Can Trump make the U.S. a ‘global subsidy cop’?

Has Trump actually come up with something right to do with trade? Are global subsidies a bad thing? Should we complain if other countries subsidise their industries? If other countries want to subsidise our consumption of imports should we care? Scott Lincicome argues that if the U.S. wants to end the practice of other countries subsidising key industries, it would require the U.S. to clean up its own business giveaways.

Resource misallocation & productive growth

Chang-Tai Hsieh, IGC steering group member, explains why some firms are more successful than others, using Indian firms as a case study. The Indian example shows that entrepreneurs can find ways around inefficient regulation. The problem of course is that the workaround is not fully efficient, a better policy would be to remove the bad regulation in the first place. But as noted by Hsieh politicians aren't willing to go there. Another example of bad politics driving out good economics.

A challenge to mercantilists

A challenge from Don Boudreaux at the Cafe Hayek blog. Boudreaux issues the following challenge to any protectionist/mercantilist/economic-nationalist who might wish to take it on:

Identify one plausible economic problem caused by free trade that is unique to trade and commerce that spans political borders. Just one. That is, identify a problem with free trade that arises when people are free to buy and sell internationally but that does not arise when people are free to buy and sell intranationally.

In other words, what economic problems can we avoid by restricting international trade that we don't have to deal with in internal trade?  I've got to admit I've yet to think of anything even remotely plausible as an answer to this challenge.

The "Adaptation Cost" theory of the firm

This material is covers chapters 3 and 4 of Wernerfelt (2016). These chapters are, in turn, based on Wernerfelt (1997) and Wernerfelt (2015), respectively.

Wernerfelt considers two questions to do with the firm that he thinks important but go largely unanswered in the standard theory of the firm literature: What determines the choice between the use of the market, a firm or a contract? Why are all of these mechanisms so commonly used?

His answer to these questions is contained in the "Adaptation Cost" theory of the firm.

Start with a situation where a worker is providing a particular service to an entrepreneur. The entrepreneur's needs change so that the worker's service would have to also change if he is to stay with that entrepreneur. But the worker's productivity will suffer if he, either, changes the service he provides or changes to another entrepreneur and in either of these cases costs would have to be incurred due to the process of bargaining over the terms of a new agreement.

But the costs of worker adaptation are not just those of bargaining, there are also costs, in terms of lower productivity, if the worker has to change, either, to a new service or a new business. A worker is most efficient when he is "double specialised". That is, when he is continually providing the same service to the same business. If this "double specialisation" is not possible it is often second-best to specialise in one of the two dimensions and deal with occasional adaption in the other dimension. Some such adaptations, whether it be between two businesses or two services, are more costly than others.

The basic theory of the Adaptation Cost theory was developed in two papers by Wernerfelt, Wernerfelt (1997, 2015). To begin with the 1997 paper (chapter 3 of Wernerfelt 2016). The focus is on workers who supply businesses with services. The problem is that the needs of the businesses change. Three mechanism to deal with the changing needs are considered: employment, sequential contracting and price lists. In chapter 3 adaptation costs are mainly price determination costs only, since production costs are held constant.

Under the employment mechanism, workers and entrepreneurs negotiate on a once-and-for-all basis over the wage and a large set of services to be supplied on demand. This is similar to the situation in Simon (1951). Here a firm is made up of an entrepreneur and a number of workers who provide the entrepreneur with services via the employment mechanism while the scope of the firm is determined by set of workers thus employed by the entrepreneur. The downside of this is that since there are a large number of things to be bargained over the initial bargaining costs are large, but once agreement is reached there are no further costs incurred so the gains from trade are realised in each period.

Under the sequential contracting mechanism a new price gets negotiated whenever the business's requirements change and thus bargaining costs are incurred on each such occasion. However as the bargains are simpler than those required for the employment contract - the parties are bargaining over a single, known service - the per-occasion bargaining costs are lower.

With the price list, a set of price are agreed upon ex ante and then the list is referred to as needed. As with the case of sequential contracting the per-service bargaining costs are low but if the initial bargaining is over a very long list of prices those costs are high. Here the diversity of needs - how long the price list needs to be - is important to the relative attractiveness of the mechanism.

When the need for a change in service adaptation arise with sufficient frequency, the folk theorem allows us to assume that all trades are efficient under the employment and sequential contracting mechanisms, while under the price list mechanism all trades actually covered by the list are efficient. An implication of this is that there are no trading inefficiencies and thus the only bargaining costs involved are those associated with the mechanism process itself. Given this, the performance of each of the three mechanisms depends only on the costs of adapting to changes in the requirements of the businesses.

In the employment mechanism, costs are a one-time thing related to the negotiation of the wage agreement; for the sequential contracting mechanism the costs are the per-occasion costs of agreeing a price for that particular event; while for the price list mechanism the costs are those one-time costs involved in negotiating the price list plus the loss in the gains from trade for any situations not covered by the list.

Given that the employment mechanism has the lowest costs of adaption - just a verbal instruction - there exists a region in the parameter space, situations in which needs change frequently, in which the employment mechanism (weakly) dominates the other two mechanisms, see Figure 1.

From Figure 1 it is clear that price lists are good when they can be kept short, i.e. there a small number of services needed, sequential bargaining is good when changes are infrequent and employment is good when needs change frequently and many diverse adaptations are required.

Next consider the Wernerfelt (2015) paper (chapter 4 of Wernerfelt 2016). Importantly in this case adaptation costs are expanded to include the costs due to less efficient production. Specifically Wernerfelt assumes that there are gains from specialisation - where specialisation implies little in the way of adaptation - along two dimensions, first businesses and second, services. The former is modelled as an increase in adaptation costs for the worker each time he wants to service a different business. The latter is captured by assuming different workers are good at different things. In this situation three mechanisms are compared: employment, sequential contracting, as before, and markets. Again it is assumed that trade is ex post efficient in all three mechanisms. Wernerfelt concentrates on minimising adaptation costs.

Under the employment mechanism performance is delineated by the gains from trade in each period minus the one-off costs of negotiating the employment contract. The performance of sequential contracting is the gains from trade minus the bargaining costs incurred each period. The important thing about the market mechanism is that it allows workers to specialise in the services at which they are most efficient. "For example, instead of being superintendents they can be plumbers, carpenters, or electricians" (Wernerfelt 2016: 19). The advantage of this is that the gains from trade are increased but the disadvantage is that workers incur business adaptation costs (lose gains from specialisation) every time they switch businesses.

Wernerfelt shows that there are three regions in the parameter space in which each of the three mechanisms (weakly) dominates both of the two other mechanisms.

The relative performance of each of the three mechanisms depends on the frequency with which the needs of the businesses change, the gains from specialisation in an particular service, the business adaptation costs and bargaining costs. See Figure 2 and Figure 3.

Consider Figure 2. Markets are good when workers' between-business adaptation costs are low, that is, the gains from business specialisation are low and thus workers can cheaply switch between businesses; sequential contracting is good when changes in needs are infrequent; and employment is good when the cost advantage of service specialists are small and needs are changing quickly.

Another parameter is shown in Figure 3. Here "service specialisation" - the gains from specialisation in a particular service - is considered. Markets are good when service specialists are a lot more efficient than an employee carrying out many different tasks.

Wernerfelt (2016: 59) illustrates the effects of specialisation, switching costs and adjustment frequency with the example of the maintenance of a medium-sized apartment building,

The owner [of the building] will typically have an employee, the superintendent, perform minor repairs (``the toilet leaks"). The building generates a steady flow of small problems, they tend to be urgent, and the superintendent can solve each of them pretty well. On the other hand, certain minor renovations, such as those having to do with electricity (``install LED light bulbs in public spaces"), are normally done through the market. The jobs are often larger, service specialists can do them better, and the building does not need a full-time electrician. Major renovations, for which advance planning reduces the need for in-process changes, are typically governed by a bilateral contract subject to occasional, though typically costly, renegotiations.

The same example can illustrate the effects of size. A landlord who owns just one or two units will typically go to the market even for minor repairs because these units do not generate enough work to support a superintendent. On the other hand, very large landlords, such as universities, typically use specialist employees (their ``own" electricians) for both repairs and minor renovations.

The major prediction of this theory is that the more frequent are changes in needs the more attractive the employment contract becomes.

Refs.:

• Simon, Herbert A. (1951). "A Formal Theory of the Employment Relationship", Econometrica, 9(3) July: 293–305.
• Wernerfelt, Birger (1997). "On the Nature and Scope of the Firm", Journal of Business, 70(4): 489-514.
• Wernerfelt, Birger (2015). "The Comparative Advantages of Firms, Markets, and Contracts", Economica, 82 no. 236: 350-67.
• Wernerfelt, Birger (2016). Adaptation, Specialization, and Theory of the Firm: Foundations of the Resource-Based View, Cambridge: Cambridge University Press.

The division of labour and the firm: Stigler (1951)

"The division of labor is not a quaint practice of eighteenth-century pin factories; it is a fundamental principle of economic organization."
Stigler (1951: 193)
The following discussion covers material from Stigler (1951) which is one paper that offers a theory of the boundaries of a firm based on the division of labour. Interestingly Adam Smith, despite his famous discussion of the division of labour in the pin factory, did not develop a theory of the firm based on it.

Stigler begins his argument by saying that the division of labour, and its limit due to the extent of the market, lies at the core of a theory of the functions, and thus the boundaries, of a firm. Stigler outlines this theory in the second section of his paper.

In this theory a firm is seen as engaging in a series of distinct operations leading to the production of a final product. That is, the firm is partitioned not among its input markets but among the functions or process that determine the scope of its activities. And thus determine the firm's boundaries.

To allow the graphical representation of the firm's costs of production we will assume that the average costs of each activity depends only on the rate of output of the firm. In addition, if we assume that there is a constant proportion between the rate of output of each activity and the rate of output of the final product then all the cost functions can be drawn on the same diagram and the vertical sum of these costs will be the conventional average cost curve for the firm. With reference to the diagram below to produce q units of final output requires a given number of units of activity 1, costing C_1(q), a number of unit of activity 2, costing C_2(q), and a number of units of activity 3, costing C_3(q). These costs can be summed to give the average cost of production for q units of output, C_1(q)+C_2(q)+C_3(q).

With respect to the shape of the average cost curves for the various activities, some are increasing continuously (C_1), some are falling continuously (C_3) and some are conventionally U-shaped, (C_2).

Now consider the Adam Smith's idea that the division of labour is limited by the extent of the market. First take the activities for which there are increasing returns, Why doesn't the firm exploit the returns more fully and in the process become a monopoly in the output market? Because as the firm expands outputs other activities also have to be increased and some of these are subject to diminishing returns and these cost increases are such that they overwhelm the cost advantages of the increasing returns and increase the average cost of the final product. So why then does the firm not abandon these C_3-like activities and let some other firm (and thus industry) specialise in them to exploit the increasing returns fully? At a given time the market for these activities may be too small to support specialised firms. Given this firms must perform these activities for themselves.

But with an expansion of the market for the increasing returns activity firms specialised in that activity would develop. The firms currently carrying out this activity for its own consumption would forgo this activity and let it be taken over by a new (monopoly) firm. This monopoly could not fully exploit its market power however since it has charge a price which is less than the average cost of production for the firm abandoning the activity. As the market for this activity grows even larger the number of firms specialising in it grows. That is the industry becomes increasingly competitive.

The abandonment of this activity by the original firms will change the cost function for each firm. The cost curve, C_1, will be replaced by a horizontal line (the black dashed line in the diagram above) in the effective region. This also changes the average cost curve for the final product with the new curve (black dashed curve in the diagram above) being lower than the current curve.

What about the increasing cost case? Why not abandon or reduce use of those activities with increasing cost? Much of the previous discussion carries over to this case with the exception that as the market and the industry grows the original firms does not have to stop utilising that activity completely. Part of the needed use of that activity can still be produced in-house without high average (and marginal) cost, with the rest being purchased via the market.

Ref.:

• Stigler, George J. (1951). "The Division of Labor is Limited by the Extent of the Market", Journal of Political Economy, Vol. 59, No. 3 June, pp. 185-193.

Private funding of the Parker fight

Related to my previous posting on the withdraw of public funding for the Parker fight in Auckland comes this news from the New Zealand Herald on pay-for-view prices for the event.

Pay-per-view prices for Joseph Parker's heavyweight world title fight are set to go sky high, with punters and pubs expected to cop the fallout from Auckland Council's refusal on ratepayer funding.

The Herald on Sunday understands from a well-placed source that the pay-TV price for Parker's fight against Andy Ruiz Jr next month could now be set between $70 and $100.

The first point to make here is that this is one way for the event to be paid for by those who want to see the event.

The Herald also states,

The expected pay-TV spike comes after Auckland Council's events and economic development arm, Ateed, threw in the towel on funding the fight with ratepayer money.

Now for the bit I don't get about all of this, Why does the Herald journalist think that the pay-TV price has anything to do with public funding? I mean if the profit maximising price for screening the event is around $70 to $100 without public funding then why isn't this the profit maximising price with public funding?

If market conditions are such that the promoter can charge in the $70-$100 range for the fight when there is no public funding then those same conditions mean he can charge the same even with public funding. This basically just turns the public funding into a rent for the promoter.

It's a strange old world: good sense from JAFAland.

This bit of good news comes from nzherald.co.nz.

Just as they appeared set to announce Parker would fight Andy Ruiz Jr for the WBO title in the city on December 10, Auckland council's events arm Ateed have withdrawn their support for the event, leaving it in a state of limbo.

Ateed Chief Executive Brett O'Riley confirmed last night: "Ateed will not be providing financial sponsorship to Duco to stage the Parker/Ruiz fight."

and

O'Riley said it was not clear if staging the fight in Auckland would have "the desired outcomes of Auckland's Major Events Strategy" so the decision was made "not provide financial sponsorship for the fight."

It is understood Ateed's contribution was going to be "hundreds of thousands of dollars".

Looks like the ratepayers of Auckland have dodged a rather large bullet here.

From another Herald article comes this comment from Howick councillor Dick Quax who is opposed "throwing public money at a private event",

"Did anyone go to Zaire following the rumble in the jungle between George Foreman and Muhammad Ali. I don't think so," said Quax in a reference to the perceived benefits for Auckland.

Questions have to be asked as to whether the fight is a goer without some form of public money and if it isn't is there a justification for staging it in New Zealand. If there are real economic benefits to the fight being in Auckland why can't private funding be found to keep the fight there? If the private sector are not welling to back the event then does this tell us they really don't think they can capture (now or in the future) enough of the supposed benefits to justify backing the fight? Does this, in turn, suggest that the benefits aren't there? In which case why have the fight here?

Joel Mokyr interview

An interview of Joel Mokyr by Ana Swanson from the Washington Post.

Why did the industrial revolution start in Europe, rather than in China? In part because,

It isn’t just that China doesn’t have an Industrial Revolution, it doesn’t have a Galileo or a Newton or a Descartes, people who announced that everything people did before them was wrong. That’s hard to do in any society, but it was easier to do in Europe than China. The reason precisely is because Europe was fragmented, and so when somebody says something very novel and radical, if the government decides they are a heretic and threatens to prosecute them, they pack their suitcase and go across the border.

So exit options can matter. One government doesn't like your ideas, move onto the next.

Antitrust: where did it come from and what did it mean?

Is the title of a new working paper by Richard N. Langlois.

This paper is a draft chapter from an ongoing book project I am calling The Corporation and the Twentieth Century. In The Visible Hand, Alfred Chandler explained the rise of the large vertically integrated corporation in the United States mostly in terms of forces of technology and economic geography. Institutions, including government policy, played a quite minor role. In my own attempt to explain the decline of the vertically integrated form in the late twentieth century, I stayed true to Chandler’s largely institution-free approach. This book will be an exercise in bringing institutions back in. It will argue that institutions, notably various forms of non-market controls imposed by the federal government, are a critical piece of the explanation of the rise and decline of the multi-unit enterprise in the U.S. Indeed, non-market controls, including those imposed in response to the dramatic events of the century, account in significant measure for the dominance of the Chandlerian corporation in the middle of the twentieth century. One important form of non-market control – though by no means the only form – has been antitrust policy. This chapter traces the history of antitrust and argues that, far from being a coherent attempt to address an actual economic problem of monopoly, the Sherman Antitrust Act emerged from the distributional political economy of the nineteenth century. More importantly, the chapter argues that the form in which antitrust emerged would prove significant for the corporation, as the Sherman Act and its successors outlawed virtually all types of inter-firm coordinating mechanisms, thus effectively evacuating the space between anonymous market transactions and full integration.

The last couple of sentences of the abstract are interesting. An unintended(?) consequence of competition policy is an all-or-nothing approach to firm organisation. It's either a market transaction or a fully integrated organisation with little between them being legal. This removes many options in terms of organisational form for entrepreneurs to use to structure a transaction. This can result in an loss of efficiency in those cases where coordination of activity is most effectively carried out by an organisation that is not neither a fully integrated firms or a market transaction. Developments in competition policy in the US during the period around 1900 sent a clear signal that coordination through inter-firm agreements would surely face legal scrutiny whereas coordination within the boundaries of a single legal entity likely would not. This created a palpable incentive for firms to integrate.

Langlois notes an irony in all of this,

Here we begin to glimpse the great irony of American antitrust policy at the turn of the twentieth century: legislation pushed in part by small independent businesses to ward off the threat of the giant corporation actually harmed the small firms, which relied on coordination through contract, and reduced the relative cost of coordination within boundaries of large enterprises.

But such unintended consequences are so often the outcome of government intervention in economic activity.

Good and bad news on the Parker fight

From Sam Richardson's Fair Play and Forward Passes blog comes some good news and some bad news with regard to the Joseph Parker fight. It turns out that despite what we were hearing last week that the fight was most likely to go overseas it will in fact take place in Auckland. Duco withdrew their application for government funding and so no central government money will be put into the fight.

First up the bad news, Sam Richardson writes,

It is not 100% privately funded, though. One of the backers of the Parker camp is the Auckland City events arm ATEED, so there are already taxpayer dollars being funneled into the fight.

Auckland ratepayers will be the losers here. As Sam writes,

Now that the fight is taking place in Auckland, the question becomes whether the fight will generate economic benefits for the city and for New Zealand. In short, the benefits are likely to be confined to Auckland city and are not likely to spill over outside the city boundaries. The extremely short-term nature of the event itself will likely mean that any impact is short and sharp - don't expect longer-term economic impacts - even if Parker happens to win the fight.

Now for the good news,

In the Takam fight, Duco auctioned off 520 general admission tickets at $1 reserve on TradeMe. The intention of this experiment was an attempt to eliminate the possibility of scalping occurring with these tickets - people buying cheap and selling at higher prices.

With interest in this fight likely to be significantly greater than what it was for the Takam fight, it will be very interesting to see if Duco try it again. If anything, they have more to gain from giving it another go - one would expect the willingness to pay for a title fight to be much greater than for a build-up fight. Yet there is always a risk that they may not make the money that they are seeking - but they are likely to sell the tickets and fill the venue. At the same time, charging a fixed price is not a sure bet either - people might decide that the price is simply too steep and there could be empty seats as a result. There is also the possibility that the price might be set too low - and scalping could occur.

The use of an auction would be a great way to generate money for the promoter and deal with scalping. The reason for scalping is that tickets are, for whatever reason, priced at less than the market rate. Given that, it is obvious that money can be made by buying cheap and selling dear. That is, some people will be willing to pay a lot to get to go to the fight and scalpers who buy at the "official" price can resale to these high willingness to pay people at a much higher price. By auctioning off tickets Duco can capture most of the rents that the scalpers would otherwise get and in the process maximise the revenues they get from the fight. Note that this means there is less of a need for any public funding of the fight.

Basically what Duco would be doing is capturing the surplus that consumers would otherwise get if they were to buy at the lower "official" price - what economists call consumer surplus - via price discrimination. Duco can charge different people different prices. An auction is a way of getting people to reveal their willingness to pay.

Anti Trump letter from 370 economists

A group of 370 economists, including eight Nobel laureates in economics, have signed a letter warning against the election of Donald Trump. The letter calls him a "dangerous, destructive choice" for the country. And given his stated views on trade he is likely a "dangerous, destructive choice" for the rest of the world as well.

A few of the letter's statements on trade:

He has misled voters in states like Ohio and Michigan by asserting that the renegotiation of NAFTA or the imposition of tariffs on China would substantially increase employment in manufacturing. In fact, manufacturing’s share of employment has been declining since the 1970s and is mostly related to automation, not trade

He has falsely suggested that trade is zero-sum and that the “toughness” of negotiators primarily drives trade deficits.

He has misled the public with false statements about trade agreements eroding national income and wealth. Although the gains have not been equally distributed—and this is an important discussion in itself—both mean income and mean wealth have risen substantially in the U.S. since the 1980s.

Economist Letter 11012016 on Scribd

Is no competition policy the best competition policy?

Donal Curtin at the Economics New Zealand blog writes.

We had a session at last week's RBB Economics conference in Sydney on "How can a Chief Economist's team enhance competition law enforcement? - an examination of different approaches", with a panel made up of people who should know: Lilla Csorgo, chief economist on the competition side of our Commerce Commission; Graeme Woodbridge, chief economist for the whole caboodle at the ACCC; and RBB founding partner Simon Bishop to talk about the European Commission's experience.

One conclusion that emerged was that competition authorities had experimented over the years with various internal structures, ranging from a separate 'consultancy on call', through the EC's model of an internal quality check unit, through to integration (or at least close involvement in) the investigation teams. Of the various models, integration with the investigation teams, or, at a minimum, close and early involvement with the cases at hand, seemed to be working best.

I want to suggest a question that I'm sure no one at the conference would dare ask, Should there be competition policy in the first place? After all if you make a living out of competition policy, for your own good, you will concentrate on technical issues such as how should economists be integration into the enforcement process rather than suggesting putting yourself (and others) out of a job.

I'll guess that all those at the conference shared the view that a competition body is needed and that it should be a powerful player in its role as competition regulator. I would suggest that the first question the chief economist should ask is, Is this really right? May be competition policy does more harm than good. Would it be better to do away with it?

The idea behind competition law in New Zealand is, according to the Act, “to promote competition in markets for the long-term benefit of consumers”. This is to say, it is believed, by the Act's supporters, that markets left to themselves, without any oversight from regulators, without any regulation of prices, quantities, or structure, would be harmful to consumers. Such a view rests on the notion that there is a large danger of monopoly power being used to harm consumers and, therefore, competition is a state of affairs which must be regulated and managed by the authorities because undesirable situations of monopoly can emerge all the time.

Frederic Sautet, ex-economist at NZ Treasury and the Commerce Commission, makes the point that this thinking is wrong headed:

At the end of the day, the problem assumed by competition law is only exacerbated by regulation, while economics shows that the entrepreneurial process solves it. So while there may be situations where competition law may seem warranted, in fact there is no crime at the crime scene. While competition law aims to protect consumers, the danger is that it may affect the self-correcting properties of the market system — an outcome worse than the disease it tries to cure.

Much of the problem is due to the fact that competition law was established on an misunderstanding of the nature of competition. The law in New Zealand aims to achieve "workable competition" but the practice of competition law relies on the view of competition as a static (equilibrium) state of affairs - derived from the idea of perfect competition. However, actual competition is a rivalrous entrepreneurial process by which the knowledge enabling a better coordination of individual plans is discovered over time. Again, as Frederic Sautet points it

[...] it must be understood that the competitive process takes place within a set of institutions that guarantee the functioning of entrepreneurial discovery and the exploitation of business opportunities over time. These institutions and regulation must guarantee entry into any market to anyone desiring to compete.

Sautet goes on to make the important point that

Under the disguise of consumer protection, competition law has in fact protected some producers from the greater efficiency of their potential competitors. Indeed, competition can be difficult for some incumbents who run the risk of being outcompeted. However, this process is necessary if the ultimate goal is to let consumers (indirectly) dictate the allocation of resources according to their preferences. The danger with competition law is that it interferes with the entrepreneurial process — a cure worse than the disease.

Thus the danger of the Commerce Commission is that it may so damage or restrict the true competitive process that it harms the very people it set out to help, consumers, but helps the people it wished to control, producers. The law of unintended consequences strikes again.

As far as empirical evidence goes it tends to suggest that competition policy does not improve consumer welfare by much. Robert W. Crandall and Clifford Winston look at the effects of antitrust enforcement in the US and ask Does Antitrust Policy Improve Consumer Welfare? And the short answer is, not much. Crandall and Winston write,

In this paper, we argue that the current empirical record of antitrust enforcement is weak.

and add

We then synthesize the available research regarding the economic effects of three major areas of antitrust policy and enforcement: changing the structure or behavior of monopolies; prosecuting firms that engage in anticompetitive practices, namely, price fixing and other forms of collusion; and reviewing proposed mergers. We find little empirical evidence that past interventions have provided much direct benefit to consumers or significantly deterred anticompetitive behavior.

Overall I'm not sure that we really do want a strong interventionist Commerce Commission.

Such questions and arguments will not win friends within the likes of the Commerce Commission but perhaps it would be good for the soul of those within such such bodies to sometimes think about these issues. And coming up with an answer may even be fun.

Refs.:
The Sautet paper, which is well worth reading, is "The Shaky Foundations of Competition Law", New Zealand Law Journal, pp. 186-190, June 2007.
The Robert W. Crandall and Clifford Winston paper is "Does Antitrust Policy Improve Consumer Welfare? Assessing the Evidence", Journal of Economic Perspectives, 17(4) Fall 2003.

Kevin Bryan on Oliver Hart and the nature of the firm

Kevin Bryan writes at VoxEU.org on Oliver Hart's contribution to the theory of the firm.

Bryan writes,

Grossman and Hart (1986) instead argue that the distinction that really makes a firm a firm is that it owns assets. Why does ownership matter? They retain the idea that contracts may be incomplete – at some point, I will disagree with my suppliers, or my workers, or my branch manager, about what should be done, either because a state of the world has arrived not covered by our contract, or because it is in our first-best mutual interest to renegotiate that contract.

They retain the idea that there are relationship-specific rents, so I care about maintaining this particular relationship. But rather than rely on transaction costs, they simply point out that the owner of the asset is in a much better bargaining position when this disagreement occurs. Therefore, the owner of the asset will get a bigger percentage of rents after renegotiation. Hence the person who owns an asset should be the one whose incentive to improve the value of the asset is most sensitive to that future split of rents.

Baker and Hubbard (2004) provide a nice empirical example: when on-board computers to monitor how long-haul trucks were driven began to diffuse, ownership of those trucks shifted from owner-operators to trucking firms. Before the computer, if the trucking firm owns the truck, it is hard to contract on how hard the truck will be driven or how poorly it will be treated by the driver. If the driver owns the truck, it is hard to contract on how much effort the trucking firm dispatcher will exert ensuring the truck isn’t sitting empty for days, or following a particularly efficient route.

The computer solves the first problem, meaning that only the trucking firm is taking actions relevant to the joint relationship that are highly likely to be affected by whether they own the truck or not. In Grossman and Hart’s ‘residual control rights’ theory, then, the introduction of the computer should mean the truck ought, post-computer, be owned by the trucking firm. If these residual control rights are unimportant – there is no relationship-specific rent and no incompleteness in contracting – then the ability to shop around for the best relationship is more valuable than the control rights provided by asset ownership.

Hart and Moore (1990) extend this basic model to the case where there are many assets and many firms, suggesting critically that sole ownership of assets that are highly complementary in production is optimal. Asset ownership affects outside options when the contract is incomplete by changing bargaining power, and splitting ownership of complementary assets gives multiple agents weak bargaining power and hence little incentive to invest in maintaining the quality of, or improving, the assets. Hart et al. (1997) provide a great example of residual control rights applied to the question of why governments should run prisons but not garbage collection.

As an aside Bryan writes,

[...] note the role that bargaining power plays in all of Hart’s theories. We do not have a ‘perfect’ – in a sense that can be made formal – model of bargaining, and Hart tends to use bargaining solutions from cooperative game theory like the Shapley value. After Lloyd Shapley’s Nobel prize alongside Alvin Roth in 2012, this makes multiple prizes heavily influenced by cooperative games applied to unexpected problems. Perhaps the theory of cooperative games ought still be taught with vigour in PhD programmes.

I have to agree with Bryan here, coopertive game theory should be taught to all students. The guy that taught me game theory in my honours degree covered cooperative as well as non-cooperative game theory and the cooperative stuff was interesting with more applied applications than you would think. One of my first publications was on the application of cooperative game theory to cost allocation problems. How do you allocate fixed ad joint costs of a project to those agents undertaking the project? Cooperative game theory gives some nice solution to this problem. It also comes in handy when dealing with bargaining problems like those utilised in Hart's work. The two most commonly use solutions concepts are the Nash bargaining solution and the Shapley Value.

Bryan continues by commenting on Hart's more recent work on the reference point approach to the firm,

[...] he has been primarily working on theories which depend on reference points, a behavioural idea that when disagreements occur between parties, the ex ante contracts are useful because they suggest ‘fair’ divisions of rent, and induce shading and other destructive actions when those divisions are not given. These behavioural agents may very well disagree about what the ex ante contract means for ‘fairness’ ex post.

The primary result is that flexible contracts (for example, contracts that deliberately leave lots of incompleteness) can adjust easily to changes in the world but will induce spiteful shading by at least one agent, while rigid contracts do not permit this shading but do cause parties to pursue suboptimal actions in some states of the world.

This perspective has been applied by Hart to many questions over the past decade, such as why it can be credible to delegate decision-making authority to agents: if you try to seize it back, the agent will feel aggrieved and will shade effort (Hart and Holmström 2010). These responses are hard, or perhaps impossible, to justify when agents are perfectly rational, and of course the Maskin-Tirole critique would apply if agents were purely rational.

So where does all this leave us concerning the initial problem of why firms exist in a sea of decentralised markets? We have many clever ideas, suitable for particular contexts, but still do not have a believable, logically ironclad theory.

A perfect theory of the firm would need to be able to explain why firms are the size they are, why they own what they do, why they are organised as they are, why they persist over time, and why inter-firm incentives look the way they do. It almost certainly would need its mechanisms to work if we assumed all agents were highly, or perfectly, rational – foolishness is not a good justification for institutions employed by millions of organisations.

Since patterns of asset ownership are fundamental, it needs to go well beyond the type of hand-waving that makes up many ‘resource’ type theories. (Firms exist because they create a corporate culture! Firms exist because some firms just are better at doing X and can’t be replicated! These are outcomes, not explanations.)

Byran is correct when he says we have, as yet, no "believable, logically ironclad theory". As I note in Walker (2016: 160)

While the post-1970 theory of the firm literature has began the task of developing a genuine understanding of the firm, and closely related issues, it has yet to coalesce around one model or even one group of models. Even within the contemporary mainstream there are a number of competing models, to say nothing of those we could add into the mix if we were to consider the heterodox literature.

As Bylund (2016: 1–2) explains,

[...] there are several notable theories that each provide a different explanation and rationale for the business firm. [...] [T]here are several different definitions of what the firm supposedly is. [...] But each one must necessarily be incomplete, since it doesn’t capture all of what the other definitions capture.

One can be forgiven for thinking that the current situation with regard to the modelling of the firm is much like a group of blind men trying to describe an elephant, each man can tell you about the part he can feel while remaining unaware of the rest of the animal. Each of the current theories tells us something about the firm, but none can tell us everything.

But if we had all the answers there would be no fun (or point) in working in the area.

Refs.:

• Baker, G, and T Hubbard (2004), ‘Contractibility and Asset Ownership: On-board Computers and Governance in US Trucking’, Quarterly Journal of Economics 119(4): 1443-79.
• Bylund, Per L. (2016). The Problem of Production: A New Theory of the Firm, London: Routledge.
• Grossman, S, and O Hart (1986), ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy 94(4): 691-719.
• Hart, O, and B Holmström (2010), ‘A Theory of Firm Scope’, Quarterly Journal of Economics 125(2): 483-513.
• Hart, O, and J Moore (1990) ‘Property Rights and the Nature of the Firm’, Journal of Political Economy 98(6): 1119-58.