EconTalk this week

Lant Pritchett of Harvard University and author of The Rebirth of Education talks with EconTalk host Russ Roberts about the ideas in the book. Pritchett argues that increases in years of schooling for students in poor countries do not translate into gains in education, learning, or achievement. This tragic situation is due to corruption and poor incentives in the top-down educational systems around the world. School reforms that imitate successful systems fail to take into account the organic nature of successful school systems that cause various external attributes to be effective. The conversation concludes with a discussion of school systems in rich countries and possible lessons for reform that might apply there.

Collaboration, stars, and the changing organisation of science

The NBER has released a new working paper on Collaboration, Stars, and the Changing Organization of Science: Evidence from Evolutionary Biology by Ajay Agrawal, John McHale and Alexander Oettl.

The abstract reads:

We report a puzzling pair of facts concerning the organization of science. The concentration of research output is declining at the department level but increasing at the individual level. For example, in evolutionary biology, over the period 1980 to 2000, the fraction of citation-weighted publications produced by the top 20% of departments falls from approximately 75% to 60% but over the same period rises for the top 20% of individual scientists from 70% to 80%. We speculate that this may be due to changing patterns of collaboration, perhaps caused by the rising burden of knowledge and the falling cost of communication, both of which increase the returns to collaboration. Indeed, we report evidence that the propensity to collaborate is rising over time. Furthermore, the nature of collaboration is also changing. For example, the geographic distance as well as the difference in institution rank between collaborators is increasing over time. Moreover, the relative size of the pool of potential distant collaborators for star versus non-star scientists is rising over time. We develop a simple model based on star advantage in terms of the opportunities for collaboration that provides a unified explanation for these facts. Finally, considering the effect of individual location decisions of stars on the overall distribution of human capital, we speculate on the efficiency of the emerging distribution of scientific activity, given the localized externalities generated by stars on the one hand and the increasing returns to distant collaboration on the other.

Now this makes sense. As we become more specialised, as the division of labour becomes greater, we each know more about less and thus collaboration offers increasing returns. Also if we think of the falling cost of communication as falling transaction costs then greater inter-departmental collaboration makes sense. This is because there is an asymmetry in the way that falling communication costs affects intra-departmental and inter-departmental transaction costs. Things like the internet, skype and email will not affect intra-departmental transaction costs much, if at all, but they will lower the transaction costs of inter-departmental collaboration. And thus we should expect to see greater use of the relatively cheaper option. Also one could see the increasing difference in institutional rank as being, in part, due to the now lower costs for up-and-comers, who may be starting their careers at lower ranked institutions,  to collaborate with "stars".

Henry Simons and laissez faire

For those not up on these things Henry C. Simons was an economist at the University of Chicago - he started teaching in the department of economics and later become the first professor of economics in the law school - and author of a pamphlet, A Positive Program for Laissez Faire: Some Proposals for a Liberal Economic Policy. This work was discussed by Ronald Coase when he gave the 1992 Henry C. Simons Memorial Lecture at the University of Chicago Law School.

Coase notes that the pamphlet was more an essay in political philosophy than economics and

[...] when it did touch on economics, or at any rate on those parts of economics in which I was interested, his views were such as to provoke serious reservations. He thought that the regulation of railroads and public utilities generally had been a dismal failure. And what was his solution for this problem? He argued that "the state should face the necessity of actually taking over, owning, and managing directly, both the railroads and the utilities, and all other industries in which it is impossible to maintain effectively competitive conditions." Carrying out Simons's proposals would have involved the nationalization of a large part of American industry, perhaps the greater part. It is a strange route to laissez-faire and brings to mind the proposals of Oskar Lange and Abba Lerner for market socialism.

Strange indeed. But what of industries other than railways and utilities?

For other industries, those not candidates for nationalization, Simons said that "there still remains a real alternative to socialization, namely, the establishment and preservation of competition as the regulative agency." But how was this to be accomplished? He thought that the antitrust laws should be used to bring about a drastic restructuring of American industry. "The Federal Trade Commission must become perhaps the most powerful of our governmental agencies." I can give the flavor of Simons's approach by describing some of his proposals regarding the corporation:

There must be an outright dismantling of our gigantic corporations. . . . Few of our gigantic corporations can be defended on the ground that their present size is necessary to reasonably full exploitation of production economies: their existence is to be explained in terms of opportunities for promoter profits, personal ambitions of industrial and financial "Napoleons", and advantages of monopoly power. We should look forward to a situation in which the size of ownership units in every industry is limited to the minimum size of operating plant requisite to efficient, but highly specialized production—and even more narrowly limited, if ever necessary to the maintenance of freedom of enterprise.

What Simons had in mind is made clearer in a footnote: "It will be necessary to revise notions commonly accepted (especially by courts) as to the maximum size of firm compatible with effective competition. The general rule and ultimate objective should be that of fixing in each industry a maximum size of firm such that the results of perfect competition would be approximated even if all firms attained the maximum size. One may suggest, tentatively, that in major industries no ownership unit should produce or control more than 5 percent of the total output."

It is interesting to see that the attempt to limit the size of firms in this way is driven by desire to apply the idea of  "perfect competition" to the real world. Competition is seen in terms of an 'end state' rather than a process, as it is for the Austrian school, and so to achieve a 'competitive' outcome the real world must be forced to meet the requirements of that end state. This without considering what the actual results of such an policy would be.

If this was his approach to the structure of industries, what were his views on other areas of industrial economics such as advertising,

"It is a commonplace that our vaunted efficiency in production is dissipated extravagantly in the wastes of merchandising. ... If present tendencies continue, we may soon reach a situation where most of our resources are utilized in persuading people to buy one thing rather than another, and only a minor fraction actually employed in creating things to be bought."

Coase continues by noting,

In making such statements and generally in dealing with industrial organization, Simons provides no empirical backing for his contentions, makes no serious investigation of what the effects of his proposals would be on the efficiency with which the economic system would operate, nor does he consider whether the Federal Trade Commission would be likely to do what he wanted or whether, even if it wanted to do so, it would be possible for it to acquire the information necessary to implement his proposals.

If this is a positive program for laissez faire, I hate to think what a negative one would be like!

I guess economics thinking at the University of Chicago has changed over the years. Coase notes,

Simons's approach is the very antithesis of that which was to become dominant as a result of the emergence of that new subject, law and economics. Stigler's description of Simons is eminently just: Simons was a Utopian.

While Simons's arguments may be rejected by economists today its interesting to ask how many Utopians there are outside of economics still.

Ref.: The quotes from Coase come from:

• Coase, R.H. (1993). 'Law and Economics at Chicago', Journal of Law and Economics, 36(1, Part 2) April: 239-54.

Managerial control versus performance pay

One of the most obvious problems in any employment relationship is moral hazard. What the boss wants workers to do and what the workers actually do can be two very different things. Two of the most common methods firms utilise to try to deal with this problem are the use of performance pay and managerial control. In the empirical literature the performance pay aspect of this solution has received much greater attention than has the managerial control aspect.

In a recent NBER working paper Kirabo Jackson and Henry Schneider examine how an experiment in managerial control affected revenue at an auto repair firm. When the firm provided detailed checklists to mechanics, and managers monitored their use, revenue was 20 percent higher under the experiment. They compare this effect to that of quasi-experimental increases in mechanic commission rates. The managerial-control effect is equivalent to that of a 10 percent commission increase.

These results suggest that managerial control can be a viable alternative to performance pay for the mitigation of the effects of moral hazard. Furthermore, the managerial-control treatment was larger for mechanics that had higher commission rates, suggesting that in this context managerial control and performance pay are complements. The results also support the theoretical prediction that the optimal incentive contract depends on the level and quality of monitoring.

When they investigated the forces underlying the results, Jackson and Schneider find that the mechanics under the managerial-control treatment increase revenue through doing more repairs on each car and working more hours each week. In contrast, mechanics that received commission increases, increased revenue by substituting away from low-revenue repairs toward high-revenue repairs and getting customers to consent to higher price repairs, with no increase in time on the job or number of repairs conducted. Because this shifting toward more expensive repairs may reflect mechanics exploiting their informational advantage over customers, the result underscore the possibility that pay-for-performance may encourage undesirable worker actions.

Also the behaviour of the mechanics is adversely affected because as they only receive a fraction of the firm's revenue, the additional compensation for mechanics for conducting a more thorough inspection of a car is insufficient to offset the associated effort and time costs. Jackson and Schneider's calculations based on their results indicate that a modest transfer of the profits due to checklist use from firm to mechanic could compensate mechanics for their additional costs and achieve a sizable Pareto improvement.

The Jackson and Schneider study shows that increased managerial control can reduce moral hazard, something that has not often been tested empirically. Evidence is also provided that shows that increased managerial control can generate complementarities with performance pay, most likely in settings with multiple complementary tasks. Given the widespread emphasis on performance pay as an incentivising tool, their results suggest that managerial control may be an additional important tool for designing compensation schemes.

Olympics don't pay

The fact that large sporting event don't pay has been mentioned on this blog, and other blogs, many times. Now British economist John Kay has joined those of us who have doubts about the economics of large sporting events with this piece on the costs of the 2012 London Olympics.

Kay writes that the principal relevant facts are these:

The first detailed specification of what was needed for London to host the games was drawn up in 2002 by Arup. The report by the engineering and planning consultancy put the cost at £1.8bn, much of it to be privately financed. An extended assessment was then commissioned by the Department of Culture, Media and Sport from PwC. The financial consultancy’s 2003 report estimated the total cost at £3.1bn, requiring a public subsidy of £1.3bn. The balance would be recovered from the private sector and from asset sales after the games. According to PwC’s risk assessment, the probability that the taxpayer would need to provide as much as £2bn was less than 5 per cent.

and

The budget had by 2007 increased to about £6.5bn. At Treasury insistence, a contingency allowance, mostly unspecific, of £2.8bn – more than the total original projected cost – was added. The costs of land acquisition and of the Olympic Village were mostly excluded in the belief that they would be recovered from property sales after the event.

But what, you may ask, of the claims that the games “within budget”?

The basis of the claim that the games came in “within budget” seems to be that a small part – currently £300m-£400m – of that £2.8bn contingency remains unspent. That was achieved, however, by excluding a number of additional unbudgeted expenditures from the calculation, as the National Audit Office has highlighted. There is likely to be little, if any, net recovery of the further costs of land and housing, which were due to be recouped from property sales.

The costs were grossly and persistently underestimated, and the financial contributions anticipated from private sources overestimated by very large amounts. Every year, to the present day, the expected cost rose and the likely revenues diminished. The cost of the games to public funds has proved to be about 10 times the original estimate.

Kay continues,

There is a halo effect; the sporting success of the Olympics fosters the mistaken belief that they were an economic success. Papers recently produced by government on the “economic benefits” must be an embarrassment to the many good people of the Government Economic Service, conflating incommensurable monetary amounts and confusing costs with benefits. At the same time, a curious puritanism requires politicians to pretend activities intended to make us feel good about ourselves are justified by their contribution to “the economy”. The Olympiad was a good party, which cost the British population about £200 per head.

Kay then makes the important point that false accounts of the past prevent us learning lessons for the future, of which, he argues, there are many.

The Olympics remind us that enthusiasts typically understate costs and overstate benefits. Consultants win work by pleasing clients, and they rarely please clients by pouring cold water on their pet schemes. We should waste no more public money on risk simulations such as those in the PwC report; the outcome in this case was one of these supposedly statistically impossible events that seem nevertheless to occur on a daily basis. Establishing an allowance for “optimism bias” is realistic, but offers little incentive to make careful projections in the first place. Money put in a budget for general contingencies is not money you are likely to see again.

Just when will governments, and taxpayers, learn that big sporting events, be it the Olympics or the rugby world cup or the America's cup, don't make economic sense. And thus taxpayer money spent on them is taxpayer money wasted.

An interview with Jeremy Adelman on Albert Hirschman

In this audio from VoxEU.org Jeremy Adelman of Princeton University talks to Romesh Vaitilingam about his biography of the economist and social scientist Albert Hirschman. They discuss Hirschman’s ideas about economic development, ‘optimal’ crises and what is perhaps his most famous book among economists, "Exit, Voice and Loyalty". Adelman also speculates on what the citation would have said had Hirschman won the Nobel Prize – and explains why we should read Hirschman now.

Use of the metaphor of the "invisible hand" 2

In the comments to the post Use of the metaphor of the "invisible hand" Owen refers us to the blog - Adam's Lost Legacy - of Scottish economist and Adam Smith scholar Gavin Kennedy. For anyone with an interest in Smith, and who hasn't?, Gavin's blog is a must read.

Gavin's view on the interpretation of the "invisible hand" is a little different from the one I was arguing. Now I see that Gavin has picked up on my comments and has commented on them at his blog.

Gavin explains his view in the following way:

I agree with Paul broadly on his critique of the popular modern economist’s idea of the “invisible hand”. I regard Paul’s treatment as a step or two forward in this debate, and praise him for taking it. In his subsequent comment to “Owen”, Paul kindly refers “Owen” to citations of my published assessments on the IH metaphor from 2008-2011.

However, Paul makes a suggestion also made by my scholarly friend, Craig Smith, several times, including in his excellent book, Smith, C. 2006. “Adam Smith’s Political Philosophy: the invisible-hand and Spontaneous Order”, Oxford, Routledge. Craig is the Reviews Editor of the “Adam Smith Review” (International Adam Smith Society), and a co-editor (with Chris Berry and Maria Paganelli “Handbook on Adam Smith”, 2013, Oxford University Press. Neither Paul nor Craig fully agree with my interpretation of the significance to Adam Smith of his use of the “IH” metaphor, though they both are disturbed with modern interpretations of it to an extent.

Nevertheless, they present an alternative view to mine (argued on Lost Legacy since 2005). In their presentations they agree in effect: “The invisible hand idea … is a very convenient shorthand for Smith’s idea that human actions have unintended consequences; and that provided a few fundamental rules such as the principles of justice are followed, the self-serving actions of individuals can unintentionally produce a well-functioning and beneficial overall social order” (Paul) and: “generally the idea of social evolution through unintended consequences, which represents Smith’s chief legacy to the modern world” (Craig).

I am pleased to see that Paul and Craig both are further away from the post-Samuelson (1948) invention that conflates Smith’s use of self-interest as “selfishness” that “miraculousy” has the effect of creating a “public” benefit.

I can agree with Paul and Craig in so far as they reject the invention, which is a step forward. However, I do not think that they have shown that Smith used the IH metaphor “as Smith’s friend Adam Ferguson observed, the results of human action, not the product of human design”. The phrase was indeed used by Adam Ferguson, and in Smith’s case it is true that Smith also referred to ‘unintended consequences” in the (long) IH paragraph, but Smith's statement says: [The merchant who invests domestically] “generally, indeed, neither intends to promote the publick interest, nor knows how much he is promoting it. By preferring the support of domestick to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. (WN IV.2.9: 456).

To argue from the above that the IH metaphor is about “unintended consequences I suggest misreads the sense of Smith’s paragraph. Smith Lectured on Rhetoric in Edinburgh and 1748 (privately sponsored public lectures) and at Glasgow University from 1751 to 1763 as a member of the Glasgow faculty and the Professor of Moral Philosophy). He was also fluent in Latin and Oxford English grammar. He was therefore most unlikely to make grammatical errors. He taught about the grammar of metaphors as figures of speech, for which we have student notes: Smith. [1762-3] 1983. “Lectures on Rhetoric and Belles Lettres”, Lectures 6, 7, 8 and 9. Oxford University Press.

Smith refers to the “objects” of metaphors, which in this case refers to the specified objects in each of the two cases in which he used the IH metaphor to “describe in a more striking and interesting manner” its “object”.

In the two (only) cases he mentioned, first in Moral Sentiments (the actions of the “proud and unfeeling Landlord” feeding his serfs, labourers, servants, and overseers, which was an absolute necessity – no food meant no labour!). It was that necessity that led the landlord to feed those employed on his estate – described by Smith that he was “led by an invisible hand”. In the second case, mentioned in Wealth Of Nations, the merchant who felt too insecure to send his capital abroad, hence he invested in “domestic revenue and employment”. It was the “merchant’s insecurity that led him to invest locally – described by Smith of him being “led by an invisible hand”.

In short, the IH metaphor refers to the motives of the landlord and merchant that LED them to act as they did. It was NOT the IH that separately intentionally led either of them to create the “unintentional consequences of their actions. The IH describes their actions. That is why the consequences of their actions were “unintentional”!

To argue otherwise makes no-sense of Smith’s use of the grammar of metaphors (still exactly the same as defined in today’s Oxford English Dictionary, 1983, as Smith described it in 1762-62).

Moreover, Paul and Craig imply a theological interpretation of his use of the IH metaphor – what, whomsoever, or whatever, leads an “IH” to cause the “unintentional outcomes”? (see Kennedy, “Adam Smith on Religion”, Handbook on Adam Smith, Oxford UP 2013, or shorter, earlier version, Kennedy, 2011. “The Hidden Adam Smith in his Alleged Theology” Journal of the History of Economics, no 3, 2011).

An action has motives which actions may have consequences, but unintended consequences do not have intentional motivated causes!

Perhaps the point I'm trying to get at is better said by James Otteson. When discussing Smith's essay on "Consideration Concerning the First Formation of Languages, and the Different Genius of Original and Compounded Languages" Otteson writes,

The reader, furthermore, would be correct to detect in this essay the early hints of an argument that Smith will later develop into perhaps his most powerful, what we will call the Invisible Hand Argument: individuals, when seeking to satisfy their own localized desires will tend to behave in ways that will also benefit other - even others they do not know and about whom they therefore have no particular concern, and without their intending to do so.

This Invisible Hand Argument would, I feel, be seen in Smith's work even if the actual references to the "invisible hand" were removed.

When Otteson goes on to talk about "What Smith Got Right" the first thing he mentions is Smith's model of spontaneous order. Otteson argues this is made up of several elements, one of which is "general welfare and the "invisible hand"". Otteson says,

Smith was under no illusion that people in their normal daily activities actually care about the general welfare. Luckily, however, people do not have to. The nature of the unintended system of order suggests that they will tend to conduce to the benefits of everyone concerned regardless - at least in the long run.

So I would argue that the "invisible hand" in a board sense, permeates Smith's works.

What's okay to buy and sell?

Aaron Ross Powell and Trevor Burrus talk with James Stacey Taylor, an Associate Professor of philosophy at the College of New Jersey and the author of Stakes and Kidneys: Why markets in human body parts are morally imperative and the forthcoming book Toxic Trade? An Unapologetic Defense of Universal Commodification, about what society thinks is okay to buy and sell. Buying and selling some things--like books, cars, or house--strike us as fine. But even the thought of trading money for things like love, babies, votes or organs makes many people uncomfortable or even angry.



If the above doesn't work try this link.

Allen's "The Institutional Revolution"

Volume 26, Issue 4 - December 2013 - of The Review of Austrian Economics continues a series of papers reviewing Doug Allen's recent book The Institutional Revolution: Measurement and the Economic Emergence of the Modern World, ... and what a set of reviewers: Deirdre N. McCloskey, Joel Mokyr and Richard N. Langlois, with a reply by Doug Allen.

A neo-institutionalism of measurement, without measurement: A comment on Douglas Allen’s The Institutional Revolution
Deirdre N. McCloskey Pages 363-373

In his elegant book Douglas Allen claims that an improvement in the measurement of Nature made for lower transaction costs and the Industrial Revolution. His argument is a typical example of neo-institutionalism in the style of Douglass North (1990) and North et al. (2009). A fall in a wedge of inefficiency is supposed to provide Good Incentives, and the modern world. But the elimination of wedges lead merely to Harberger Triangles of improved efficiency—not to the factor of 100 in properly measured real income per head, which is the Great Enrichment 1800 to the present to be explained. Allen does yeoman work in explaining some of the peculiarities of British public administration, such as the reliance on aristocratic honor and on the prize system in naval warfare. But he attributes to public administration an implausible effect on private incomes. The merging of power and plenty is mistaken. Further, the alleged increase in a modern ability to measure marginal products is implausible. Large modern enterprises face greater, not smaller, problems of assessing the contribution of individuals. Allen’s book on measurement does not measure, and the probable order of magnitude of the items he focuses on is too small to explain any but the details of administration.

The Institutional Revelation: A comment on Douglas W. Allen’s The Institutional Revolution
Joel Mokyr, José-Antonio Espín-Sánchez Pages 375-381

Institutions are a central topic in economic history. Allen’s work differs in that he is interested in institutions per se, not as a means to economic performance and prosperity. The purpose of this book is to explain the institutions of the premodern world and to show why they changed. His argument is that in a Principal-Agent situation, before the Industrial Revolution, it was harder for the Principal to attribute whether the failure of the project was due to acts of nature or some acts of the agent, hence the “strange” institutions. In a modern world, with a much improved monitoring technology, we can use more “efficient” institutions, hence the Institutional Revolution. Although innovative and interesting, the author over-stresses his argument. Much more than monitoring in a principal-agent relationship is needed to explain the Industrial Revolution and the changes in institutions associated with it.

The Institutional Revolution: A review essay
Richard N. Langlois Pages 383-395

This review essay discusses and appraises Douglas Allen’s The Institutional Revolution (2011) as a way of reflecting on the uses of the New Institutional Economics (NIE) in economic history. It praises and defends Allen’s method of asking “what economic problem were these institutions solving?” But it insists that such comparative-institutional analysis be imbedded within a deeper account of institutional change, one driven principally by changes – often endogenous changes – in the extent of the market and in relative scarcities. The essay supports its argument with a variety of examples of the NIE applied to economic history.

In defence of the institutional revolution
Douglas W. Allen Pages 397-412

I defend my thesis laid out in The Institutional Revolution against the comments made by McCloskey, Espin and Mokyr, and Langlois, who all believe that the weight of the great institutional transition is too great for my theory of measurement, and who all quibble with some aspects of my historical analysis. I argue that some of the comments fail to fully appreciate the Coasean approach, and that most of the historical comments miss the mark. I begin with a short discussion of Coase, and then turn to each author in turn.

Is this really a good deal?

Not for the Scottish taxpayer. From the TVNZ website,

Infratil, the Wellington-based infrastructure investor, has sold its unprofitable Glasgow Prestwick Airport to the Scottish government for 1 British pound.

The transaction was completed over the weekend and will see the airport transferred to TS Prestwick Holdco, an entity wholly-owned by the Scottish Ministers, for a cash consideration of 1 pound.

The purchase price reflected the need for more investment, and the Scottish government is seeking a commercial partner to operate the airport on its behalf, it said in a statement yesterday.

"This acquisition secures continuity of service and we will now begin work with our local partners on developing our vision for the business so we can maximise its contribution to the local, regional and national economy," Deputy First Minister Nicola Sturgeon said.

I can't but help thinking that there is a message in the fact that someone will sell you an airport for one pound. If we think of the sale price of an asset as the present value of the future income stream for the asset then selling the asset for such a price should be a warning to the Scottish taxpayer. It is very unlikely that the taxpayer will ever see a reasonable return on their (forced) investment.

This looks like a bad deal for three related reasons: 1) Prestwick loses money, 2) it is not obvious what the new owners can do that Infratil didn't do to make it pay and 3) it is far from clear that politicians can run the airport better than a private operator. The very fact that a private buyer could not be found is a worrying signal as to the future prospects for the airport.

Libertarians and the poor

Philosopher Matt Zwolinski (Zwolinski is Associate Professor of Philosophy at the University of San Diego, and co-director of USD’s Institute for Law and Philosophy) discusses with Aaron Ross Powell and Trevor Burrus how libertarianism can help the least well-off.

Multitasking can be a problem

One thing theory tells us about multitasking is that you can get into trouble if some of the things you want people to do are easier to measure than other things. What you would expect is that the people will put more effort into the well measured things than the less well measured things. For example, teaching is harder to measure well than research so you would expect to see more effort placed on research than teaching in academia. And, by and large, you do.

But according to a new NBER working paper it's not just academics who respond to such incentives.

Testing the Theory of Multitasking: Evidence from a Natural Field Experiment in Chinese Factories
Fuhai Hong, Tanjim Hossain, John A. List, Migiwa Tanaka
NBER Working Paper No. 19660
Issued in November 2013

A well-recognized problem in the multitasking literature is that workers might substantially reduce their effort on tasks that produce unobservable outputs as they seek the salient rewards to observable outputs. Since the theory related to multitasking is decades ahead of the empirical evidence, the economic costs of standard incentive schemes under multitasking contexts remain largely unknown. This study provides empirical insights quantifying such effects using a field experiment in Chinese factories. Using more than 2200 data points across 126 workers, we find sharp evidence that workers do trade off the incented output (quantity) at the expense of the non-incented one (quality) as a result of a piece rate bonus scheme. Consistent with our theoretical model, treatment effects are much stronger for workers whose base salary structure is a flat wage compared to those under a piece rate base salary. While the incentives result in a large increase in quantity and a sharp decrease in quality for workers under a flat base salary, they result only in a small increase in quantity without affecting quality for workers under a piece rate base salary.

Excess demand?

From TVNZ,

Monty Python's reunion show sold out in just 43.5 seconds today.

EconTalk this week

Joel Mokyr of Northwestern University talks with EconTalk host Russ Roberts about the future of the American economy. Mokyr rejects the claims that the we are entering an area of stagnation or permanently lower economic growth. He argues that measured growth understates the impact on human welfare. Many of the most important discoveries are new products that are often poorly measured and not reflected in measures such as gross domestic product or income. The conversation closes with a discussion of the downsides of technology and why Mokyr remains optimistic about the future.

Use of the metaphor of the "invisible hand"

In the comments section to the previous post on the Foundations of a free society Owen writes,

Shame he mis-quotes Smith. AS never mentioned an invisible hand in reference to markets, in fact he only mentioned it once in Wealth of Nations. Also, AS notion of self-interest was appealing to others self-interest to gain what you wanted, ie mutual trade, nothing selfish about it. I'm not aware of any evidence that markets automatically lead to good outcomes for society, I do think they are the best allocative mechanism though (in most cases).

Butler is not quoting Smith and I'm sure that he is aware of the use Smith made of the term "invisible hand". To quote Butler,, at some length,

Adam Smith is famous for his ‘invisible hand’ idea. Most people take this to mean that our self-interested actions somehow produce an overall social benefit. Our hard bargaining, for
example, creates a market system that allocates resources with great efficiency.

In fact, apart from a mention of the ‘invisible hand of Jupiter’ in The History of Astronomy, Smith uses the phrase just twice in his entire output and not really in the commonly presumed sense. The rich make work for the poor.

In The Theory of Moral Sentiments, Smith suggests that the hand of ‘Providence’ equalises economic rewards. The rich can eat no more than the poor. Their only use for most of the food produced by their land is to exchange it with others – those who supply the luxuries, the ‘baubles and trinkets’, that the rich demand. Thinking only of themselves, the rich provide employment to thousands:

The rich only select from the heap what is most precious and agreeable. They consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.

The only mention of the invisible hand in The Wealth of Nations is in a passage about official monopolies that promote domestic industries over foreign trade. Smith notes that this induces people to commit more capital to home industries, and then slides into the point:

As every individual ... endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it.
By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.

These two passages suggest to critics that Adam Smith’s real ‘invisible hand’ concept is far removed from the popular notion of it. In one, the happy outcome of self-interest is attributed to ‘Providence’. In the other, it is a side comment in a discussion about the export trade.

In fact, the critics read too narrowly. The invisible hand idea, as commonly understood, pervades Smith’s work, and would do so even if these two specific references had never existed. For the phrase is a very convenient shorthand for Smith’s idea that human actions have unintended consequences; and that provided a few fundamental rules such as the principles of justice are followed, the self-serving actions of individuals can unintentionally produce a well-functioning and beneficial overall social order.

Or as Craig Smith has point it,

It is the idea of the invisible hand, or more generally the idea of social evolution through unintended consequences, which represents Smith’s chief legacy to the modern world. The recognition that many of the most important human achievements are, as Smith’s friend Adam Ferguson observed, the results of human action, not the product of human design, is a profound lesson to us all. It is this observation which leads Smith to his deep scepticism towards ‘men of system’ who would organise humanity to achieve noble ends.

As to whether markets automatically lead to good outcomes for society, Butler is not claiming that they do and Smith never claimed that they do. What I think most economists would say is that markets lead to good outcomes for society more often than any alternative method of resource allocation. A system of rules are required to achieve this end - such as competition and a system of justice - but as long as these are in place then markets are a better bet to achieve good outcomes than "men of system".

I don't follow this argument

This article in the Guardian states,

Joffe [Michael Joffe, professor of economics at Imperial College, London] said university economics department were continuing to teach concepts that had been disproved. In one example he said the idea that companies suffer "dis-economies of scale" when they increase production beyond certain capacity was true in only a small number of firms.

The U-shaped curve shows that unit costs are high when production begins and become cheaper as economies of scale allow a company to spread costs over more units. Units become more expensive to produce after a factory reaches capacity.

Joffe said: "We ought to stop teaching the U shape as the typical relationship between costs and scale, for the simple reason that it is false."

What does this imply? Is Joffe really saying that he thinks all firms are natural monopolies? I think that is what Joffe's comment leads to. If firm's average cost curves are not U-shaped then I assume they are downward sloping over the relevant range and this implies that firms are natural monopolies. Now this may be true for some firms but I can't  see it as true in general. Is your local dairy really a natural monopoly?

Foundations of a free society

An interesting new book by Eamonn Butler published by the IEA in London. Butler makes the point that a free society is not a random collection of selfish individuals. It is something complex and organic, and based on deep values – not values that challenge other moral systems but values that make cooperation and social harmony possible. As Butler wrote in a previous book on Adam Smith,

He [Smith] realised that social harmony would emerge naturally as human beings struggled to find ways to live and work with each other. Freedom and self-interest need not lead to chaos, but – as if guided by an ‘invisible hand’ – would produce order and concord. They would also bring about the most efficient possible use of resources. As free people struck bargains with others – solely in order to better their own condition – the nation’s land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends and purposes that people valued most highly. Thus the maintenance of a prospering social order did not require the continued supervision of kings and ministers. It would grow organically as a product of human nature. To grow best and to work most efficiently, however, it required an open, competitive marketplace, with free exchange and without coercion. It needed rules to maintain this openness, just as a fire-basket is needed to contain a fire. But those rules, the rules of justice and morality, are general and impersonal, quite unlike the specific and personal interventions of the mercantilist authorities.

And this is still a rather good summary of the basic argument in favour of a free society today. Butler argues that the essential foundations of a free society are freedom, property, trade, justice, toleration, moral rules, incentives, rights, and limited government. He also notes that none of us really lives in a free society, its a case of being more or less free and that we must be vigilant so we doesn't end up ambling down the Road to Serfdom.

A brief summary of the book is:

• Freedom creates prosperity. It unleashes human talent, invention and innovation, creating wealth where none existed before. Societies that have embraced freedom have made themselves rich. Those that have not have remained poor.
• People in a free society do not become rich by exploiting others, as the elites of less-free countries do. They cannot become rich by making others poorer. They become rich only by providing others with what they want and making other people’s lives better.
• The chief beneficiaries of the economic dynamism of free societies are the poor. Free societies are economically more equal than non-free societies. The poor in the most-free societies enjoy luxuries that were undreamed of just a few years ago, luxuries available only to the ruling elites of non-free countries.
• International trade gives entrepreneurs new market opportunities and has helped lift more than a billion people out of abject poverty in the last twenty years. Freedom is truly one of the most benign and productive forces in human history.
• Attempts by governments to equalise wealth or income are counter-productive. They destroy the incentives for hard work and enterprise and discourage people from building up the capital that boosts the productivity of the whole society.
• A free society is a spontaneous society. It builds up from the actions of individuals, following the rules that promote peaceful cooperation. It is not imposed from above by political authorities.
• Government has a very limited role in a free society. It exists to prevent harm being done to its citizens by maintaining and enforcing justice. It does not try to impose material equality and it does not prohibit activities just because some people consider them disagreeable or offensive. Leaders cannot plunder citizens for their own benefit, grant favours to their friends, or use their power against their enemies.
• The government of a free society is constrained by the rule of law. Its laws apply to everyone equally. There must be due process of law in all cases, with fair trials and no lengthy detention without trial. People accused of offences must be treated as innocent until proved guilty, and individuals must not be harassed by being prosecuted several times for the same offence.
• Tolerating other people’s ideas and lifestyles benefits society. Truth is not always obvious; it emerges in the battle of ideas. We cannot trust censors to suppress only wrong ideas. They may mistakenly suppress ideas and ways of acting that would greatly benefit society in the future.
• Communications technology is making it more difficult for authoritarian governments to hide their actions from the rest of the world. As a result, more and more countries are opening up to trade and tourism, and new ideas are spreading. More people see the benefits of economic and social freedom, and are demanding them.

Venezuelan inflation

Not a good look. Steve H. Hanke, Professor of Applied Economics and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University, has been writing on inflation in Venezuela over at the Cato Institute. Hanke writes,

Just how big of a problem is inflation in Venezuela? The implied annual inflation rate in Venezuela is actually now in the triple digits, coming in at a whopping 283%, as shown in the chart below.

What’s more, the implied monthly inflation rate has now ramped up to 36%, as shown in the chart below. That’s dangerously close to the hyperinflation threshold of 50% per month. This is due to an accelerating depreciation of the bolivar, reflecting Venezuelan’s deteriorating economic outlook.

For the record, official government data put Venezuela’s inflation rate at a mere 50%.

So how soon will it be before Venezuela becomes the new Zimbabwe?

EconTalk this week

Angus Deaton of Princeton University and author of the Great Escape talks with EconTalk host Russ Roberts about the book--the vast improvements in health and standard of living in recent times. Deaton surveys the improvements in life expectancy and income both in the developed and undeveloped world. Inequality of both health and wealth are discussed as well. The conversation closes with a discussion of foreign aid and what rich nations can do for the poor.

Just for fun: Marx on the firm

That Marx didn't much like markets is obvious enough, but what of firms? On the positive side Marx preferred the deliberate order of the firm to the anarchy of the market. After all he wanted to run the entire economy like a firm. This view that the firm can be seen as an organisational alternative to the market anticipated Coase in this regard. But on the other hand he saw the firm as the key locus where labour exploitation ad alienation was perpetrated and he has "issues" with the detailed division of labour that capitalism introduced. His model of communism, to be realised after single-firm socialism, was meant to overcome the depressing human condition existing in the capitalist firm.

Besides being a political proposal, single-firm socialism was, according to Marx, a historical necessity imposed by the development of productive forces. The firm’s greater efficiency (relatively to markets) had already been evinced by the growth in firms’ size during capitalism, and productive forces exerted strong pressure for their further growth. By eliminating private property, socialism did nothing other than complete an inevitable process of concentration, whose onset was 'scientifically guaranteed' by historical materialism (Pagano 2012: 42).

For Marx single-firm socialism’ would supersede the dualism of capitalism, under which firms and markets coexisted, and enable the greater development of the productive forces. The limitations of the market sprang from what Marx saw as its nature as a decentralised coordination mechanism dealing with the, often inconsistent, decisions made by buyers and sellers. This negative view of the market lead Marx to argue for the extension of firm-type organisation to society as a whole.

The extension of the planned organization of production of the capitalist factory would complete a process already ongoing in the historical dynamics of capitalism whereby productive forces tended constantly to increase the size of firms. Socialism was the final outcome of this tendency of the productive forces to shift production relations within the firm. The scientific certainty of the advent of socialism was, for Marx, inherent in the tendency of the productive forces to influence production relations. The extension of the authoritarian world of the capitalist firm to the whole of society was necessary to reap the benefits of a planned coordination made more and more necessary by the increasing interdependence among the production sectors (Pagano 2012: 43).

Even if firms are better than markets, firms are not all good. For Marx capitalism produced a very detailed and hierarchical division of labour. This was one of his major criticisms of capitalism. The capitalist-owned firm is a structure that involved a massive deskilling of workers and made labour alienated and painfully homogeneous. But, in the short term at least, socialism could do little about this:

[ ... ] in the early stage of socialism, planning could be made on an objective basis because, according to Marx, capitalism had eliminated the possibility of subjective preferences among repetitive and simple tasks. These conditions suggested, for the first phase of a socialist society, a form of authoritarian planning based on the theory of labour value that ignored the subjective preferences for different kinds of work (Pagano 2012: 43).

Over the longer term, of course, all this would change and

[ ... ] work would entirely match the preferences and development of individuals [ ... ] (Pagano 2012: 43).

Such an idea was constantly present in Marx’s critique of capitalism but its implications were postponed to a distant future.

Interestingly Marx, unlike Coase, saw costs in using the market but assumed that the firm could be used at basically zero cost.

In some respects, Marx made a mistake mirroring orthodox economics when he assumed that, while the costs of market coordination were very high, the costs of firm-type coordination were negligible, with the consequence that all the economic transactions could be coordinated at zero costs by centralized planning (Pagano 2012: 44).

The standard neoclassical model assumes that transactions costs are zero and thus there is no need for firms while Marx assumed that management coasts are zero and thus there is no need for markets. Coase's argument is that both firms and markets come with costs and it is the comparison of these costs that determined the boundaries of the firm.

Ref.:

• Pagano. Ugo (2012). `Marx'. In Michael Dietrich and Jackie Krafft (eds.) Handbook on the Economics and Theory of the Firm (pp. 42-8), Cheltenham: Edward Elgar.