Oliver Hart - reference points and the theory of the firm

This series of videos, from sabanciuniversity, cover a talk given by Oliver Hart (Andrew E. Furer Professor of Economics at Harvard University) on the topic of "Reference Points and the Theory of the Firm". If you're into the theory of the firm - and lets face it, who isn't? - then these videos are well worth the time to watch. Each one is around 12-13 minutes long.

Shares in companies are an old idea

It turns out that shares are more than 700 years old, at least. From the BBC website comes this picture of what is the oldest known share in a company. In 1288, Stora Enso issued this share giving a bishop an eighth of a copper mountain.

Is history is more or less bunk?

The Economist magazine reports on a paper given at the recent Economic History Society's annual conference in the U.K. This work suggests history matters and matters for a long time. The paper looks at the effect of lynchings before 1930 in the U.S. on income distribution today.

The first, by Cornelius Christian of Oxford University, looks at the consequences of the lynching of black Americans between 1882 and 1930. Mr Christian found that this history of racial violence still echoes down the decades. He also found that the higher an area’s lynching rate before 1930, the wider the income gap between blacks and whites remained in 2008-12, even when adjusted for factors such as the education and employment levels of a local area. A high rate of lynching widens this gap by as much as 15% in some cases.

While an interesting empirical result, the question this raises is What is the mechanism that brings this effect about? Just how can something like lynchings 80-120 years ago be affecting income distribution today? It is not obvious what the link is. We need a theory to explain the data.

Why would a firm want to become a multinational?

A question asked at the Federal Reserve Bank of St. Louis. Another way to think about the question is to ask why is it worthwhile to carryout a cross border transaction within the boundaries of a firm rather than by using the market? Three reasons are given:

Ownership Advantage

Multinational firms usually develop and own proprietary technology (the Coca-Cola formula is patented and kept extremely secret) or widely recognized brands (such as Ferrari) that other competitors cannot use. Multinationals often are technological leaders and invest heavily in developing new products, processes and brands, while usually keeping them confidential and protected by intellectual property rights. Maintaining stronger protection of these elements helps firms enjoy greater profits from innovation.

Localization Advantage

Multinationals usually try to build facilities that produce and sell their products in locations near the consumer (the Polish consumers of Coke in our example). This helps reduce transportation costs or helps the company fit in better with local tastes and needs. Proximity to demand also helps firms adapt their products and services to different markets. At the same time, they also may take advantage of lower production costs (for example, labor costs, energy, sometimes even lower environmental standards) or more abundant production factors, such as expert engineering or greater raw materials). For example, the Polish affiliate of Coca-Cola also owns bottling plants in the Beskidy Mountains region of Poland, which is rich in mineral water for making other beverages.

Internalizing Benefits

Finally, multinationals want to internalize the benefits from owning a particular technology, brand, expertise or patents that they find too risky or unprofitable to rent or license to other firms. Enforcing international contracts can be costly or ineffective in countries in which the rule of law is weak and court procedures are long and inefficient. In these cases, the company also may risk losing its ownership advantage, which it has created at a substantial cost.

In house production can lower the cost of the transaction and lessen the likelihood of hold-up that could occur when using another firm. When a transaction can be specified clearly enough to be written into a contract so that any possible problems can be dealt with via court proceedings then an outside contractor or firm can be utilised. But where, say quality is hard to control via contract since the nature of "high quality" can not be specified precisely enough to make a contract enforceable in court, then in house production is more likely.

How long do firms live?

Many commentators, even today, argue that the economy and the nation are controlled by powerful, large, very long lived corporations. John Kenneth Galbraith is perhaps the most (in)famous economist who argued along these lines. He argued that in the industrial sectors of the economy, which are composed of the largest corporations - think S&P 500 companies, the principal function of market relations is, not to constrain the power of the corporate behemoths, but to serve as an instrument for the implementation of their power. Moreover, the power of these corporations extends into commercial culture and politics, allowing them to exercise considerable influence upon popular social attitudes and value judgements. That this power is exercised in the shortsighted interest of expanding commodity production and the status of the few - the 1% - is, in Galbraith's view, both inconsistent with democracy and a barrier to achieving the quality of life that the "new industrial state" with its affluence could provide to the many. Galbraith argued that we find ourselves living in a structured state controlled by these large and all powerful corporations. Control over demand and consumers is exercised via the use of advertising which creates a never ending consumer "need" for products, where no such "need" had existed before. In addition, as Princeton University Press said in its advertising for a new edition of Galbraith's "The New Industrial State",

The goal of these companies is not the betterment of society, but immortality through an uninterrupted stream of earnings.

I have always thought that an implication of these ideas is that large firms, e.g. those in the S&P 500, would be very long lived. After all given the amount of control that these firms apparently have over their markets and the economy at large its hard to see how they could ever go bankrupt or be taken over. They are, after all, able to ensure "immortality through an uninterrupted stream of earnings." Thus these firms would have a long life.

Given this I was interested to see this comment by Bourlee Lam at The Atlantic:

[...] Richard Foster, a lecturer at the Yale School of Management, has found that the average lifespan of an S&P company dropped from 67 years in the 1920s to 15 years today. Foster also found that on average an S&P company is now being replaced every two weeks, and estimates that 75 percent of the S&P 500 firms will be replaced by new firms by 2027.

I just don't see how a 15 year (or even a 67 year) life span is in anyway consistent with the story that Galbraith tried to tell. Such a short life time looks more like support for a Schumpeter like "creative destruction" interpretation of the life cycle of business firms.

Just to show how short a life span 15, or even 67 years, is note:

Cho and Ahn (2009: 160-1) state “The oldest company in the world is known to be a Japanese construction company, Kongo Gumi, which was founded in 578 and thus existed for 1431 years. [However a footnote at this point states “Kongo Gumi went bankrupt in 2006 and was acquired by Takamatsu group, thus depending on the definition of corporate death it may be excluded from a long-lived company” According to Wikipedia (http://en.wikipedia.org/wiki/Kong_Gumi), “As of December 2006, Kong Gumi continues to operate as a wholly owned subsidiary of Takamatsu”.] There are also several other companies which are reported to have existed over 1000 years such as Houshi Ryokan (Japan, Innkeeping, founded in 717), Stiftskeller St. Peter (Austria, restaurant, founded in 803), Chateau de Goulaine (France, vineyard, founded in 1000) and Fonderia Pontificia Marinelli (Italy, bell foundry, founded in 1000)”.

Ref.:

• Cho, Dong-Sung and Se-Yeon Ahn (2009). ‘Exploring the Characteristics of the Founder and CEO Succession as Causes of Corporate Longevity: Findings from Korean Long-Lived Companies’, Journal of International Business and Economy, 10(2) Fall: 157-87.

EconTalk this week

Phil Rosenzweig, professor of strategy and international business at IMD in Switzerland and author of the book Left Brain, Right Stuff: How Leaders Make Winning Decisions talks with EconTalk host Russ Roberts about his book. The focus of the conversation is on the lessons from behavioral economics--when do those lessons inform and when do they mislead when applied to real-world business decisions. Topics discussed include overconfidence, transparency, the winner's curse, evaluating leaders, and the role of experimental findings in thinking about decision-making.

A direct link to the audio is available here.

Modelling science as a contribution good 2

Continuing on with the Kealey and Ricketts paper, Modelling science as a contribution good we see that in section 7.2 Kealey and Ricketts discuss "Science and the firm". They write,

The contribution good model requires that scientists are able to gain financial rewards from the common pool of science. The institutional mechanisms that enable these rewards to be claimed are not modelled explicitly but are simply assumed to exist. The contribution good model of science has direct relevance, therefore, for research programmes in business structure and organisation. In modern Institutional Economics the firm is seen (i) as a substitute for relatively high costs of transacting in the market, after Coase (1937); (ii) as a means of coping with uninsurable uncertainty and continual change, after Knight (1921); and (iii) as a vehicle for instigating technological innovation, after Schumpeter (1934, 1943). The conversion of scientific knowledge into new tradable goods and services confronts obvious transactional difficulties between scientists and technologists, technologists and entrepreneurs, and entrepreneurs and financiers. Cooperation between these elements entails high costs of transacting and is likely to involve the formation of firms with internal labour markets and specially designed incentive arrangements to mitigate them. Hansmann’s (1996) proposition that ownership rights tend to be assigned to the group that faces the highest transactions costs might suggest, for example, the development of scientist-owned firms or firms with significant control rights in the hands of the knowledge creators and users.

There are a number of reasons for thinking that the development of scientist-owned firms could occur.

Within the property rights (also often referred to as the incomplete contracts approach) approach to the firm Brynjolfsson (1994) and Rabin (1993) show that there are adverse selection and moral hazard reasons why a scientist-entrepreneur may have to form their own firm to develop their ideas. In Rabin (1993) Rabin shows that adverse selection problems can be such that, in some situations, an informed party (the scientist-entrepreneur in this case) has to take over or form a firm to show that their information is indeed useful. For Rabin an informed party has information about how to make a firm more productive but can't reveal the information to the owners of a current firm. If the information is revealed the current firm can produce using it without any payment to the informed party. If the information is not revealed why should the firm believe the information is in fact useful? Within the Rabin framework it is suggested that firms are more likely to trade through markets when informed parties are also superior providers of productive services that are related to their information but if, on the other hand, information is a firm’s only competitive advantage, it is likely to obtain control over assets, possibly by buying firms that currently own those assets or setting up his own firm.

The Brynjolfsson (1994) model on the other hand works within a moral hazard framework. Brynjolfsson considers a situation where an scientist-entrepreneur has some expertise needed to run a firm but no value can be created without both the knowledge asset of the scientist-entrepreneur and the physical assets of a firm. He assumes that no comprehensive contract can be written between the entrepreneur and the firm. If the scientist-entrepreneur does not own the firm and he makes an investment in effort and creates value, he can be subject to hold-up by the other party since he needs the firm's physical assets. If the scientist-entrepreneur owns the firm then clearly the hold-up problem ceases to exist. The most obvious interpretation of Brynjolfsson model is as a model of a labour-owned firm (scientist-owned firm in this case). Brynjolfsson argues that it is optimal to give the entrepreneur ownership of the physical assets of the firm since he has information that is essential to its productivity. This result is obviously just an application of Hart and Moore’s proposition that an agent who is ‘indispensable’ to an asset should own it (Hart and Moore 1990). Here, firms are owned by the indispensable human capital (a scientist), or, as is more usual, by a small section of the human capital, e.g. a partnership between a number of scientists.

The above arguments support the Kealey and Ricketts notion that scientist-owned firms are a viable form of governance to allow the scientists to capture the returns from their work. However we should ask if there are limits to such arguments? Walker (forthcoming) suggests their may be such limits. In this model the reference point approach to contracts (Hart and Moore 2008) is applied to the modelling of a human-capital based firm. First a model of firm scope is offered which argues that the organisation of a human-capital based firm depends on the "types" (a crude interpretation of a "type" in this context could be the kind of scientist involved in the project, e.g. chemist, microbiologist or may be both.) of human capital involved. Having a homogeneous group of human capital leads to a different governance structure for a firm than that of a firm which involves a heterogeneous group of human capital. For a homogeneous group of human capital, say just chemists, a labour (scientist) owned firm is viable but for a heterogeneous group, say chemists, microbiologists and physicists, ownership by the owners of the firm's non-human capital may be optimal (that is an investor-owned firm may develop). This is because the more heterogeneous the human capital, the more likely it is that some groups will be "aggrieved" (a party is aggrieved when they do not receive the payoff they think they should) and will therefore "shade" on their performance (i.e. they put in a low level rather than a high level of performance) thereby creating deadweight losses. A firm which involves heterogeneous human capital will more more unstable due to the greater amount of a aggrievement/shading and will therefore require some "glue"”, in the form of non-human capital of some kind, to keep the human capital together and thus keep the firm viable. Given the importance of this glue to the firm, ownership of the firm by the owner of the non-human capital is likely.

Thus while it is possible that Kealey and Ricketts are right that scientist-owned firms will develop such a governance arrangement is not the only possibility. What is likely is that we would see what we see today in terms of firm's governance structures with a range of different governance structures being utilised depending on the exact circumstances.

Refs.:

• Brynjolfsson, E. (1994). Information assets, technology, and organization. Management Science, 40, 12, pp. 1645–62.
• Hart, O.D. and Moore, J. (1990) Property rights and the nature of the firm. Journal of Political Economy 98(6): 1119–1158.
• Hart, O.D. and Moore, J. (2008). Contracts as reference points, Quarterly Journal of Economics, 123(1), 1–48.
• Rabin, M. (1993). Information and the control of productive assets, Journal of Law, Economics, and Organization, 9(1), 51–76.
• Walker, P. (forthcoming). Simple Models of a Human-Capital-Based Firm: a Reference Point Approach, Journal of the Knowledge Economy.

Modelling science as a contribution good

is the title of a recent paper by Terence Kealey and Martin Ricketts in the journal Research Policy (Volume 43, Issue 6, July 2014, Pages 1014–1024).

The paper makes a contribution to "the new economics of science" in that it argues that science is not a pure public good, as is often believed, but is, rather, a contribution good. Pure public goods are both non-excludable and non-rival. A contribution good, in contrast, is like a club good in that it is non-rivalrous but at least partly excludable. The excludability is due to the fact that not everyone is a member of the "club". To be a member of the "club" you have to be able to understand the science at issue. Also consumption is tied to contribution. If you want to be able to make use of the science you need to have mastered the underlying material which normally means you have to be trained as a scientist - you are a member of the "club". This in turns means you will be contributing to the subject.

The important problem here is not, as is the case for public goods, that of free riding but rather being able to create a critical mass of scientists. The club must be of a size large enough to generate both private and social gains.

The abstract reads

The non-rivalness of scientific knowledge has traditionally underpinned its status as a public good. In contrast we model science as a contribution game in which spillovers differentially benefit contributors over non-contributors. This turns the game of science from a prisoner's dilemma into a game of ‘pure coordination’, and from a ‘public good’ into a ‘contribution good’. It redirects attention from the ‘free riding’ problem to the ‘critical mass’ problem. The ‘contribution good’ specification suggests several areas for further research in the new economics of science and provides a modified analytical framework for approaching public policy.

Just when you thought things couldn't get any worse in Venezuela ....

it looks like they have.

Andrew Rosati writes at Bloomberg Business

Venezuela, which already has the world’s fastest inflation rate at a reported 69 percent in December, could see that rate more than double this year as it struggles to respond to falling oil prices.

“We may end up this year with inflation at close to 200 percent,” Alberto Ades, co-head of global economics research at Bank of America, said in an interview on Bloomberg Surveillance Friday.

and

Annual inflation could rise to as much as 150 percent in 2015, and climb as high as 250 percent if the Central Bank included factors currently being omitted in the official statistics, he said.

But interestingly the inflation numbers have not been released so far this year.

The central bank, which typically releases inflation data each month, has yet to publish any information for this year.

[...]

“It’s a strictly a political decision,” Asdrubal Oliveros, director of the Caracas-based consultant Ecoanalitica, said Friday in an interview, referring to the data delays. “It’s not like they’ve stopped calculating inflation. The director of the Central Bank knows what the rate is.”

Not releasing the numbers is not a good look. It does suggest that they are bad and the government doesn't want people to know just how bad.

Part of the problem is that Venezuela relies on oil for the vast majority of its foreign-exchange earnings and the price of oil is dropping. Its almost half of what it was last year.

Venezuela has received an average $45.21 a barrel for its exports so far this year compared with $88.42 in 2014, according to the oil ministry. The nation relies on oil for about 95 percent of its foreign-currency earnings.

Loss of foreign exchange means that imports have to be cut.

Venezuela has responded to falling oil prices by reducing imports, which dropped 18 percent in January compared with the same month last year, BofA Merrill Lynch Global Research said in a report on April 7.

“The Maduro administration is in the midst of undertaking one of the largest import adjustments in Venezuelan history,” the bank said, adding that many of the country’s economic problems are “to a large extent self-inflicted.”

and the economy is suffering,

He [Alberto Ades] forecast the economy would shrink 4 percent. “Venezuela is in a dire crisis.”

The 50 percent drop in oil prices in the past year has buffeted Venezuela’s economy and forced it to reduce imports, exacerbating shortages of everything from shampoo to beef. On the black market, the bolivar has weakened 74 percent in the past year to about 257 bolivars per dollar, compared with the official rate of 6.3 for priority imports.

Are we watching an economy implode simply because of its government's policies?

Should we be spooked by deflation?

Concerns about deflation – falling prices of goods and services – have loomed large in many recent policy discussions. In such discussions deflation is seen as always and everywhere a bad phenomenon. But as I have discussed a number of times before, see for example here, here and here, you need to draw a distinction between good and bad deflation The basic point is that we indeed do have two forms of deflation, the bad driven by demand shrinking and the good caused by supply expanding. The good kind of deflation is the result of increases in productivity. Research and development means new technology, efficiency gains, cost-cutting, price-cutting and, yes, deflation. Productivity gains mean that businesses could afford to sell their products for less since it is costing less to make them. The bad kind usually follows a collapse of aggregate demand. There is a severe drop in spending: producers have to cut prices to find buyers. This has the effect of causing recession, high unemployment and widening financial stress. This the 1930s type deflation that people fear.

The deflation debate is shaped by the deep-seated view that deflation, regardless of context, is an economic pathology that stands in the way of any sustainable and strong expansion. This view is largely based on the experience of the Great Depression. But in a new column, Should we be spooked by deflation? A look at the historical record by Claudio Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann, at VoxEU.org it is argued that it is misleading to draw inferences about the costs of deflation from the Great Depression since it was the archetypal example.

Borio, Erdem, Filardo and Hofmann write,

The evidence from our historical analysis raises questions about the prevailing view that goods and services price deflations, even if persistent, are always pernicious. It suggests that asset price deflations, and particularly house price deflations in the postwar era, have been more damaging. And it cautions against presuming that the interaction between debt and goods and services price deflation, as opposed to debt’s interaction with property price deflations, has played a significant role in past episodes of economic weakness.

Inevitably, our results come with significant caveats. The data set could be further improved. We have focused on only a few drivers of output costs. We have only a few episodes of persistent deflation in the postwar period. And present debt levels are at, or close to, historical highs in relation to GDP. This should caution against drawing sweeping conclusions or firm inferences about the future.

Even so, the analysis does suggest a number of considerations relevant for policy.

• First, it is misleading to draw inferences about the costs of deflation from the Great Depression, as if it was the archetypal example.

The episode was an outlier in terms of output losses; in addition, the scale of those losses may have had less to do with the fall in the price level per se than with other factors, including the sharp fall in asset prices and associated banking distress.

• Second, and more generally, when calibrating a policy response to deflation, it is critical to understand the driving factors and, as always, the effectiveness of the tools at the authorities’ disposal.

This can help to better identify the benefits and risks involved.

• Finally, there is a case for policymakers to pay closer attention than hitherto to the financial cycle – that is, to booms and busts in asset prices, especially property prices, alongside private sector credit [...].

So deflation is not a good reason for running round screaming the sky is falling as many commentators, journalists and politicians seem to want to do. Reality is more complex and subtle. The VoxEU.org column finds a link between output growth and asset price deflations, particularly during postwar property price deflations, that there is no evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations and that the most damaging interaction appears to be between property price deflations and private debt.

Richie Benaud on the "underarm" incident

Benaud taking his own country's national team and captain to task over a disgraceful bit of play.

Assessing Böhm-Bawerk's contribution to economics

A good weekend read. 2014 was the 100th anniversary of the death of the economist Eugen von Böhm-Bawerk (1851-1914). From the Online Library of Liberty at Liberty Fund comes this Liberty Matters debate on:

"Assessing Böhm-Bawerk’s Contribution to Economics after a Hundred Years"
The aim is to evaluate von Böhm-Bawerk contributions as one of the founders of the Austrian school of economic theory with his theoretical work at the University of Vienna, a leading critic of Marxism, and a the Minister of Finance in the Austro-Hungarian Empire.

The Debate

Lead Essay: Richard M. Ebeling, “Eugen von Böhm-Bawerk: Leading Austrian Economist and Finance Minister of Fiscal Restraint” [Posted: April 1, 2015]

Responses and Critiques

1. Joseph T. Salerno, "Eugen von Böhm-Bawerk: Pioneer of Causal-Realist Price Theory" [Posted: April 3, 2015]
2. Roger W. Garrison, “Böhm-Bawerk as Macroeconomist” [Posted: April 6, 2015]
3. Peter Lewin, "Eugen von Böhm-Bawerk – A man for his time, and ours" [Posted: April 7, 2015]

The Conversation

1. Richard M. Ebeling, "Böhm-Bawerk’s Enduring Legacy: The Pricing Process, the Savings-Investment Nexus, and the Capital Structure in the Context of Time" [Posted: April 9, 2015]

So it's all endogenous

There has been much comment around the traps about a study that claims that ageing populations  hinder economic growth.The study predicts the effect of demographic change on growth rates in the current decade and shows that an ageing population will knock over a percentage point off growth rates for some countries, including New Zealand - see the graphic below.


But now James Zuccollo at the TVHE blog points out that the effect may be endogenous. Zuccollo writes,

In a ray of light, this morning’s FT (£) reported a study of over 15,000 German employees that examined the relationship between ageing and productivity. One of the authors is quoted saying:

As workforces age, employers are concerned that productivity will decrease. That is not so. What matters is not chronological age but subjective age.

The research suggests that older people are systematically excluded from training activities, and are relegated to less creative and meaningful work, which renders them less productive. As the workforce ages, that may begin to change. As it changes, the relationship between growth and age structures is likely to weaken.

Getting cause and effect right is important. This highlights why when thinking about topics like productivity you need to think at the firm level. How firms react to changes in the demographics of their workforce will help determine the rate of productivity growth. Just looking at aggregate data can obscure such effects.

The exchange rate is just a price

How often must this be said?

Oliver Hartwich writes in the latest New Zealand Initiative Insights (Insights 12: 10 April 2015 ),

The Reserve Bank of Australia’s surprise decision not to cut interest rates only postponed the expected “parity party” between the Kiwi and the Aussie dollars. The way things are going, it is a matter of time until both currencies are of equal value.

The currency development leaves politicians and commentators divided. On Wednesday, The New Zealand Herald was jubilant (“Transtasman parity worth a celebration”) whereas the Waikato Times played the party-pooper (“Dollar parity bad news”).

Unsurprisingly, Prime Minister John Key claimed the strong Kiwi as an indication of a strong economy while his counterpart, Labour leader Andrew Little warned of negative side effects of our strong dollar.

But why are they talking about parity at all? The exchange rate is just a price like any other price in the economy. The exchange rate being talked about in this case is just the price of the Australian dollar, which given it is floating will go up and down when the demand for and supply of the two currencies change. Just like every other good in he economy. If there are changes in the supply and /or demand for bread, the price of bread changes but we don't see stupid comments by politicians and newspaper editors about it. Why not? If changes in one price are worthy of comments why not changes in all prices?

At best changes in exchange rates may act as an indicator that something is amiss in some sector of the economy. But if this is so then the proper reaction should be to identify the problem and curing it at its source. Not with going on about the exchange rate. Don't shoot the messenger.

Can these commentators just get over their unjustified obsession with exchanges rates. Also why are they getting excited about the nominal exchange rate without asking questions about what is happening to the real exchange rate?

Academic freedom at the University of Chicago and Princeton

The following comes from the website of The National Association of Scholars (NAS) who in turn got it from the Facebook page of NAS board of advisors member Robert P. George (McCormick Professor of Jurisprudence at Princeton University).

Every now and then sanity still manages to prevail. The worrying thing is that academics at these universities find it necessary to have to make such statements at all.

At campuses across the country, traditional ideals of freedom of expression and the right to dissent have been deeply compromised or even abandoned as college and university faculties and administrators have capitulated to demands for language and even thought policing. Academic freedom, once understood to be vitally necessary to the truth-seeking mission of institutions of higher learning, has been pushed to the back of the bus in an age of "trigger warnings," "micro-aggressions," mandatory sensitivity training, and grievance politics. It was therefore refreshing that the University of Chicago, one of the academic world's most eminent and highly respected institutions, in the face of all this issued a report ringingly reaffirming the most robust conception of academic freedom. The question was whether other institutions would follow suit.

Yesterday, the Princeton faculty, led by the distinguished mathematician Sergiu Klainerman, who grew up under communist oppression in Romania and knows a thing or two about the importance of freedom of expression, formally adopted the principles of the University of Chicago report. They are now the official policy of Princeton University. I am immensely grateful to Professor Klainerman for his leadership, and I am proud of my colleagues, the vast majority of whom voted in support of his motion.

At Chicago and Princeton, at least, academic freedom lives!

Here are the principles we adopted:

Education should not be intended to make people comfortable, it is meant to make them think. Universities should be expected to provide the conditions within which hard thought, and therefore strong disagreement, independent judgment, and the questioning of stubborn assumptions, can flourish in an environment of the greatest freedom' ... Because the University is committed to free and open inquiry in all matters, it guarantees all members of the University community the broadest possible latitude to speak, write, listen, challenge, and learn. Except insofar as limitations on that freedom are necessary to the functioning of the University, the University of Chicago fully respects and supports the freedom of all members of the University community “to discuss any problem that presents itself.” Of course, the ideas of different members of the University community will often and quite naturally conflict. But it is not the proper role of the University to attempt to shield individuals from ideas and opinions they find unwelcome, disagreeable, or even deeply offensive. Although the University greatly values civility, and although all members of the University community share in the responsibility for maintaining a climate of mutual respect, concerns about civility and mutual respect can never be used as a justification for closing off discussion of ideas, however offensive or disagreeable those ideas may be to some members of our community.

The freedom to debate and discuss the merits of competing ideas does not, of course, mean that individuals may say whatever they wish, wherever they wish. The University may restrict expression that violates the law, that falsely defames a specific individual, that constitutes a genuine threat or harassment, that unjustifiably invades substantial privacy or confidentiality interests, or that is otherwise directly incompatible with the functioning of the University. In addition, the University may reasonably regulate the time, place, and manner of expression to ensure that it does not disrupt the ordinary activities of the University. But these are narrow exceptions to the general principle of freedom of expression, and it is vitally important that these exceptions never be used in a manner that is inconsistent with the University’s commitment to a completely free and open discussion of ideas. In a word, the University’s fundamental commitment is to the principle that debate or deliberation may not be suppressed because the ideas put forth are thought by some or even by most members of the University community to be offensive, unwise, immoral, or wrong-headed. It is for the individual members of the University community, not for the University as an institution, to make those judgments for themselves, and to act on those judgments not by seeking to suppress speech, but by openly and vigorously contesting the ideas that they oppose.

Indeed, fostering the ability of members of the University community to engage in such debate and deliberation in an effective and responsible manner is an essential part of the University’s educational mission. As a corollary to the University’s commitment to protect and promote free expression, members of the University community must also act in conformity with the principle of free expression. Although members of the University community are free to criticize and contest the views expressed on campus, and to criticize and contest speakers who are invited to express their views on campus, they may not obstruct or otherwise interfere with the freedom of others to express views they reject or even loathe. To this end, the University has a solemn responsibility not only to promote a lively and fearless freedom of debate and deliberation, but also to protect that freedom when others attempt to restrict it.

Now is it time for New Zealand's universities to think about the adoption of such principles.

EconTalk this week

Vernon Smith and James Otteson talk with EconTalk host Russ Roberts about Adam Smith in front of a live audience at Ball State University. Topics discussed include Smith's view of human nature, the relevance of Smith for philosophy and economics today, and the connection between Smith's two books, The Theory of Moral Sentiments and The Wealth of Nations.

A direct link to the audio is available here.

Video for this special edition of EconTalk, "Will the Real Adam Smith Please Stand Up?" is available below.

GDP and social welfare in the long run

A few weeks ago over at the Offsetting Behaviour blog Eric Crampton was talking about The Case for Economic Growth, a new report put out by the New Zealand Initiative. An obvious question to ask about growth is, What's so great about it? Why should we care if the economy grows or not? After all GDP, and thus growth in GDP, is not identical to social well-being or growth in social well-being. The answer many economists would give, and the New Zealand Initiative report gives, is that growth of GDP over time has a positive correlation with human well-being broadly understood.

It turns out that Offsetting Behaviour isn't the only blog where the advantages of growth are being thought about. At the Conversable Economist blog Timothy Taylor takes a look at an OECD report from last year which asks, How Was Life? Global Well-Being Since 1820, edited by Jan Luiten van Zanden, Joerg Baten, Marco Mira d’Ercole, Auke Rijpma, Conal Smith and Marcel Timmer.

Taylor writes,

So how have other dimensions of human well-being been correlated with this rise in per capita GDP, both over time and across countries? The short answer is that there is a strong positive correlation between per capita GDP and and indicators of education and health status. There is a weaker but still positive correlation between higher per capita GDP and participatory political institutions. There is no clear-cut correlation between per capita GDP and personal security. The relationship between per capita GDP and the environment (viewed as a whole) seems to be an inverted U-shape: that is, growth of per capita GDP is first associated with higher environmental damage, but at some point it seems to be associated with lower damage. The relationship between per capita and income inequality seems to follow a regular U-shape: that is, growth of per capita GDP is first associated with greater within-country income equality up to about the 1970s, but since then is associated with greater inequality. Here are some details.

1) Education

Gains in education have a strong positive correlation with per capita GDP over time and across countries, probably a part of a virtuous circle: that is, a more educated workforce helps economic growth, and an economy with higher per capita income can afford to spend more on education.

[...]

2) Health status over the long-term can be proxied by measures like life expectancy and height. It seems clear that higher per capita GDP is associated with gains in both, although there is some evidence that at the highest levels of GDP, higher incomes are not associated with larger health gains. The report says:

"Life expectancy at birth was about 33 years in Western Europe around 1830, 40 years in 1880, and almost doubled in the period after, with the largest improvements occurring in first half of the 20th century. In the rest of the world, life expectancies started to increase from much lower levels, rising in particular after 1945. Worldwide life expectancy increased from less than 30 years in 1880 to almost 70 in 2000. There is strong evidence of a shift in the relationship between health status and GDP per capita over the past two centuries. Life expectancy improved around the world even when GDP per capita stagnated, due to advances in knowledge and the diffusion of health care technologies."

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3) Personal security over the long-run can be approximated by using data on homicide rates and on war. The report summarizes the evidence on per capita GDP and homicide rates like this: "Western Europe was already quite peaceful from the 19th century onwards, but homicide rates in the United States have been high by comparison. Large parts of Latin America and Africa are also violent crime “hotspots”, and so is the former Soviet Union (especially since the fall of communism), while large parts of Asia show low homicide rates. Homicide rates are in general negatively correlated with GDP per capita – the richer a country, the lower the level, but there are important exceptions."

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4) The overall pattern of political institutions over time is toward greater participation, but the path has often been a bumpy one. [...] an Index of Democracy, where the measure of competition is based on what share of the vote is received by the winning party (when a winning party receives nearly all the votes, competition is low) and a measure of participation based on the share of the adult population that votes. On a worldwide basis, both are rising since 1820. But the rise is bumpy and spiky at times.

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5) Environmental quality is proxied by three measures in this report: biodiversity, and emissions of sulfur dioxide and carbon dioxide. The summary reads: "A negative correlation with GDP per capita is clearly in place when looking at quality of the environment. Biodiversity declined in all regions and worldwide as land use changed dramatically. Per capita emissions of CO2 increased after the industrial revolution in Western Europe and its Offshoots, accelerating in the mid-20th century as other regions increased their GDP, and is still increasing globally. Per capita emission of SO2 (a local pollutant) also increased alongside higher industrial production, but were curbed since the 1970s thanks to the advent of cleaner technologies."

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A key question is whether countries will tend to find ways to reduce environmental damage as their per capita GDP rises--as appears to be happening with SO2. Another way of making the point is that the ways in which economic growth affects the environment are strongly affected by public policy choices. As the report notes:

To some extent SO2 emissions follow an environmental Kuznets curve, with declining emissions beyond a certain level of GDP per capita, and in recent periods biodiversity is also less directly (negatively) related to real income levels. Overall, there is still a rather strong negative link between environmental quality (as measured by these indicators) and GDP per capita, but this link has been weakening in recent years (since the 1970s), probably as a result of successful policies to lower emissions (SO2 probably being the best example).

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6) Inequality of incomes is hard to summarize, in part because we live in a time when there is growing inequality of incomes within countries at the same time that global inequality of incomes is falling (with the rise of incomes in countries like China and India).

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For the global distribution of income, the curves [...] are gradually moving out to the right as economic growth raises the average world income. The area under the curves is also getting larger, which captures the fact that world population has dramatically expanded. It's interesting to notice that in 1970 and 1980, the global distribution of income had two humps, one at a lower income level and one at a higher income level. By 2000, the world is back to a one-hump income distribution.

From a national and regional level, the patterns show look different: "Long-term trends in income inequality, as measured by the distribution of pre-tax household income across individuals, followed a U-shape in most Western European countries and Western Offshoots. It declined between the end of the 19th century until about 1970, followed by a rise. In Eastern Europe, communism resulted in strong declines in income inequality, followed by a sharp increase after its disintegration in the 1980s. In other parts of the world (China in particular) income inequality has been on the rise recently. The global income distribution, across all citizens of the world, was uni-modal in the 19th century, but became increasingly bi-modal between 1910 and 1970 and suddenly reverted to a uni-modal distribution between 1980 and 2000."

What then is the take home measure from this? For a start it is clear that GDP is not the same thing as real social welfare. However, it tends to be true that countries with a higher level of per capita GDP are better off on other dimensions of well-being, not just the consumption of goods and services, but also other factors like education, health, and even personal freedom.

Both the New Zealand Initiative report and the OECD report make the same basic point, growth is good.

Walter Williams on the great thing that is profit

Is profit a dirty word? For many people it seems to be. Would the world be better off without them? Or are profits progressive -- the only thing that can move potatoes from Idaho to Manhattan and medicine from America to Africa? Economist Professor Walter Williams of George Mason University explains.


(HT: Cafe Hayek)

From the comments: A strange view of economics

Jd Dalisay kindly left the following comment on my posting on A strange view of economics which raised some questions about the ideas underlying Dalisay's blog Socioeconomic Science:

Here are the answers to most of your questions:

what are we make of the work of people like Amartya Sen or Tony Atkinson.. and subjects like welfare economics?

I'm unfamiliar with those. Though I know a little of Sen in that he said that famines are caused by lack of freedom or 'failure of exchange entitlements', which was already explained by Smith earlier: "A famine only arose from the government’s violence in attempting to remedy a dearth by improper means."

How does behavioural economics fit into jundalisay's framework?

Behavioural economics has its roots in psychology which sees the mind as an entity subordinate to the brain. Smith's and Hume's political economy is based on metaphysics which sees the mind as an entity which can exist without the brain, as a soul. This is taboo now because metaphysics is regarded as pseudoscience. In Smith's time it made 1/3 of the sciences: Natural Philosophy, Metaphysics, and Logic: “This general division seems perfectly agreeable to the nature of things" (5.1.151)

Much of post-19th century economics is to do with proper government policies and regulation.. So how does standard economics and 'Political Economy version 2.0' differ in this regard?

Economics needs many regulations because its underlying philosophy is utility or personal desire, begun by Say and Mill. Because personal desires vary per person, it creates many complexities which likewise need complex regulations. Metaphysicians such as Smith, Hume, Buddha and Laotzu never advocated utlity because it leads to selfishness and destruction: "Power and riches are enormous and operose machines ready at any moment to crush their unfortunate possessor." (TMS Part 4). Socio-economics replaces utility with 'natural self-interest in the context of one's society'. To avoid ambiguity, I equated this term to svadharma, which roughly translates in English as own dharma, own path, in existence. A baker bakes because he naturally loves baking (cause), not because it will bring him cash (effect), otherwise he would've been banker.

Who in post-19th century economics is it that championed the cause of businesses?

Says Law. It says "Supply creates its own demand". Smith pointed out that this 'Production Motive' is a mercantilist sophistry. In reality, the wealth of a society is in the purchasing power of its people: "The net revenue is their stock which they can..spend on their subsistence, conveniencies, and amusements.." In Smith's system, the wealth of countries will be measured in Purchasing Power, or in how much each citizen can buy, not on Gross Domestic Product or how much its businesses can sell. Thus GDP is the first proof of the business-cause.

It's irrelevant whether a business is called a firm, corporation, or company. The main guide is if it earns by profits. The dominance of profit maximization is another proof of the business-cause. In Smith's system, ordinary profits is the target and is defined as the minimum profit needed by the owner/s to continue their business. This minimum profit translates to maximum benefit to all members: "The increased competition would reduce the profits of the masters and the wages of the workmen. The trades, the crafts, the mysteries, would all be losers. But the public would be a gainer because the work of all artificers would become cheaper this way. All corporations and most of corporation laws have been established to prevent this reduction of price by restraining that free competition which would most certainly occasion it."

Let me just a a quick comment on the last point. Gross domestic product can be determined in three ways all of which give the same result. They are the production (or output or value added) approach, the income approach, or the expenditure approach.

The production approach sums the outputs of every class of enterprise to arrive at the total. The expenditure approach works on the principle that all of the product must be bought by somebody, therefore the value of the total product must be equal to people's total expenditures in buying things. The income approach works on the principle that the incomes of the productive factors ("producers," colloquially) must be equal to the value of their product, and determines GDP by finding the sum of all producers' incomes.

So by the expenditure approach GDP is basically what people spend on their "subsistence, conveniencies, and amusements".

I take Say's Law to be a point about macroeconomics, not micro. As Mark Blaug has said:

The assertion that 'products are paid for by products' [the gist of Say's Law] is by no means trivial. In one sense it is the beginning of sound thinking in macroeconomics.

The important point is that I don't see it as having anything to do with firms, that is, with what institutional arrangement is used to produce goods and services. Say's Law doesn't depend on firms being private for-profit organisations. Output could be produced by not-for-profit firms, worker cooperatives, SOEs or whatever and Say's Law would not be affected. Say's Law just implies that in aggregate it is impossible for all goods to be produced in relative excess. That is, general overproduction is impossible. Also Say's Law had nothing to do with mercantilism. I am sure Say would have rejected mercantilism, as do modern economists.

Note also that that in perfect competition a profit maximising firm will make zero economic profit and will, in partial equilibrium terms, maximise welfare by maximising the sum of consumer plus producer surplus. So within a standard economic model, maximum profits equals minimum profits, ie zero, and benefits to all members of society is  also maximised.

The dominance in economics of using the idea that firms maximise profits is, in part, due to the obvious point that most firms in an economy are for-profit firms.

One more point about this comment,

Economics needs many regulations because its underlying philosophy is utility or personal desire, begun by Say and Mill.

Actually thinking in terms of utility goes back well before Say or Mill. As D. P. O'Brien has written,

He [Smith] inherited a subjective value theory: and, instead of developing this, he largely substituted for it a "cost of production" theory of value. A developed subjective theory was available in the works of Pufendorf, Smith's teacher Hutcheson, and Hutcheson's teacher Carmichael. These writers made value dependent on usefulness and relative scarcity-just as has been done in economics since the Marginal Revolution of the 1870s. Adam Smith himself advanced a somewhat similar value theory in his Lectures and there solved the paradox that water is very useful but valueless, while diamonds are useless but valuable, on the basis of relative scarcity.

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

hotels start asking guests to bring their own toilet paper and soap.

Not exactly a common practise in tourism unless you are holidaying in Venezuela.

Manuel Rueda at Fusion is reporting that

Venezuela’s product shortages have become so severe that some hotels in that country are asking guests to bring their own toilet paper and soap, a local tourism industry spokesman said on Wednesday.

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“It’s an extreme situation,” says Xinia Camacho, owner of a 20-room boutique hotel in the foothills of the Sierra Nevada national park. “For over a year we haven’t had toilet paper, soap, any kind of milk, coffee or sugar. So we have to tell our guests to come prepared.”

But if you have price controls and a very weak currency then you get smuggling and a black market.

“Five hotels have told me they are going through this situation, where they have to ask guests to bring their own toilet paper,” Montilla told Fusion. “We’re near the border with Colombia, just two and a half hours away, and lots of [Venezuelan] goods are taken there, because they sell for more money in Colombia.”

Montilla says bigger hotels can circumvent product shortages by buying toilet paper and other basic supplies from black market smugglers who charge up to 6-times the regular price.

And the government response?

Recently, Venezuelan officials have been stopping people from transporting essential goods across the country in an effort to stem the flow of contraband. So now Camacho’s guests could potentially have their toilet paper confiscated before they even make it to the hotel.

Can't help thinking removing price controls and letting the price mechanism work would fit the problem most quickly.