can be residual claimants for profit, and hence there is no need to distribute profit fully to members of the team.

A brief discussion of a simple version of Holmstrom's 1982 paper, due to Kim C. Border, and its relationship to Alchian and Demsetz's work is given in chapter 4 of The Theory of the Firm: An overview of the economic mainstream.

Bryan goes on:

Free-riding can therefore be eliminated by simply paying team members a wage of X if the team outcome is optimal, and zero otherwise. Even a slight bit of shirking by a single agent drops their payment precipitously (which is impossible if all profits generated by the team are shared by the team), so the agents will not shirk. Of course, when there is uncertainty about how team effort transforms into outcomes, this harsh penalty will not work, and hence incentive problems may require team sizes to be smaller than that which is first-best efficient.

A third justification for simple contracts is career concerns: agents work hard today to try to signal to the market that they are high-quality, and do so even if they are paid a fixed wage. This argument had been made less formally by 2013 Nobel laureate Eugene Fama, but Holmström in a 1982 working paper (finally published in 1999) showed that this concern about the market only completely mitigates moral hazard if outcomes within a firm are fully observable to the market, or the future is not discounted at all, or there is no uncertainty about agent’s abilities. Indeed, career concerns can make effort provision worse; for example, agents may take actions to signal quality to the market that are negative for their current firm.

A final explanation for simple contracts comes from Holmström’s 1987 paper with Milgrom. They argue that simple ‘linear’ contracts, with a wage and a bonus based linearly on output, are more ‘robust’ methods of solving moral hazard because they are less susceptible to manipulation by agents when the environment is not perfectly known. [...]

These ideas are reasonably intuitive, but the way Holmström answered them is not. Think about how an economist before the 1970s, like Adam Smith in his famous discussion of the inefficiency of sharecropping, might have dealt with these problems. These economists had few tools to deal with asymmetric information, so although economists like George Stigler (1961) analysed the economic value of information, the question of how to elicit information useful to a contract could not be discussed in any systematic way.

These economists would also have been burdened by the fact that the number of contracts one could write are infinite. So beyond saying that under a contract of type X does not equate marginal cost to marginal revenue, the question of which ‘second-best’ contract is optimal is extraordinarily difficult to answer in the absence of beautiful tricks like the revelation principle, partially developed by Holmström himself.

And when thinking about agency costs and innovation Bryan writes,

Holmström’s work is brilliant in how it clarifies many puzzles that are tricky to understand without thinking about incentives within a firm. For example, why would a risk-neutral firm not work enough on high-variance moonshot-type R&D projects? This is a question Holmström asks in his 1989 paper. Four reasons:

• First, in Holmström and Milgrom’s 1987 linear contracts paper, optimal risk-sharing leads to more distortion by agents the riskier the project being incentivised, so firms may choose lower expected value projects even if they themselves are risk-neutral.
• Second, firms build reputation in capital markets just as workers do with career concerns, and high-variance output projects are more costly in terms of the future value of that reputation when the interest rate on capital is lower (for example, when firms are large and old).
• Third, when R&D workers can potentially pursue many different projects, multitasking suggests that workers should be given small and very specific tasks so as to lessen the potential for bonus payments to shift worker effort across projects. Smaller firms with fewer resources may naturally have limits on the types of research a worker could pursue, which surprisingly makes it easier to provide strong incentives for research effort on the remaining possible projects.
• Fourth, multitasking suggests that agent’s tasks should be limited, and that high-variance tasks should be assigned to the same agent, which provides a role for decentralising research into large firms providing incremental, safe research, and small firms performing high-variance research. A deep understanding of how these types of internal incentives aggregate into explanations for why firms appear the way they do can best be achieved by a thorough reading of Holmström and Milgrom’s beautiful 1987 paper, “The Firm as an Incentive System”.

You know that your economy is in trouble when .....

Tim Worstall at the Forbes blog writes,

The stirring achievements of Bolivarian socialism as practised in Venezuela never cease to amaze. They’ve managed to create, at one time, an entire country running out of beer. The banknotes cost more to print than they are worth. A fertile tropical nation has widespread food shortages. They’ve even managed that the place sitting on the world’s largest oil reserves has to import oil from the United States. To add to this list of blows struck against the imperialist yankees we can now add the possible bankruptcy , or at least default on its debts, of the monopoly oil company sitting on top of that ocean of oil which is the world’s largest reserves.

Quite a list of achievements. It would be funny if the costs to the Venezuelan people weren't so high. It is the people who pay in terms on increasing poverty and hardships. Such outcomes do suggest mismanagement by the government of  the economy on a massive scale.

The problems with the state oil company, in Worstall's view, include,

This is that Venezuela’s oil is very heavy and thus needs large capital investment for it to continue to be extracted. The basic operating method of the Chavez and then Maduro administrations has been to skimp on that capital spending and then spend the money saved on consumer imports into Venezuela. Largely as a means of buying political support despite their complete and total mismanagement of the domestic economy. There were also further borrowings using the oil company as the legal form doing the borrowing, again to fund such spending upon consumers.

But, obviously, borrowing spent on rice doesn’t increase the ability of the oil company to produce more oil to pay back the borrowings. Production, and thus income, has been falling, even without any influence of the falling oil price itself.

You can indeed buy bread and circuses with resource rents. But do too much of it and you’ll not have the capital to keep those resource rents coming.

All this doesn't say much for Bolivarian socialism.

Production and the firm

This lecture was presented by Peter Klein at the 2013 Mises University, hosted by the Mises Institute in Auburn, Alabama, on 23 July 2013.

The New Zealand Initiative on inequality and poverty

As most readers will be aware the New Zealand Initiative recently published a second report on inequality and poverty. This report, The Inequality Paradox: Why inequality matters, follows on from their earlier report, Poorly Understood: The state of poverty in New Zealand.

Now at the Sand Pit blog  they have listed 21 major messages and arguments from their research. (The references in parenthesis are to the Inequality Paradox report, unless otherwise stated.)

1. Increased housing costs are hitting those on low incomes hardest, and to a very severe degree. (Figure 28.) Getting more houses built is a critical issue, regardless of economic inequality.
2. There is substantial material hardship in New Zealand households. Specifically, around 4% of the population are “doing without” to a severe degree and 11% to a less severe degree. For children the proportions are higher, at 8% and 18% respectively. For the elderly they are lower, at 1% and 3% respectively. The overall proportions are similar to an average for a group of EU countries. (Table 5 of the Poorly Understood report.)
3. It is wrong and potentially counter-productive to conflate relatively low incomes with poverty or hardship. Claims that quarter of a million of children or more (25%+) are living in poverty because they are in relatively low income households are gross exaggerations.
4. Economic inequality rose markedly from the mid-1980s to the mid-1990s on all three of the main measures: pre-tax market income, disposable income and consumer spending. The share of the top 1% rose sharply in particular. Changes in household structure, socio-demographic attributes, employment outcomes and economic returns could account for perhaps 50% of the rise in disposable income inequality during this period.
5. Current income is a poor indicator of hardship. Specifically, only around 40-50% of those experiencing relatively low current incomes are also experiencing hardship, and some on higher incomes are experiencing hardship.One reason is that low income is a temporary situation for a considerable proportion of households, another is that the elderly can be asset rich but income poor.But a real difficulty is that unanchored relative income measures don’t tell us anything about actual living standards, eg poverty. Our Poorly Understood report shows that current welfare benefits are much higher, inflation adjusted, than what was deemed to be an adequate wage for a labourer to earn in order to be able to support a dependent spouse and three children back in 1936. The Ministry of Social Development’s authoritative annual statistical reviews of well-being and inequality show that real income growth has markedly reduced the proportion of households falling below an earlier real income threshold.
6. Consumer spending is a better indicator of living standards. More recent Motu research has found that it is also a much better indicator of self-assessed well-being.
7. Consumer spending inequality rose from the mid-1980s to the mid-1990s, but by 2013 it had returned to around its mid-1980s level, despite the housing cost issue. (Figure 9)
8. Contrary to what the public is continually told, disposable income inequality has not trended up since the mid-1990s on the most commonly cited measure (the Gini coefficient). Market income inequality has actually trended down. (Figures 4 and 5.) The paradox is that newspaper headlines featuring inequality have risen more than 8-fold in the last decade.
9. Much market income inequality arises from substantial differences in hours of paid work and wage differentials that are related to differences in educational achievement (a proxy for skill) and age (a proxy for experience and responsibility). (Figures 23-27.) What else would we expect?
10. The share of top income earners in private income was much higher in the first half of the last century than it is today. A long decline occurred from the 1950s to the late 1980s. (Figure 3.)
11. The big rise in the pre-tax income share of the top 1% of income earners in the late 1980s occurred at a time of severe recession, major company collapses and tax reforms that sharply increased the tax take from top income earners overall while reducing the tax rate on the last dollars of their income. (Figures 3 and 10.) It is implausible that the real pre-tax market incomes of this group accelerated upwards during this period. It is plausible that a lot more of their incomes became taxable. The real rise in income inequality in New Zealand could be overstated to some degree for this reason. The (more modest) rise in spending inequality might be a better indicator. Moreover, since the mid-1990s the income share of the top 1% has, if anything, trended down not up. (Figure 1.) Since the early 1990s household income growth has been reasonably proportionately shared on MSD’s calculations. (Figure 8.)
12. The proportion of top income earners in New Zealand who are salary and wage earners, has risen in the last decade, contrary to the Thomas Piketty thesis of a growing dominance by the passive income of inherited wealth.
13. Our report is dubious about the quality of wealth distribution measures. For a start the measures ignore human capital and the net present value of NZS. But for what it is worth, the wealth share of the wealthiest 1% in New Zealand is not out of line with that in the member countries of the OECD. (Figure 15.) It is actually right at the bottom end of the spectrum for estimates that adjust for the under-reporting of wealth by the richest. (Figure 36.)
14. It is ridiculous to attribute the sharp 1988-1991 rise in the share of the top 1% to the decline in unionisation in the years following the Employment Contracts Act 1991
15. Our top executives are only paid a small fraction of what top Australian executives and their pay is a lower multiple of worker pay. (Table 1 and text.)
16. On the limited evidence available, income mobility in New Zealand is comparable to that in other countries. (Figures 21 and 22.)
17. One response to the call that the rich should be “asked” to pay more in tax is that they already do. Indeed, on Treasury numbers the top 40% of households by income are the only ones that pay any income or GST over and above what they receive in return through the welfare system and health and education benefits in kind.
18. It is very important that market incomes are fairly earned and are seen to be fairly earned. Anything else corrodes community trust and cohesiveness. There should be a strong presumption against corporate welfare, including bail-outs for bankers.
19. Survey evidence for New Zealand suggests that it is widely held that beneficiaries are responsible for their own situation and that high incomes in New Zealand are a reward for talent. (Table 4.) But there is also considerable concern about the degree of economic inequality in New Zealand. (Table 2.)
20. Survey evidence globally and in New Zealand also indicates that the public is widely ignorant concerning the degree of economic inequality and that people’s policy preferences tend to reflect their perceptions rather than reality, where there is a difference. (Figure 36.)
21. An ongoing public debate about economic inequality is important so that valid concerns are addressed and invalid concerns are identified.

So those who wish to complain about the great evils of the New Zealand Institute's research but can't be bothered actually reading it now have a nice numbered list of things to get all hot and bothered about.

A response to the latest NZI report by Max Rashbrooke is available here. He argues that the most fundamental omission in the report is its failure to deal in any significant way with the long-running consequences of widened inequality. But I find myself asking, Why do we care if inequality has increased, assuming it in fact has? Is poverty not the real problem? The two are not necessarily the same thing. He does agree however that "housing costs are a big problem, particularly for lower earners". As point 1 above says "Getting more houses built is a critical issue, regardless of economic inequality".

Peter G. Klein on government and big business

This video was recorded at the Mises Institute in Auburn, Alabama, on 29 July 2016.

Business owners, employees and firm performance

Business Owners, Employees and Firm Performance is a new working paper, by Mika Maliranta and Satu Nurmi, from the Research Institute of the Finnish Economy (ETLA).

The abstract reads:

The novel Finnish Longitudinal OWNer-Employer-Employee (FLOWN) database was used to analyze how the characteristics of owners and employees relate to firm performance as determined by labor productivity, survival and employment growth. Focusing on the role of the owner’s formal education and previous experience as an employee, the results show that previous experience in a high-productivity firm strongly predicts high productivity and probability of survival for the entrepreneur’s new firm. This can be interpreted as evidence of knowledge spillover through labor mobility. Strikingly, firms established in times of intensive excess job reallocation were found to exhibit superior productivity performance in the later phases of their life cycles.

The conclusion to the paper includes,

The diversified paths of primary owners and their employees are reflected in future company performance. Previous employer quality, measured in terms of relative productivity, is transferred through owners and employees as knowledge spillover related, for example, to technology or management. High-quality owners create firms capable of achieving and maintaining sustained high performance in terms of productivity, survival and employment growth.

Our results lend support to the view that employees’ entrepreneurial skills nurtured in high-productivity firms can be transferred to achieve higher productivity, especially in entrepreneur-owner firms. First, there is a strong positive relationship between the productivity level of the previous firm (where the owner worked as an employee) and the productivity level of the firm where the owner now works. Second, there is evidence of considerable employee mobility from high-productivity firms to ownership of a new firm (where the owner also works). These findings are consistent with the view that the transition of employees from high-productivity firms to entrepreneurship is an important business dynamic, driving knowledge spillover in the economy. Our results also indicate intensive employee mobility from low-productivity firms toward new and young firms, representing an important element of creative destruction. The reallocation of employees in creative destruction means that a greater share of the employees provide labor inputs to productively managed firms

and

Our results demonstrate the importance of considering owner and employee characteristics separately but in parallel in any analysis of firm performance, as owner and employee background and skills may play different roles in the development of employment and productivity. In addition, this analysis indicates a need to deal separately with entrepreneur-owner and pure owner firms. In entrepreneur-owner firms, an owner’s technically orientated education was found to impact positively on productivity performance and survival probability, but no such relationship was found in pure owner firms. One explanation for this difference is that closer owner links to production are needed to successfully exploit technical education and previous experience. In contrast, the potential contribution of pure owners pertains to factors that cannot be captured by measures of education and experience.

One interpretation of this is the perhaps not too surprising result that the human-capital of an entrepreneur-owner matters for the performance of a newly created firm. Knowledge gained from experience as an employee of a high productivity firm can be transferred to the firm of the entrepreneur-owner. Newer firms have relatively younger and more educated human capital but are more dependent on the older firms for an inflow of know-how.

Why falling prices are good for business

Introduced by Murray Sabrin, Joseph Salerno spoke on "Why Falling Prices Are Good for Business" at Ramapo College in New Jersey on October 4.

Dr. Salerno's portion of the talk begins at 6:20. The lecture is followed at the one-hour mark by a panel discussion covering business cycles, the Fed, interest rates, and financial crises.

The Elemental Case for Free Trade

From the Cafe Hayek blog comes this great piece from Don Boudreaux on The Elemental Case for Free Trade. Everybody, especially politicians, should read and think about this.

The following are remarks delivered by Professor Boudreaux on October 14th, 2016, in Atlanta, GA, at Hillsdale College’s 10th annual Free Market Forum.

I.

The positive economic case for free trade is straightforward. Here I distill it into ten – well, as you’ll see, really eleven – elemental points.

First, nothing about political borders justifies treating trades that cross those borders differently than trades that don’t. Whatever benefits result from you trading with someone in Kentucky are no less available when you trade with someone in Korea. Whatever economic problems – real or imaginary – are caused by you trading with someone in Korea are no less likely when you trade with someone in Kentucky.

Second, all economic activity is ultimately justified by how much it enables us to expand our consumption, not by how much it enables us to expand our production. Consumption is the end; production is the means. Of course, production is an essential means; we cannot expand consumption without expanding production. But production is not the ultimate purpose of economic activity. If you disbelieve me, ask yourself how much you’d pay for a sawdust-nail-‘n’-cardboard pie that took its well-meaning baker several days to produce. If you answer “nothing,” then you get this point.

Third, specialization expands output. And the greater the amount of specialization, the greater the output. A medical profession made up only of family-practice physicians will save fewer lives and reduce less pain than a medical profession made up of specialists such as neurosurgeons, podiatrists, cardiologists, ophthalmologists, and – my favorite (because many years ago one of these specialists saved my young son’s life) – pediatric gastroenterologists.

Fourth, specialization requires trade. A pediatric gastroenterologist based in New York City today enjoys a high standard of living, but only because many people willingly pay him to specialize in that highly specialized line of work and willingly accept his money in exchange for what they produce. This physician is rich only because he trades with others. If farmers, carpenters, tailors, airline pilots, and economics professors were unwilling to trade with him, he’d have no time to practice pediatric gastroenterology. He’d instead have to grow his own food, build his own home, and make his own clothing. He, and the rest of us, would be much poorer.

Fifth, specialization increases with the size of the market. The greater the number of consumers and producers, the larger is the scope for each producer to focus on a narrow specialization. This fact is why large cities have niche restaurants, such as vegan Lebanese, and highly specialized physicians, such as pediatric gastroenterologists, while small towns don’t feature restaurants and trades so highly specialized.

Points four and five working together spark self-reinforcing improvement: more trade promotes more specialization which, in turn, promotes more trade. Economies grow and standards of living improve.

Sixth, an important consequence of expanding the area of trade – of increasing the size of the market – is what economists call “increasing returns.” Doubling the number of people who trade freely with Americans causes the GDP of this larger economy to more than double. Per-capita GDP rises for all of these people who trade freely with each other. Compare medical care in an economy that features among its health-care professionals only 100 family-practice physicians to medical care in an economy with, say, 20 family-practice physicians and 180 specialists, such as pediatric gastroenterologists.

Seventh, there’s no limit to the degree to which labor can specialize and to which, as a result, total output can expand and expand at an increasing rate – that is, exhibit increasing returns. Put differently, the degree to which labor can specialize and cause total output to expand isn’t limited to, or defined by, the size of any particular country. Nor does the size of any particular country define a point beyond which the growth of specialization and output slows or becomes less reliable.

That is, even in a country as geographically large and as heavily populated as the United States, nothing in economic theory or history suggests that expanding the boundaries of our trading patterns externally – that is, beyond our borders – results in less expansion of our consumption and production than when we expand the boundaries of our trading patterns internally. We in Georgia or Virginia stand to gain just as much by expanding our trade with Mexicans as we stand to gain by expanding our trade with New Mexicans. There’s no reason not to have a global economy without economic boundaries.

Eighth, economic competition is good and it works just as effectively across political boundaries as it does within political boundaries. Competition disciplines firms, it spurs entrepreneurial creativity, and it discovers and encourages – much like a process of natural selection – what works best economically. Importantly, the competition that comes from free trade directs workers and other resources into those lines of productive activities at which each is most efficient. There’s simply no reason to neuter with trade restrictions the competition that comes from abroad simply because that competition isn’t home-grown.

Ninth, as Julian Simon taught, human beings in market economies are the ultimate resource. The ultimate resource isn’t land or petroleum or deposits of iron ore or of gold; it’s not factories or software or tractors; it’s not inventories of wheat or of rolled steel or of cash on hand. It’s human creativity and ingenuity. Indeed, it’s only because human creativity made them so that petroleum and iron ore and wheat and you-name-it are resources. Without human creativity these things would be mere raw materials, mere globs of molecules, that are no more valuable or useful to human beings than they are now to antelopes and hamsters.

And yet human creativity is one of the few resources that has consistently gotten more scarce over the course of the past 250 years.

We know that human creativity has gotten more scarce because its market price has risen enormously over the past few centuries in the market-oriented world. For example, the real hourly pay of the average American worker is today, conservatively estimated, about 60 times higher than it was in 1790.[1] This rise in the price of labor signals that it is has become more scarce relative to the demand for human labor.

In contrast, most other resources and productive inputs – including energy, metals, and transportation services – have become, and are still becoming, less scarce, if we judge them (as we should) by the trends in their real prices. They’re becoming less scarce precisely because we have more creative human beings contributing to the market economy.

Free trade maximizes the ability of the people of a country both to contribute their own creativity and effort to the global economy and to tap into the creativity and effort of the billions of other ultimate resources that reside in other countries. We tap into that creativity directly when we offshore productive tasks to foreign workers. We tap into it indirectly when we buy goods produced by foreign workers and entrepreneurs. Why would we wish to artificially reduce our and our fellow citizens’ access to supplies of the ultimate resource?

Tenth, restrictions on trade inevitably are driven by special-interest-group politics. Even if a sound theoretical case can be made for trade restrictions, it’s simply unrealistic to expect the state to be guided by that case. Instead, politicians and bureaucrats will only use that case as cover to create monopoly privileges for politically influential producer groups.

I here, at the last minute, add an eleventh point to the elemental case for free trade. I was reminded of this point just this morning by an e-mail from my great colleague Walter Williams. Walter asked me to remind you that countries don’t trade with each other; people trade with each other. China doesn’t trade with America. Individuals who reside on that part of the earth that we today call “China” choose to trade with other individuals who reside on that part of the earth that we today call “America” and who choose to trade with people in China.

That’s it. That’s the elemental economic case for free trade.

II.

But there’s a second part to the case for free trade. It’s the part that’s been constructed in response to the multitude of misunderstandings that have arisen over the centuries with regard to trade.

This second part to the case for free trade is the longer part. The reason is that the capacity for misunderstanding and mischaracterizing trade is enormous. Many falsehoods require many corrections.

Here I’ve time only to mention a few pieces of this second part of the case for free trade.

First, over the long-run free trade causes no net loss of jobs. Put differently – and harkening back to a point made above – any change in consumer spending causes some workers to lose jobs while creating jobs for other workers. International trade isn’t unique on this front. The jobs lost today to imports are replaced tomorrow by other jobs.

And these other jobs are, overall, better than the lost jobs because they are the ones at which the workers in the country have a comparative advantage. The jobs lost are ones at which the workers have a comparative disadvantage.

If you worry that the loss of particular jobs today cannot be made up for by the creation of new jobs, consider that in 1950 the U.S. workforce contained roughly 60 million people, with roughly 57 million jobs. The unemployment rate in 1950 was 5.3 percent. Today, the size of the U.S. workforce is about 160 million, with about 152,000 jobs. In 66 years, the number of workers and the number of jobs in America have each increased by a bit more than 150 percent. The rate of unemployment today is a not-too-shabby five percent.

Over the long run, the number of jobs is determined not by the freedom of trade but by the size of the labor force, by the flexibility of labor markets, and by workers’ willingness and abilities to remain unemployed as they search for better job offers. What free trade does is to replace worse jobs with better jobs; protectionism protects worse jobs by preventing the creation of better ones.

Another objection to free trade is that it is undesirable if it creates trade deficits. This is an egregious fallacy, because another name for trade deficits is “capital surpluses.” Every cent of a U.S. trade deficit is a cent invested by foreigners in America or in dollar-denominated assets. These investments not only return the dollars to the U.S., they also signal that the U.S. is a relatively attractive place to invest. Further, by enlarging our capital stock, they enrich us.

If commenters started referring not to “our trade deficit” but to “our capital surplus” – an exactly equivalent term – there’d be much less misunderstanding and mischief caused by this accounting artifact.

Finally here, it’s a myth that high-wage Americans can’t compete against low-wage foreigners.

Specialization arises according to comparative advantage, which doesn’t stop operating as the wages of workers in a nation rise relative to wages elsewhere. But this point is esoteric. Another point is that low wages reflect low productivity. Americans’ wages are higher than Chinese wages because American workers on average are more productive than Chinese workers. So next time someone says “We can’t compete against low-wage foreigners,” translate that claim into its equivalent: “We can’t compete against low-productivity foreigners.” The latter claim sounds as silly as it really is.

III.

I close not with economics but with ethics. After all is said and done my support for free trade is grounded in ethics, regardless of the economics. I believe deeply that if you work and earn income honestly, that income is yours to use as you choose. You may use it to buy tomatoes from your neighbor or to buy tomatoes from a farmer in Mexico. It’s your money. It belongs neither to the state nor to any domestic producer.

Yet protectionist arguments rest on the premise that your neighbor has some positive claim on your income. If you are prohibited from buying tomatoes from Mexico, or – more commonly today – penalized with a tariff for doing so, the state is insisting that domestic tomato growers have an ethical claim on part of your income. If you do not spend your income as the state, or as domestic tomato growers, deem best, you will be penalized. Tomato-growers’ economic well-being is elevated above yours. I find this presumption, which undergirds nearly all protectionist policies, to be reprehensible and ethically indefensible.

Ed Glaeser on building effective and functioning cities

Professor Ed Glaeser, IGC research programme director, explains why cities are the best pathway to prosperity and outlines three lessons from over 30 years of economics research on urbanisation.

For just how long are there "behavioural" responses to contract changes?

In a recent paper in the American Economic Review (vol. 106, no. 2, February 2016, pp.316-58) Rajshri Jayaraman, Debraj Ray and Francis de Véricourt look at the Anatomy of a Contract Change.

The abstract reads:

We study a contract change for tea pluckers on an Indian plantation, with a higher government-stipulated baseline wage. Incentive piece rates were lowered or kept unchanged. Yet, in the following month, output increased by 20 to 80 percent. This response contradicts the standard model and several variants, is only partly explicable by greater supervision, and appears to be "behavioral." But in subsequent months, the increase is comprehensively reversed. Though not an unequivocal indictment of "behavioral" models, these findings suggest that nonstandard responses may be ephemeral, and should ideally be tracked over an extended period of time.

So we see behavioural responses in the short-run but they fade over the longer term. What does this tell us about the likely long-term effects of Walmart's much publicised "efficiency wage" experiment?

Jayaraman, Ray and de Véricourt conclude their article by saying,

Our study suggests that classical monetary incentives ultimately dominate, despite a possibly “behavioral” response in the shorter term. More generally, our findings speak to a literature in behavioral economics that highlight both the interaction between “intrinsic” and “extrinsic” motivations, as well as the dynamic evolution of those motivations following a policy change: see Gneezy and Rustichini (2000) and Gneezy, Meier, and Rey-Biel (2011). This literature emphasizes how the introduction of financial incentives might erode more social incentives (reciprocity, gratitude, or fair play).

In this paper the baseline relationship is an employment contract. The transaction is monetary to begin with, and gratitude, reciprocity and prosocial behavior are secondary considerations. Do prosocial motivations ultimately hold sway? It would appear not: they matter in the short run, but do not persist. Ultimately, in this labor market setting, monetary incentives come to dominate their nonpecuniary counterparts. This is not to argue that agents are never driven by notions of the social good, or that loyalty to an employer cannot be nurtured. But, particularly in markets where the fundamental relationship is delineated along economic lines, we need to be alert to the possibility that long- and short-term effects differ, and consequently to the hurried classification of many important economic phenomena as fundamentally “behavioral.”

At the very least these results suggest that it is important to examine responses to a policy change, not just immediately after the change but for a substantive period of time afterwards since short and long-term responses can differ substantially.

UK migration: separating fact and fiction

From the Royal Economic Society website comes a piece on UK migration: separating fact and fiction. Perhaps the most interesting part of the article is

For the UK, the existing evidence does not indicate a clear impact of immigration on employment, and only very modest effects on wages at the low end of the wage distribution, but positive effects further up the distribution. He illustrated that migrants tend to upgrade their labour status over time, often starting in work which is below their skill and educational attainment and moving up into more appropriate skill level employment over time.

Also interesting is the comment that in fact economic issues have little impact on people's views on immigration. The finding of the research discussed is that

When discussing attitudes to immigration, Dustmann noted that economic factors were not a key determining issue. Social and cultural factors are much more important, as his research with David Card and Ian Preston has shown.

Part of the problem with whole immigration debate is lack of knowledge.

He pointed out that it is quite typical that people do not know basic facts about migration, and he illustrated that by showing that individuals vastly overestimate the numbers of immigrants in their country, with higher overestimates the lower someone’s educational level.

What of the the fiscal consequences of migration? What of the cost of publicly provided services?

Finally he presented evidence for the UK that immigrants are less likely to claim benefits or live in social housing than the native population. Further detailed analysis of the fiscal contribution of immigrants shows that those who came to the UK after 2000, and in particular those from EU countries, made a substantial net fiscal contribution.

Perhaps this last result isn't too surprise if we think that immigrants are not a random selection from their home country, but are more likely to be risk-takers and entrepreneurs.

Overall the effect of immigration, on the UK at least, looks positive. We should keep such results in mind when discussing immigration into New Zealand.

2016 NZAE conference papers are now available online

Copies of papers made available by the authors for 2016 New Zealand Association of Economists Conference are now available online.

Happy reading!

Yes we can run trade deficits forever

Over at the EconLog blog Scott Sumner has blogged on Why America can run trade deficits forever. The logic, of course, applies to any county. Summer writes,

The US has been running large current account deficits for many decades. Commenters often suggest that this means we are becoming a debtor nation, living beyond our means. This is not true.

The US earns more from our foreign investments overseas that foreigners earn on their investments in the US. China earns $65 billion selling goods to the US, and fritters the money away in loans to places like Venezuela. Meanwhile our multinational corporations make shrewd investments overseas, which bring lots of money back to the US economy.

The international accounts balance out perfectly, once you include trade in goods, services, and assets. The overall balance of payments deficit is precisely zero, if measured properly. Some countries, such as China, are relatively good at exporting goods. They run a positive trade balance. The US is relatively good at international investment---we run a persistent trade deficit, financed by our profits on overseas investments. Or we sell the Chinese "goods" such as houses in LA, that don't count as US exports because they are not physically moved overseas.

Our balance of payments accounting doesn't really correspond to what's going on in the real world. If we sold the Chinese mobile homes, and put them on a ship to China, they'd count as exports. It sounds crazy, and it is, but that's how the accounting is done.

This does not mean that we live beyond our means. GDP in the US is much larger than US consumption. Over time, we are becoming wealthier and wealthier. If countries like China ever became more adept at international investment, then the US would have to share a greater proportion of its GDP with the rest of the world.

In the comments to the post Don Boudreaux writes:

Nice job - but why do you suggest that America's trade (or current-account) deficit requires that Americans consistently earn profits on their foreign investments? It seems to me that all that is required for Americans to run capital-account surpluses consistently or even indefinitely is that foreigners continue, year after year, to find America to be a relatively more attractive place to invest than Americans find non-American places. Indeed, if we Americans were so very good at investing abroad that we consistently profit on most such investments, that reality - by steadily increasing our foreign investments relative to foreigners' investments in America - would put downward pressure on our current-account deficit.

Any interesting response to the Summer post comes from Phil in the comments,

A perpetuation of this transfer will lead to major trouble. To understand why, take a wildly fanciful trip with me to two isolated, side-by-side islands of equal size, Squanderville and Thriftville. Land is the only capital asset on these islands, and their communities are primitive, needing only food and producing only food. Working eight hours a day, in fact, each inhabitant can produce enough food to sustain himself or herself. And for a long time that's how things go along. On each island everybody works the prescribed eight hours a day, which means that each society is self-sufficient.

Eventually, though, the industrious citizens of Thriftville decide to do some serious saving and investing, and they start to work 16 hours a day. In this mode they continue to live off the food they produce in eight hours of work but begin exporting an equal amount to their one and only trading outlet, Squanderville.

The citizens of Squanderville are ecstatic about this turn of events, since they can now live their lives free from toil but eat as well as ever. Oh, yes, there's a quid pro quo--but to the Squanders, it seems harmless: All that the Thrifts want in exchange for their food is Squanderbonds (which are denominated, naturally, in Squanderbucks).

Over time Thriftville accumulates an enormous amount of these bonds, which at their core represent claim checks on the future output of Squanderville. A few pundits in Squanderville smell trouble coming. They foresee that for the Squanders both to eat and to pay off--or simply service--the debt they're piling up will eventually require them to work more than eight hours a day. But the residents of Squanderville are in no mood to listen to such doomsaying.

Meanwhile, the citizens of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island? So the Thrifts change strategy: Though they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land. And eventually the Thrifts own all of Squanderville.

At that point, the Squanders are forced to deal with an ugly equation: They must now not only return to working eight hours a day in order to eat--they have nothing left to trade--but must also work additional hours to service their debt and pay Thriftville rent on the land so imprudently sold. In effect, Squanderville has been colonized by purchase rather than conquest.

In reply to this argument Don Boudreaux writes:

The scenario you describe is possible. But it does not undermine the larger point made by Scott. The reason is that you implicitly assume throughout your tale that all of Squanderville's trade deficit becomes Squanderville's debt and that none, or too little, of that debt is used to finance the production of capital that will increase future output in Squanderville. Given the name of that mythical country, that is not a bad assumption.

But in reality any real country can run a trade (or current-account) deficit without incurring a smidgen of debt - such as, for example, when producers in country F simply hold some of the currency they earn by selling goods to denizens of country D, or when producers in country F use some of these earnings to buy shares of stock in businesses headquartered in country D, or when producers in country F use some of these earnings to build factories or retail outlets in country D.

When Ikea, for example, builds a store in Newark, New Jersey, the stock of capital in America increases as the U.S. trade 'deficit' thereby rises. It's true that some higher proportion of capital in the U.S. is now owned by people whose passports are issued by a foreign government, but so what? From my perspective as an American I am no poorer because of this Swedish investment in NJ, and I am likely wealthier: I can now get more furniture at lower prices and, perhaps, I might even get a better job working at that Ikea store (or, alternatively, my wage in my current job at Acme Furniture Retailer in Hackensack, NJ, might be bid up due to the resulting additional competition for workers such as myself)

There are other reasons why your tale fails to capture the full range of reasons why country D's consistent trade deficits are not necessarily a problem for the people of country D, but I'll not list them here.

In reality, country D's consistent trade deficits in fact do not imply that country D is mortgaging its future to foreigners. Country D's trade deficit might very well be both a signal that the people and economy of country D are growing stronger and more prosperous over the long run and fuel for that stronger growth, for stronger growth in country D is what more capital investment in country D's private economy causes regardless of the nationalities of the investors. (The trade deficits that the U.S. has run for most of its history are almost certainly generally of this happy sort. Witness, for example, the British investments that helped in the 19th century to finance the building of railways in America.)

Further, the fact that country D's trade deficit, in any particular circumstance, might in fact be the result of such mortgaging as you describe in your tale is a reflection not of trade policy but of the high time preferences (or, if you prefer, the economic myopia) of citizens of country D. High-time-preferences (or myopia) among the citizens of D - whether expressed purely privately or through the agency of government borrowing - might indeed be a problem, but it is neither one that will be solved by trade restrictions nor one that even requires that the citizens of D trade with foreigners at all. Such profligacy as you rightly suggest is damaging over the long run is perfectly possible to play out exclusively within the borders of country D, without D running a trade deficit.

Much of the issue here is just a misunderstanding of an accounting convention, what gets recorded where in the national accounts. The so-called "trade deficit" or current-account deficit may be a symptom of something being wrong somewhere in the economy, but it is not in and of itself a problem.