Friday, 12 July 2019

The Conservative Sensibility

Caleb O. Brown interview George F. Will about his new book The Conservative Sensibility
Rights precede government. That’s the core of the American founding, and George F. Will argues that it’s worth preserving. His new book is The Conservative Sensibility.

Wednesday, 12 June 2019

Making Sense of the minimum wage

Recently the Cato Institute put out a new Policy Analysis (No. 867) on Making Sense of the Minimum Wage: A Roadmap for Navigating Recent Research by Jeffrey Clemens. Clemens is an associate professor of economics at the University of California, San Diego.

Executive Summary:
The new conventional wisdom holds that a large increase in the minimum wage would be desirable policy. Advocates for this policy dismiss the traditional concern that such an increase would lower employment for many of the low-skilled workers that the increase is intended to help. Recent economic research, they claim, demonstrates that the disemployment effects of increasing minimum wages are small or nonexistent, while there are large social benefits to raising the wage floor.

This policy analysis discusses four ways in which the case for large minimum wage increases is either mistaken or overstated.

First, the new conventional wisdom misreads the totality of recent evidence for the negative effects of minimum wages. Several strands of research arrive regularly at the conclusion that high minimum wages reduce opportunities for disadvantaged individuals.

Second, the theoretical basis for minimum wage advocates’ claims is far more limited than they seem to realize. Advocates offer rationales for why current wage rates might be suppressed relative to their competitive market values. These arguments are reasonable to a point, but they are a weak basis for making claims about the effects of large minimum wage increases.

Third, economists’ empirical methods have blind spots. Notably, firms’ responses to minimum wage changes can occur in nuanced ways. I discuss why economists’ methods will predictably fail to capture firms’ responses in their totality.

Finally, the details of employees’ schedules, perks, fringe benefits, and the organization of the workplace are central to firms’ management of both their costs and productivity. Yet data on many aspects of workers’ relationships with their employers are incomplete, if not entirely lacking. Consequently, empirical evidence will tend to understate the minimum wage’s negative effects and overstate its benefits.

Saturday, 8 June 2019

Tyler Cowen interviews Russ Roberts

What are the virtues of forgiveness? Are we subject to being manipulated by data? Why do people struggle with prayer? What really motivates us? How has the volunteer army system changed the incentives for war? These are just some of the questions that keep Russ Roberts going as he constantly analyzes the world and revisits his own biases through thirteen years of conversations on EconTalk.

Russ made his way to the Mercatus studio to talk with Tyler about these ideas and more. The pair examines where classical liberalism has gone wrong, if dropping out of college is overrated, and what people are missing from the Bible. Tyler questions Russ on Hayek, behavioral economics, and his favorite EconTalk conversation. Ever the host, Russ also throws in a couple questions to Tyler.

Saturday, 25 May 2019

The employment effects of minimum wages

A brief summary of the state of play.
First, the evidence on the disemployment effect of minimum wages is contested, and there clearly are studies that find no employment effect – both in the United States and in other countries. However, the preponderance of evidence indicates that minimum wages reduce employment of the least-skilled workers. Earlier estimates suggested an ‘elasticity’ of about -0.1 to -0.2. Many estimates are still in this range, some are closer to zero, and some are larger. To be clear, some researchers may have reason to put more store in the types of estimates that tend to find no employment effects – typically the research designs that I have labeled ‘close controls’. I have indicated reasons I am somewhat skeptical of these designs, but also indicated that the jury is still out. More definitively, though, it is indisputable that there is a body of evidence pointing to job losses from higher minimum wages. Characterizations of the literature as providing no evidence of job loss are simply inaccurate.

Second, there are two kinds of changes in minimum wages about which we know a lot less. The first change is the adoption of much higher minimum wages – as is happening in the United States with serious movement toward a $15 minimum. There is a great deal of uncertainty about the employment effects of a $15 minimum wage. One thing we do know is that it would impact far more workers than the current minimum wage, especially in lower-wage states and lower-wage areas of most states. More speculatively, my sense is that the costs of a much higher minimum wage are likely to be understated by simply scaling up the effects based on employment elasticities in the existing literature, because the much higher share of workers affected will reduce employers’ ability to partially offset minimum wage increases by changes in margins other than employment.

The second kind of change about which we know relatively little concerns the introduction of a new minimum wage – like in Germany. There is some evidence from the introduction of a new minimum wage in the United Kingdom. Some of this evidence points to job loss, but the evidence is mixed. And, of course, the institutional setting is not the same.
From "The Econometrics and Economics of the Employment Effects of Minimum Wages: Getting from Known Unknowns to Known Knowns" by David Neumark, German Economic Review, Forthcoming.

Saturday, 18 May 2019

Coase and Plant on the market versus the firm

In a 1937 paper, "Centralise or decentralise" Arnold Plant writes,
"[...] centralisation is the means by which the collaborating enterprises secure the advantage of specialised services or equipment which would not otherwise be available to them on such favourable terms, if at all. If the service or merchandise in question is freely bought and sold on any scale in a well-organised market, there will be no need for centralisation of firms. It is the absence of a well-organised market which may justify firms in pooling their requirements".
He sees a clear trade-off between market provision and in-house production. When markets are available and relatively cheap their use makes sense. But when they are expensive, or unavailable, production in a firm makes sense. Today we would express this by saying when transaction costs are high we use the firm but when they are low we use the market.

Plant's line of argument has a somewhat modern, Coaseian, feel to it. The question this gives rise to is, For how long had Plant been thinking in this way? And did he discuss this line of reasoning in classes that Coase took? Or does the causation run in the opposite direction? Plant's paper was published in 1937 and we know that Coase's analysis of the firm was largely complete by 1932. Did Coase discuss his approach with his former teacher? Or did the two of them reach similar conclusions independently?

I'm not sure we know enough to answer these questions, but it does raise an interesting possibility about the development of Coase's ideas on the firm.

Ref.:
  • Plant, Arnold (1974). 'Centralise or decentralise?'. In Arnold Plant, "Selected Economic Essays and Addresses (174-98), London: Routledge & Kegan Paul. First published in Arnold Plant (ed.), "Some Modern Business Problems: A Series of Studies", London: Longmans, Green and Co., 1937.

Thursday, 25 April 2019

The 2018 trade war

Has the trade war with China been good for American businesses and consumers? The first results are in, and David Weinstein tells Tim Phillips who the winners and losers are.

Wednesday, 24 April 2019

Latest Blogwatch column

My Blogwatch column from the latest issue (Issue 63, December 2018) of the NZAE magazine Asymmetric Information

Being neoclassical before it was cool to be neoclassical: the case of the theory of the firm

This paper looks at the contribution made by pre-1870 writers in economics (proto-neoclassicals) to what would later become known as the neoclassical theory of the firm. In particular we briefly consider the work of Dionysius Lardner, Johann von Thunen, John Stuart Mill, Charles Ellet, Jr. and Antoine Augustin Cournot. This paper shows that the proto-neoclassical "theory of the firm" gave rise to the neoclassical theory of markets.

Tuesday, 23 April 2019

The division of labour and the mainstream theory of the firm

This paper looks at the influence (or lack of influence) that ideas to do with the division of labour have had on the mainstream economic theory of the firm. The notion of the division of labour goes back at least to the ancient Greeks and ancient Chinese but it took two thousand years before the division of labour was used to create a theory of the firm. It was only in the 20th century that such a theory started to be developed.

Tuesday, 9 April 2019

Dave Rubin interviews Tyler Cowen

Tyler Cowen (Economics professor, George Mason U.) joins Dave to discuss his new book “Stubborn Attachments: A Vision for a Society of Free, Prosperous, and Responsible Individuals” covering topics like government regulation, why he identifies as a “small L” libertarian, and economic ideas like Universal Basic Income, climate change, the cryptocurrency revolution, his sensible plan for immigration etc.

Thursday, 4 April 2019

The effects of the Australian National Firearms Agreement

There has been, not too surprisingly, much discussion of the government's idea of a compulsory 'gun buyback' scheme, see for example, Peter Cresswell at the Not PC blog. This legislation the Deputy PM says will cost somewhere around $300 million. An obvious question is what will this money buy us?

One way to see the likely outcomes is to look at the effects of the Australian National Firearms Agreement (NFA) introduced after the mass shooting in Port Arthur, Tasmania in 1996. Some studies suggest the effects of the NFA may not have been large. Lee and Suardi (2008), for example, state that
"The 1996-97 National Firearms Agreement (NFA) in Australia introduced strict gun laws, primarily as a reaction to the mass shooting in Port Arthur, Tasmania in 1996, where 35 people were killed. Despite the fact that several researchers using the same data have examined the impact of the NFA on firearm deaths, a consensus does not appear to have been reached. In this paper, we re-analyze the same data on firearm deaths used in previous research, using tests for unknown structural breaks as a means to identifying impacts of the NFA. The results of these tests suggest that the NFA did not have any large effects on reducing firearm homicide or suicide rates."
But there is some evidence that the Australian reforms, as a whole, reduced suicide and homicide rates. Leigh and Neill (2010) say
"In 1997, Australia implemented a gun buyback program that reduced the stock of firearms by around one-fifth. Using differences across states in the number of firearms withdrawn, we test whether the reduction in firearms availability affected firearm homicide and suicide rates. We find that the buyback led to a drop in the firearm suicide rates of almost 80 per cent, with no statistically significant effect on non-firearm death rates. The estimated effect on firearm homicides is of similar magnitude, but is less precise. The results are robust to a variety of specification checks, and to instrumenting the state-level buyback rate".
But you have to be careful with the Australian case as the NFA had several aspects to it, only one of these aspects being a buyback scheme. Leigh and Neill (2010) also say
"Perhaps a more likely explanation of the strength of the relationship found is that the NFA led states with relatively weak legislation or enforcement relating to sale, ownership and storage of firearms to strengthen their regimes relative to states with initially stronger standards. There is evidence that states with relatively high firearm ownership and therefore high gun buyback rates also had relatively weak regulation prior to 1996. Then, our estimates need to be interpreted as reflecting a combination of both the removal of firearms and the relative strengthening of legislation and enforcement. We might expect to see smaller effects in the case of a buyback that was not accompanied by stricter firearm legislation".
Thus there was more going on in the Australian case than just a buyback, and it's difficult to know which bits of the reforms drive the results.

At the very least such results should highlight the need to very clear as to what we are talking about when discussing the likely effects of the government's proposed legislation. Are we talking about the whole package of reforms that the government wishes to introduce or are we just talking about the buyback scheme. It is possible that the whole package could have worthwhile effects, while the buyback scheme by itself would not. It is also possible that the whole package may not be worthwhile.

One reason for not rushing into any new legislation is to give time for a proper valuation of the empirical evidence to be done.

Refs.
  • Lee, Wang-Sheng and Sandy Suardi (2008). "The Australian Firearms Buyback and Its Effect on Gun Deaths", Melbourne Institute Working Paper Series Working Paper No. 17/08 August.
  • Leigh, Andrew and Christine Neill (2010). "Do Gun Buybacks Save Lives? Evidence from Panel Data", IZA Discussion Paper No. 4995, June.

Friday, 29 March 2019

Price v's policy for reducing emissions

At the New Zealand Initiative, Matt Burgess makes an important point about the advantages of using price rather than policy to reduce emissions. Prices act like information signals that allocate resources to their best uses in the economy. This, as Matt points out, means that prices can do easily what policymakers find almost impossible, dealing with the trade-offs involved with choosing between different methods of reducing emissions. When should we stop investing in one particular method of emissions reduction and invest in other methods instead? Policymakers find this an almost insurmountable problem.
When governments want to reduce emissions, they have a choice between using policy or price.

Policy includes rules – for example, 100% of electricity must be generated from renewables – as well as incentive payments, such as electric vehicle subsidies.

Alternatively, governments can price carbon using cap-and-trade, or tax carbon directly.

The fact that emissions occur in millions of places in the economy strongly affects the relative performance of policy and price.

Consider the following question: At what share of renewable electricity does further investment in renewable electricity cease to be competitive with other ways of reducing emissions?

For policymakers, this is an astonishingly difficult question.

It is not just a matter of working out how the per tonne carbon abatement cost rises as the share of renewables approaches 100%. That is hard enough.

It is also about understanding the consequences for downstream users of electricity, who comprise the rest of the economy.

At a very high share of renewables, the cost of electricity will tend to increase. For downstream users, that affects emissions: If electricity costs more, they will be less willing to switch from petrol to electric vehicles, or to switch their industrial processes from coal or gas to electricity.

For policymakers, working out how the share of renewables affects overall emissions is impossibly complicated.

But for a carbon price, whether through cap-and-trade or a tax, discovery of the ‘right’ share of renewable electricity is easy.

Confronted with the relative cost of emissions-intensive coal and gas generation against green alternatives, buyers of electricity decide their willingness to pay.

For some users, green energy is attractive. For other users, coal and gas has real advantages and means a high willingness to pay.

For a problem like emissions, price enables discovery of the answer to non-obvious questions like how much coal and gas generation to retain. Price can access information that is lost to top-down policy.

Policy’s disadvantage is measurable. A survey of the literature on the performance of government emissions reduction programmes reveals governments spend perhaps $5 to avoid harm from emissions worth $1, on average.

Under cap-and-trade like an Emissions Trading Scheme (ETS), retaining coal and gas generation does not increase overall emissions. These high-emissions generators stay in business only by outcompeting alternative emissions sources for the right to emit.

The government recently calling the ETS its “main tool” for achieving its emissions targets is a step in the right direction.

Monday, 25 March 2019

Social media's content challenge

Moderating content in a polarized political climate while also respecting the value of free speech is a challenge still vexing social media companies. Thomas Kadri of the Yale Information Society Project comments.

Friday, 8 March 2019

A voluminous congressional attack on free political speech

A massive new plan unveiled by Democrats is a wish list of restrictions on free political speech. If this kind of attack on free speech can occur in the US why not New Zealand?

Tuesday, 5 March 2019

Jacob Vigdor on the Seattle Minimum Wage

An interesting discussion of many of the issues to do with the effects of minimum wage increases and how to work them out and estimate how big they are. Well worth the hour to listen to.

Jacob Vigdor of the University of Washington talks with EconTalk host Russ Roberts about the impact of Seattle's minimum wage increases in recent years. Vigdor along with others from the Evans School of Public Policy and Governance have tried to measure the change in employment, hours worked, and wages for low-skilled workers in Seattle. He summarizes those results here arguing that while some workers earned higher wages, some or all of the gains were offset by reductions in hours worked and a reduction in the rate of job creation especially for low-skilled workers.

Monday, 4 March 2019

Partial versus general equilibrium: the theory of the firm example

A point worth making about the modern models of the theory of the firm is that they illustrate a general issue to do with post-1970 microeconomics, namely, the retreat from the use of general equilibrium (GE) models.

Historian of economic thought Roger Backhouse writes that
 “[i]n the 1940s and 1950s general equilibrium theory [ ...] became seen as the central theoretical framework around which economics was based” (Backhouse 2002: 254)
and that by the
“[ ...] early 1960s, confidence in general equilibrium theory, and with it economics as a whole, as at its height, with Debreu’s Theory of Value being widely seen as providing a rigorous, axiomatic framework at the centre of the discipline” (Backhouse 2002: 261), 
but
“[ ...] there were problems that could not be tackled within the Arrow-Debreu framework. These include money (attempts were made to develop a general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models, often dealing only with a specific part of the economy or with a particular problem. The search for ever more general models of general competitive equilibrium, that culminated in Theory of Value, was over” (Backhouse 2002: 262).
As early as 1955 Milton Friedman was suggesting that to deal with “substantive hypotheses about economic phenomena” a move away from Walrasian towards Marshallian analysis was required. When reviewing Walras’s contribution to GE, as developed in Walras’s famous Elements of Pure Economics, Friedman argued,
“[e]conomics not only requires a framework for organizing our ideas [which Walras provides], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall” (Friedman 1955: 908).
By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

All the models considered in this book are partial equilibrium models, but in this regard, the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back, presumably temporarily, on GE theory and has worked almost exclusively within a partial equilibrium framework. This illustrates the point that there is a close relationship between the economic mainstream and the theory of the firm; when the mainstream forgoes general equilibrium, so does the theory of the firm.

One major path of influence from the mainstream of modern economics to the development of the theory of the firm has been via contract theory. But contract theory is an example of the mainstream’s increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of GE. As Salanie (2005: 2) has argued,
“[t]he theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well defined institutional settings”.
The Foss, Lando and Thomsen classification scheme for the theory of the firm clearly illustrates the movement of the current theory of the firm literature away from GE towards partial equilibrium analysis. The scheme divides the contemporary theory into two groups based on which of the standard assumptions of GE theory is violated when modelling issues to do with the firm. The theories are divided into either a principal-agent group, based on violating the ‘symmetric information’ assumption, or an incomplete contracts group, based on the violation of the ‘complete contracts’ assumption. The reference point approach extends the incomplete contracts grouping to situations where ex-post trade is only partially contractible.

The introduction of the entrepreneur, as in the models proposed by Silver, Spulber and by Foss and Klein, also challenges, albeit in a different way, the standard GE model since, as William Baumol noted more than 40 years ago, the entrepreneur has no place in formal neoclassical theory.
“Contrast all this with the entrepreneur’s place in the formal theory. Look for him in the index of some of the most noted of recent writings on value theory, in neoclassical or activity analysis models of the firm. The references are scanty and more often they are totally absent. The theoretical firm is entrepreneurless−the Prince of Denmark has been expunged from the discussion of Hamlet” (Baumol 1968: 66).
The reasons for this are not hard to find. Within the formal model, the ‘firm’ is a production function or production possibilities set, it is simply a means of creating outputs from inputs. Given input prices, technology and demand, the firm maximises profits subject to its production plan being technologically feasible. The firm is modelled as a single agent who faces a set of relatively uncomplicated decisions, e.g. what level of output to produce, how much of each input to utilise etc. Such ‘decisions’ are not decisions at all, they are simple mathematical calculations, implicit in the given conditions. The ‘firm’ can be seen as a set of cost curves and the ‘theory of the firm’ as little more than a calculus problem. In such a world there is a role for a ‘decision maker’ (manager) but no role for an entrepreneur.

The necessity of having to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms or other important economic institutions. Bernard Salanie has noted that,
“[ ...] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models” (Salanie 2005: 1).
This would suggest that to make GE models a ubiquitous tool of microeconomic analysis - including the analysis of issues to do with non-market organisations such as the firm - developing models which can account for information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions and the like is not so much desirable as essential. One catalyst for the development of such a new approach to GE is that partial equilibrium models can obscure the importance of the theory of the firm for overall resource allocation, a point which is more easily appreciated in a GE framework.

Wednesday, 23 January 2019

Rosolino Candela interviews Peter Boettke on Hayekian ideas

Widely considered as one the most influential economists of the 20th century, F. A. Hayek continues to command the attention of scholars with his life and work. On this episode, Peter Boettke and Rosolino Candela sit down to discuss Boettke's new book F. A. Hayek: Economics, Political Economy and Social Philosophy (Palgrave, 2018). Boettke presents this new book as focusing less on Hayek as an individual and more on Hayekian ideas. Throughout the discussion Boettke and Candela examine Hayek's uniting theme of epistemic institutionalism, the competitive market process, and how Hayek's contemporaries picked up on his work. They also discuss the limitations of 'Big Data' to answer the important questions of social science. These Hayekian ideas, Boettke and Candela contend, are still as pressing and worthy of research today.

Thursday, 10 January 2019

Trade: the effects of a border between East and West Germany

From the Peterson Institute for International Economics comes this interview in which Soumaya Keynes and Chad Bown talk with Stephen Redding (Princeton University) about his research on the border between East and West Germany erected in the mid-20th century. They discuss the loss of market access for cities near the border, and how being cut off from one's neighbours affected the local economy. Spoiler: It wasn't pretty ...

Wednesday, 9 January 2019

Harold Demsetz 1930-2019

Harold Demsetz has passed away. He was a longtime member of the UCLA economics department and one area he wrote on was the theory of the firm. Here he took an anti-Coaseian view of the firm. Ten years ago I wrote on Demsetz's view:
In an provocative and interesting paper written for the Markets, Firms and Property Rights: A Celebration of the Research of Ronald Coase conference, Harold Demsetz articulates a somewhat non-standard view of the firm as it appears in the neo-classical model of the competitive economic system. A common attack, one which I would make, on the neo-classical model is that it has no theory of the firm in it. It is a theory with firms but without a theory of firms. The model has no theory of the structure and methods of firms and no theory of why a firm should even exist in an economy in which prices are treated as the sole guides to the opportunities available for putting resources to work. As Foss, Lando and Thomsen (2000: 632) summarise it:
"The pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist".
Demsetz takes issue with all of this. He argues that the neo-classical model offers both a definition of the firm and a rationalisation for the existence of firms, but, he notes, these are mostly implicit. For Demsetz the concern of the neo-classical model is with the function of the firm. The function is what defines the neo-classical firm: this function being the production of goods and services for purchase by persons who, in the main, are not involved in the production of what they buy. The firm is an institution specialised in production for use by others. The rationale for the existence of firms in this theory is implicit in this function. They exist because specialisation is productive.

But what form does this institution being called the firm take? Demsetz explains that the internal organisation of the firm is largely irrelevant to the neoclassical theory of a private, decentralized economic system. If the firm has no internal organisation, then how does production take place? The view of the firm Demsetz is arguing for is one in which the theoretical task served by the firm is that of creating a grand coordination problem whose resolution is sought in the price system. He argues this view of the firm is very different from that of Ronald Coase. For Coase the firm stands in contrast to the market, it becomes less vertically integrated and less important in the economic system the smaller are the costs of using the price system, ie lower are the costs of using the market. For Demsetz the firm stands in contrast to self-sufficient production within households. The firm becomes more important the lower is the cost of using the market. This is simply because low transaction costs facilitates the substitution of specialised production destined for others for self-sufficient production for oneself. The lower is the cost of using the price system the more effectively firms can bring their products to consumers and the more effective are households in supplying inputs to specialised producers.

I think this still leaves the question of the institutional structure that production takes place in unanswered. If production does not take place via Coase-type firms, how does it take place? Is it, as the Foss, Lando and Thomsen quote above would suggest, taking place via groups of autonomous agents who enter into very elaborate (complete) contracts with each other. That is, production takes place over the market. If this is so it would, in turn, make the firm look, perhaps unsurprisingly, like a "nexus of contracts".

The nexus of contracts view was developed in papers by Alchian and Demsetz (1972), Jensen and Meckling (1976), Barzel (1997), Fama (1980) and Cheung (1983). The important innovation here was to see that it is difficult to draw a line between firms and markets, firms are seen as a special type of market contracting. What distinguishes firms from other forms of market contract is the continuity of the relationship between input owners.

Most famously in the Alchian and Demsetz version of this approach, they argue that the authority relationship between the employer and employee is in no way the defining characteristic of a firm. The employer has no more authority over an employee than a customer has over his grocer. "Firing", of either the employee or grocer, is the ultimate punishment that either the employer or customer can use in cases of "disobedience". Alchian and Demsetz argue that, in economic terms, the customer "firing" his grocer is no different from the employer firing his employee. In both cases one party stops dealing with the other, terminating the "contract" between them. In this approach the firm is seen as little more than a nexus of contracts, special only in its legal standing and characterised by long term nature of the relationship between the input owners. In this approach it is not generally useful to talk about firms as distinctive entities, a nexus of contracts could be called more firm-like if, for example, the residual claimants belong to a concentrated group but the term "firm" has little meaning beyond this.

Would such a burring of the lines between markets and firms make sense within the neo-classical model? Given the implicit use of complete contracts in the neo-classical approach I would argue that it does. Under complete contracts any institutional form is able to mimic any other institutional form. A well known example of this is the neutrality theorems of the theory of privatisation literature, under whichstate-ownership and private ownership of firms results in the same outcome. In the case of the neo-classical model, production via the market would achieve anything that production via (Coase-type) firms could achieve and thus there is no need for (Coase-type firms in the model.

But I'm not sure we are left with a role for a firm of any type in the neo-classical model. If the firm is defined by its function, production for outsiders, in a zero transaction cost world it is not clear to me that we have any form of firm at all. What we have is production via the market, which doesn't result in a real meaning being given to the term "firm".

In the neo-classical model, then, I think we are left with having to take production for outsiders as the definition of the firm, without knowing how that production takes place, or we have to say that the model doesn't really have firms in it at all. The grand coordination problem is resolved by the price system, by the market, but without recourse to firms. Demsetz's definition of the "firm" and his rationalisation for their existence is, if I understand it correctly, a definition and rationalisation for production, but production via the market, without firms.

If we accept this position, then we also have to ask, What meaning can we give to the "household" in the neo-classical model?

Of course it could all just be semantics.

Update: Thinking about this a bit more, I wonder if perhaps another way to see the point I’m trying to make is to follow the Alchian and Demsetz argument a bit further. As noted above Alchian and Demsetz argue that it is meaningless to try to draw a hard line between markets and firms. They go on to say that the reason that firms are special has to do with the technology of team production., that is, production where the individual production functions are inseparable from one another. This gives raise to the problem of free riding since team production can act as a cover for shirking. Alchian and Demsetz’s answer to this principal-agent problem is to appoint a monitor to oversee the workers. So in this framework team production is the underlying reason that the "nexus of contracts" can be considered a firm. But there are no team production or principal-agent problems within the neo-classical framework. So while the neo-classical firm may be a "nexus of contracts", it is a "nexus of contracts" without team production and thus there is no rationale for firm based production as opposed to market based production.

References:
  • Alchian, Armen and Demsetz, Harold (1972 ). 'Production , Information Costs, and Economic Organization', American Economic Review, December, v. 62, iss. 5, pp. 777-95.
  • Barzel, Yoram (1997). Economic analysis of property rights Second edition. Political Economy of Institutions and Decisions series. Cambridge; New York and Melbourne: Cambridge University Press.
  • Cheung, Steven N.S. (1983). 'The Contractual Nature of the Firm', Journal of Law and Economics, 26(1) April: 1-21.
  • Fama, Eugene F. (1980). 'Agency Problems and the Theory of the Firm', Journal of Political Economy, April, v. 88, iss. 2, pp. 288-307.
  • Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics, Volume III, Cheltenham U.K.: Edward Elgar Publishing Ltd.
  • Jensen, Michael C. and Meckling, William H. (1976). 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure', Journal of Financial Economics, October, v. 3, iss. 4, pp. 305-60.

Friday, 4 January 2019

Dismissals and CEO incentives


CEO's face relatively stronger incentives from their compensation package than from the threat of dismissal, so a firm should put a lot of time and effort into getting that package right.

What is a firm?

This seems an obvious question which many people would assume would have an obvious answer. And yet it doesn't.

No one can agree on a definition. For neoclassical theory, a firm is little more than a production function or production possibilities set. For Demsetz a firm is an organisation in which production is carried out exclusively for sale to those formally outside the organisation. For Coase the firm is defined as an employment relationship. X is a firm because the owner of X employs A and B to work for him. For Williamson and Hart a firm is defined in terms of the ownership of alienable assets. The question for them is who owns what rather than who employs who. Spulber sees a firm as a transaction institution whose objectives differ from those of its owners. For Foss and Klein a firm is made up of an entrepreneur and the assets owned by them. All of these ideas have some merit. Its 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.

At first, it may seem odd that economists can not agree on what a firm is. But is it really that strange? When you think about it, coming up with a definition that covers every organisation from a sole proprietorship to a partnership to a limited liability company to a multinational is asking a lot, maybe too much. Foss, Klein and Linder (2015: 275)  suggest that a "[...] better question than "what is a firm" is "what are the important research questions that can be answered when the firm is defined in a particular way?" ".

That idea does seem to have merit.  At least then you can use a definition which is useful for the question under consideration rather than trying to come up with an all-embracing definition. A lot of otherwise wasted time and energy could be saved by not having to come up with the perfect one size fits all definition.

Ref.:
  • Foss, Nicolai J., Peter G. Klein and Stefan Linder (2015). 'Organizations and Markets'. In Peter J. Boettke and Christopher Coyne (eds.), The Oxford Handbook of Austrian Economics (pp. 272-95), Oxford: Oxford University Press.

Wednesday, 2 January 2019

Paul Krugman talks trade

From the Peterson Institute for International Economics comes this interview in which Soumaya Keynes and Chad Bown talk with Paul Krugman about trade theory and policy.
Soumaya Keynes and Chad Bown sit down with Nobel Prize-winning economist Paul Krugman (CUNY and New York Times) in a wide-ranging interview about international trade. They discuss NAFTA, labour standards, and the USMCA (2:25); the current toxicity of trade politics (8:00); the wonky economics of comparative advantage versus increasing returns to scale trade (16:55); when and why the trade world changed (21:30); trade’s impact on US wage inequality (25:10); more wonky economics of strategic trade policy (29:30); China’s trade and industrial policy (34:45); what the Trump administration gets right about trade (39:40); and more.