Friday, 2 December 2016
Stories from the stone age First Farmers pt.1
Out of the Stone age and into the Neolithic one of human's most incredible accomplishments 6000 yrs before the pyramids. The story of Near Eastern "The First Farmers".
Saturday, 26 November 2016
Can Trump make the U.S. a ‘global subsidy cop’?
Has Trump actually come up with something right to do with trade? Are global subsidies a bad thing? Should we complain if other countries subsidise their industries? If other countries want to subsidise our consumption of imports should we care? Scott Lincicome argues that if the U.S. wants to end the practice of other countries subsidising key industries, it would require the U.S. to clean up its own business giveaways.
Friday, 25 November 2016
Resource misallocation & productive growth
Chang-Tai Hsieh, IGC steering group member, explains why some firms are more successful than others, using Indian firms as a case study. The Indian example shows that entrepreneurs can find ways around inefficient regulation. The problem of course is that the workaround is not fully efficient, a better policy would be to remove the bad regulation in the first place. But as noted by Hsieh politicians aren't willing to go there. Another example of bad politics driving out good economics.
Wednesday, 23 November 2016
A challenge to mercantilists
A challenge from Don Boudreaux at the Cafe Hayek blog. Boudreaux issues the following challenge to any protectionist/mercantilist/economic-nationalist who might wish to take it on:
Identify one plausible economic problem caused by free trade that is unique to trade and commerce that spans political borders. Just one. That is, identify a problem with free trade that arises when people are free to buy and sell internationally but that does not arise when people are free to buy and sell intranationally.In other words, what economic problems can we avoid by restricting international trade that we don't have to deal with in internal trade? I've got to admit I've yet to think of anything even remotely plausible as an answer to this challenge.
The "Adaptation Cost" theory of the firm
This material is covers chapters 3 and 4 of Wernerfelt (2016). These chapters are, in turn, based on Wernerfelt (1997) and Wernerfelt (2015), respectively.
Wernerfelt considers two questions to do with the firm that he thinks important but go largely unanswered in the standard theory of the firm literature: What determines the choice between the use of the market, a firm or a contract? Why are all of these mechanisms so commonly used?
His answer to these questions is contained in the "Adaptation Cost" theory of the firm.
Start with a situation where a worker is providing a particular service to an entrepreneur. The entrepreneur's needs change so that the worker's service would have to also change if he is to stay with that entrepreneur. But the worker's productivity will suffer if he, either, changes the service he provides or changes to another entrepreneur and in either of these cases costs would have to be incurred due to the process of bargaining over the terms of a new agreement.
But the costs of worker adaptation are not just those of bargaining, there are also costs, in terms of lower productivity, if the worker has to change, either, to a new service or a new business. A worker is most efficient when he is "double specialised". That is, when he is continually providing the same service to the same business. If this "double specialisation" is not possible it is often second-best to specialise in one of the two dimensions and deal with occasional adaption in the other dimension. Some such adaptations, whether it be between two businesses or two services, are more costly than others.
The basic theory of the Adaptation Cost theory was developed in two papers by Wernerfelt, Wernerfelt (1997, 2015). To begin with the 1997 paper (chapter 3 of Wernerfelt 2016). The focus is on workers who supply businesses with services. The problem is that the needs of the businesses change. Three mechanism to deal with the changing needs are considered: employment, sequential contracting and price lists. In chapter 3 adaptation costs are mainly price determination costs only, since production costs are held constant.
Under the employment mechanism, workers and entrepreneurs negotiate on a once-and-for-all basis over the wage and a large set of services to be supplied on demand. This is similar to the situation in Simon (1951). Here a firm is made up of an entrepreneur and a number of workers who provide the entrepreneur with services via the employment mechanism while the scope of the firm is determined by set of workers thus employed by the entrepreneur. The downside of this is that since there are a large number of things to be bargained over the initial bargaining costs are large, but once agreement is reached there are no further costs incurred so the gains from trade are realised in each period.
Under the sequential contracting mechanism a new price gets negotiated whenever the business's requirements change and thus bargaining costs are incurred on each such occasion. However as the bargains are simpler than those required for the employment contract - the parties are bargaining over a single, known service - the per-occasion bargaining costs are lower.
With the price list, a set of price are agreed upon ex ante and then the list is referred to as needed. As with the case of sequential contracting the per-service bargaining costs are low but if the initial bargaining is over a very long list of prices those costs are high. Here the diversity of needs - how long the price list needs to be - is important to the relative attractiveness of the mechanism.
When the need for a change in service adaptation arise with sufficient frequency, the folk theorem allows us to assume that all trades are efficient under the employment and sequential contracting mechanisms, while under the price list mechanism all trades actually covered by the list are efficient. An implication of this is that there are no trading inefficiencies and thus the only bargaining costs involved are those associated with the mechanism process itself. Given this, the performance of each of the three mechanisms depends only on the costs of adapting to changes in the requirements of the businesses.
In the employment mechanism, costs are a one-time thing related to the negotiation of the wage agreement; for the sequential contracting mechanism the costs are the per-occasion costs of agreeing a price for that particular event; while for the price list mechanism the costs are those one-time costs involved in negotiating the price list plus the loss in the gains from trade for any situations not covered by the list.
Given that the employment mechanism has the lowest costs of adaption - just a verbal instruction - there exists a region in the parameter space, situations in which needs change frequently, in which the employment mechanism (weakly) dominates the other two mechanisms, see Figure 1.
From Figure 1 it is clear that price lists are good when they can be kept short, i.e. there a small number of services needed, sequential bargaining is good when changes are infrequent and employment is good when needs change frequently and many diverse adaptations are required.
Next consider the Wernerfelt (2015) paper (chapter 4 of Wernerfelt 2016). Importantly in this case adaptation costs are expanded to include the costs due to less efficient production. Specifically Wernerfelt assumes that there are gains from specialisation - where specialisation implies little in the way of adaptation - along two dimensions, first businesses and second, services. The former is modelled as an increase in adaptation costs for the worker each time he wants to service a different business. The latter is captured by assuming different workers are good at different things. In this situation three mechanisms are compared: employment, sequential contracting, as before, and markets. Again it is assumed that trade is ex post efficient in all three mechanisms. Wernerfelt concentrates on minimising adaptation costs.
Under the employment mechanism performance is delineated by the gains from trade in each period minus the one-off costs of negotiating the employment contract. The performance of sequential contracting is the gains from trade minus the bargaining costs incurred each period. The important thing about the market mechanism is that it allows workers to specialise in the services at which they are most efficient. "For example, instead of being superintendents they can be plumbers, carpenters, or electricians" (Wernerfelt 2016: 19). The advantage of this is that the gains from trade are increased but the disadvantage is that workers incur business adaptation costs (lose gains from specialisation) every time they switch businesses.
Wernerfelt shows that there are three regions in the parameter space in which each of the three mechanisms (weakly) dominates both of the two other mechanisms.
The relative performance of each of the three mechanisms depends on the frequency with which the needs of the businesses change, the gains from specialisation in an particular service, the business adaptation costs and bargaining costs. See Figure 2 and Figure 3.
Consider Figure 2. Markets are good when workers' between-business adaptation costs are low, that is, the gains from business specialisation are low and thus workers can cheaply switch between businesses; sequential contracting is good when changes in needs are infrequent; and employment is good when the cost advantage of service specialists are small and needs are changing quickly.
Another parameter is shown in Figure 3. Here "service specialisation" - the gains from specialisation in a particular service - is considered. Markets are good when service specialists are a lot more efficient than an employee carrying out many different tasks.
Wernerfelt (2016: 59) illustrates the effects of specialisation, switching costs and adjustment frequency with the example of the maintenance of a medium-sized apartment building,
The major prediction of this theory is that the more frequent are changes in needs the more attractive the employment contract becomes.
Refs.:
Wernerfelt considers two questions to do with the firm that he thinks important but go largely unanswered in the standard theory of the firm literature: What determines the choice between the use of the market, a firm or a contract? Why are all of these mechanisms so commonly used?
His answer to these questions is contained in the "Adaptation Cost" theory of the firm.
Start with a situation where a worker is providing a particular service to an entrepreneur. The entrepreneur's needs change so that the worker's service would have to also change if he is to stay with that entrepreneur. But the worker's productivity will suffer if he, either, changes the service he provides or changes to another entrepreneur and in either of these cases costs would have to be incurred due to the process of bargaining over the terms of a new agreement.
But the costs of worker adaptation are not just those of bargaining, there are also costs, in terms of lower productivity, if the worker has to change, either, to a new service or a new business. A worker is most efficient when he is "double specialised". That is, when he is continually providing the same service to the same business. If this "double specialisation" is not possible it is often second-best to specialise in one of the two dimensions and deal with occasional adaption in the other dimension. Some such adaptations, whether it be between two businesses or two services, are more costly than others.
The basic theory of the Adaptation Cost theory was developed in two papers by Wernerfelt, Wernerfelt (1997, 2015). To begin with the 1997 paper (chapter 3 of Wernerfelt 2016). The focus is on workers who supply businesses with services. The problem is that the needs of the businesses change. Three mechanism to deal with the changing needs are considered: employment, sequential contracting and price lists. In chapter 3 adaptation costs are mainly price determination costs only, since production costs are held constant.
Under the employment mechanism, workers and entrepreneurs negotiate on a once-and-for-all basis over the wage and a large set of services to be supplied on demand. This is similar to the situation in Simon (1951). Here a firm is made up of an entrepreneur and a number of workers who provide the entrepreneur with services via the employment mechanism while the scope of the firm is determined by set of workers thus employed by the entrepreneur. The downside of this is that since there are a large number of things to be bargained over the initial bargaining costs are large, but once agreement is reached there are no further costs incurred so the gains from trade are realised in each period.
Under the sequential contracting mechanism a new price gets negotiated whenever the business's requirements change and thus bargaining costs are incurred on each such occasion. However as the bargains are simpler than those required for the employment contract - the parties are bargaining over a single, known service - the per-occasion bargaining costs are lower.
With the price list, a set of price are agreed upon ex ante and then the list is referred to as needed. As with the case of sequential contracting the per-service bargaining costs are low but if the initial bargaining is over a very long list of prices those costs are high. Here the diversity of needs - how long the price list needs to be - is important to the relative attractiveness of the mechanism.
When the need for a change in service adaptation arise with sufficient frequency, the folk theorem allows us to assume that all trades are efficient under the employment and sequential contracting mechanisms, while under the price list mechanism all trades actually covered by the list are efficient. An implication of this is that there are no trading inefficiencies and thus the only bargaining costs involved are those associated with the mechanism process itself. Given this, the performance of each of the three mechanisms depends only on the costs of adapting to changes in the requirements of the businesses.
In the employment mechanism, costs are a one-time thing related to the negotiation of the wage agreement; for the sequential contracting mechanism the costs are the per-occasion costs of agreeing a price for that particular event; while for the price list mechanism the costs are those one-time costs involved in negotiating the price list plus the loss in the gains from trade for any situations not covered by the list.
Given that the employment mechanism has the lowest costs of adaption - just a verbal instruction - there exists a region in the parameter space, situations in which needs change frequently, in which the employment mechanism (weakly) dominates the other two mechanisms, see Figure 1.
From Figure 1 it is clear that price lists are good when they can be kept short, i.e. there a small number of services needed, sequential bargaining is good when changes are infrequent and employment is good when needs change frequently and many diverse adaptations are required.
Next consider the Wernerfelt (2015) paper (chapter 4 of Wernerfelt 2016). Importantly in this case adaptation costs are expanded to include the costs due to less efficient production. Specifically Wernerfelt assumes that there are gains from specialisation - where specialisation implies little in the way of adaptation - along two dimensions, first businesses and second, services. The former is modelled as an increase in adaptation costs for the worker each time he wants to service a different business. The latter is captured by assuming different workers are good at different things. In this situation three mechanisms are compared: employment, sequential contracting, as before, and markets. Again it is assumed that trade is ex post efficient in all three mechanisms. Wernerfelt concentrates on minimising adaptation costs.
Under the employment mechanism performance is delineated by the gains from trade in each period minus the one-off costs of negotiating the employment contract. The performance of sequential contracting is the gains from trade minus the bargaining costs incurred each period. The important thing about the market mechanism is that it allows workers to specialise in the services at which they are most efficient. "For example, instead of being superintendents they can be plumbers, carpenters, or electricians" (Wernerfelt 2016: 19). The advantage of this is that the gains from trade are increased but the disadvantage is that workers incur business adaptation costs (lose gains from specialisation) every time they switch businesses.
Wernerfelt shows that there are three regions in the parameter space in which each of the three mechanisms (weakly) dominates both of the two other mechanisms.
The relative performance of each of the three mechanisms depends on the frequency with which the needs of the businesses change, the gains from specialisation in an particular service, the business adaptation costs and bargaining costs. See Figure 2 and Figure 3.
Consider Figure 2. Markets are good when workers' between-business adaptation costs are low, that is, the gains from business specialisation are low and thus workers can cheaply switch between businesses; sequential contracting is good when changes in needs are infrequent; and employment is good when the cost advantage of service specialists are small and needs are changing quickly.
Another parameter is shown in Figure 3. Here "service specialisation" - the gains from specialisation in a particular service - is considered. Markets are good when service specialists are a lot more efficient than an employee carrying out many different tasks.
Wernerfelt (2016: 59) illustrates the effects of specialisation, switching costs and adjustment frequency with the example of the maintenance of a medium-sized apartment building,
The owner [of the building] will typically have an employee, the superintendent, perform minor repairs (``the toilet leaks"). The building generates a steady flow of small problems, they tend to be urgent, and the superintendent can solve each of them pretty well. On the other hand, certain minor renovations, such as those having to do with electricity (``install LED light bulbs in public spaces"), are normally done through the market. The jobs are often larger, service specialists can do them better, and the building does not need a full-time electrician. Major renovations, for which advance planning reduces the need for in-process changes, are typically governed by a bilateral contract subject to occasional, though typically costly, renegotiations.
The same example can illustrate the effects of size. A landlord who owns just one or two units will typically go to the market even for minor repairs because these units do not generate enough work to support a superintendent. On the other hand, very large landlords, such as universities, typically use specialist employees (their ``own" electricians) for both repairs and minor renovations.
The major prediction of this theory is that the more frequent are changes in needs the more attractive the employment contract becomes.
Refs.:
- Simon, Herbert A. (1951). "A Formal Theory of the Employment Relationship", Econometrica, 9(3) July: 293–305.
- Wernerfelt, Birger (1997). "On the Nature and Scope of the Firm", Journal of Business, 70(4): 489-514.
- Wernerfelt, Birger (2015). "The Comparative Advantages of Firms, Markets, and Contracts", Economica, 82 no. 236: 350-67.
- Wernerfelt, Birger (2016). Adaptation, Specialization, and Theory of the Firm: Foundations of the Resource-Based View, Cambridge: Cambridge University Press.
Tuesday, 15 November 2016
The division of labour and the firm: Stigler (1951)
Stigler (1951: 193)
The following discussion covers material from Stigler (1951) which is one paper that offers a theory of the boundaries of a firm based on the division of labour. Interestingly Adam Smith, despite his famous discussion of the division of labour in the pin factory, did not develop a theory of the firm based on it.
Stigler begins his argument by saying that the division of labour, and its limit due to the extent of the market, lies at the core of a theory of the functions, and thus the boundaries, of a firm. Stigler outlines this theory in the second section of his paper.
In this theory a firm is seen as engaging in a series of distinct operations leading to the production of a final product. That is, the firm is partitioned not among its input markets but among the functions or process that determine the scope of its activities. And thus determine the firm's boundaries.
To allow the graphical representation of the firm's costs of production we will assume that the average costs of each activity depends only on the rate of output of the firm. In addition, if we assume that there is a constant proportion between the rate of output of each activity and the rate of output of the final product then all the cost functions can be drawn on the same diagram and the vertical sum of these costs will be the conventional average cost curve for the firm. With reference to the diagram below to produce q units of final output requires a given number of units of activity 1, costing C_1(q), a number of unit of activity 2, costing C_2(q), and a number of units of activity 3, costing C_3(q). These costs can be summed to give the average cost of production for q units of output, C_1(q)+C_2(q)+C_3(q).
With respect to the shape of the average cost curves for the various activities, some are increasing continuously (C_1), some are falling continuously (C_3) and some are conventionally U-shaped, (C_2).
Now consider the Adam Smith's idea that the division of labour is limited by the extent of the market. First take the activities for which there are increasing returns, Why doesn't the firm exploit the returns more fully and in the process become a monopoly in the output market? Because as the firm expands outputs other activities also have to be increased and some of these are subject to diminishing returns and these cost increases are such that they overwhelm the cost advantages of the increasing returns and increase the average cost of the final product. So why then does the firm not abandon these C_3-like activities and let some other firm (and thus industry) specialise in them to exploit the increasing returns fully? At a given time the market for these activities may be too small to support specialised firms. Given this firms must perform these activities for themselves.
But with an expansion of the market for the increasing returns activity firms specialised in that activity would develop. The firms currently carrying out this activity for its own consumption would forgo this activity and let it be taken over by a new (monopoly) firm. This monopoly could not fully exploit its market power however since it has charge a price which is less than the average cost of production for the firm abandoning the activity. As the market for this activity grows even larger the number of firms specialising in it grows. That is the industry becomes increasingly competitive.
The abandonment of this activity by the original firms will change the cost function for each firm. The cost curve, C_1, will be replaced by a horizontal line (the black dashed line in the diagram above) in the effective region. This also changes the average cost curve for the final product with the new curve (black dashed curve in the diagram above) being lower than the current curve.
What about the increasing cost case? Why not abandon or reduce use of those activities with increasing cost? Much of the previous discussion carries over to this case with the exception that as the market and the industry grows the original firms does not have to stop utilising that activity completely. Part of the needed use of that activity can still be produced in-house without high average (and marginal) cost, with the rest being purchased via the market.
Ref.:
- Stigler, George J. (1951). "The Division of Labor is Limited by the Extent of the Market", Journal of Political Economy, Vol. 59, No. 3 June, pp. 185-193.
Sunday, 6 November 2016
Private funding of the Parker fight
Related to my previous posting on the withdraw of public funding for the Parker fight in Auckland comes this news from the New Zealand Herald on pay-for-view prices for the event.
The Herald also states,
If market conditions are such that the promoter can charge in the $70-$100 range for the fight when there is no public funding then those same conditions mean he can charge the same even with public funding. This basically just turns the public funding into a rent for the promoter.
Pay-per-view prices for Joseph Parker's heavyweight world title fight are set to go sky high, with punters and pubs expected to cop the fallout from Auckland Council's refusal on ratepayer funding.The first point to make here is that this is one way for the event to be paid for by those who want to see the event.
The Herald on Sunday understands from a well-placed source that the pay-TV price for Parker's fight against Andy Ruiz Jr next month could now be set between $70 and $100.
The Herald also states,
The expected pay-TV spike comes after Auckland Council's events and economic development arm, Ateed, threw in the towel on funding the fight with ratepayer money.Now for the bit I don't get about all of this, Why does the Herald journalist think that the pay-TV price has anything to do with public funding? I mean if the profit maximising price for screening the event is around $70 to $100 without public funding then why isn't this the profit maximising price with public funding?
If market conditions are such that the promoter can charge in the $70-$100 range for the fight when there is no public funding then those same conditions mean he can charge the same even with public funding. This basically just turns the public funding into a rent for the promoter.
It's a strange old world: good sense from JAFAland.
This bit of good news comes from nzherald.co.nz.
From another Herald article comes this comment from Howick councillor Dick Quax who is opposed "throwing public money at a private event",
Just as they appeared set to announce Parker would fight Andy Ruiz Jr for the WBO title in the city on December 10, Auckland council's events arm Ateed have withdrawn their support for the event, leaving it in a state of limbo.and
Ateed Chief Executive Brett O'Riley confirmed last night: "Ateed will not be providing financial sponsorship to Duco to stage the Parker/Ruiz fight."
O'Riley said it was not clear if staging the fight in Auckland would have "the desired outcomes of Auckland's Major Events Strategy" so the decision was made "not provide financial sponsorship for the fight."Looks like the ratepayers of Auckland have dodged a rather large bullet here.
It is understood Ateed's contribution was going to be "hundreds of thousands of dollars".
From another Herald article comes this comment from Howick councillor Dick Quax who is opposed "throwing public money at a private event",
"Did anyone go to Zaire following the rumble in the jungle between George Foreman and Muhammad Ali. I don't think so," said Quax in a reference to the perceived benefits for Auckland.Questions have to be asked as to whether the fight is a goer without some form of public money and if it isn't is there a justification for staging it in New Zealand. If there are real economic benefits to the fight being in Auckland why can't private funding be found to keep the fight there? If the private sector are not welling to back the event then does this tell us they really don't think they can capture (now or in the future) enough of the supposed benefits to justify backing the fight? Does this, in turn, suggest that the benefits aren't there? In which case why have the fight here?
Saturday, 5 November 2016
Joel Mokyr interview
An interview of Joel Mokyr by Ana Swanson from the Washington Post.
Why did the industrial revolution start in Europe, rather than in China? In part because,
Why did the industrial revolution start in Europe, rather than in China? In part because,
It isn’t just that China doesn’t have an Industrial Revolution, it doesn’t have a Galileo or a Newton or a Descartes, people who announced that everything people did before them was wrong. That’s hard to do in any society, but it was easier to do in Europe than China. The reason precisely is because Europe was fragmented, and so when somebody says something very novel and radical, if the government decides they are a heretic and threatens to prosecute them, they pack their suitcase and go across the border.So exit options can matter. One government doesn't like your ideas, move onto the next.
Antitrust: where did it come from and what did it mean?
Is the title of a new working paper by Richard N. Langlois.
Langlois notes an irony in all of this,
This paper is a draft chapter from an ongoing book project I am calling The Corporation and the Twentieth Century. In The Visible Hand, Alfred Chandler explained the rise of the large vertically integrated corporation in the United States mostly in terms of forces of technology and economic geography. Institutions, including government policy, played a quite minor role. In my own attempt to explain the decline of the vertically integrated form in the late twentieth century, I stayed true to Chandler’s largely institution-free approach. This book will be an exercise in bringing institutions back in. It will argue that institutions, notably various forms of non-market controls imposed by the federal government, are a critical piece of the explanation of the rise and decline of the multi-unit enterprise in the U.S. Indeed, non-market controls, including those imposed in response to the dramatic events of the century, account in significant measure for the dominance of the Chandlerian corporation in the middle of the twentieth century. One important form of non-market control – though by no means the only form – has been antitrust policy. This chapter traces the history of antitrust and argues that, far from being a coherent attempt to address an actual economic problem of monopoly, the Sherman Antitrust Act emerged from the distributional political economy of the nineteenth century. More importantly, the chapter argues that the form in which antitrust emerged would prove significant for the corporation, as the Sherman Act and its successors outlawed virtually all types of inter-firm coordinating mechanisms, thus effectively evacuating the space between anonymous market transactions and full integration.The last couple of sentences of the abstract are interesting. An unintended(?) consequence of competition policy is an all-or-nothing approach to firm organisation. It's either a market transaction or a fully integrated organisation with little between them being legal. This removes many options in terms of organisational form for entrepreneurs to use to structure a transaction. This can result in an loss of efficiency in those cases where coordination of activity is most effectively carried out by an organisation that is not neither a fully integrated firms or a market transaction. Developments in competition policy in the US during the period around 1900 sent a clear signal that coordination through inter-firm agreements would surely face legal scrutiny whereas coordination within the boundaries of a single legal entity likely would not. This created a palpable incentive for firms to integrate.
Langlois notes an irony in all of this,
Here we begin to glimpse the great irony of American antitrust policy at the turn of the twentieth century: legislation pushed in part by small independent businesses to ward off the threat of the giant corporation actually harmed the small firms, which relied on coordination through contract, and reduced the relative cost of coordination within boundaries of large enterprises.But such unintended consequences are so often the outcome of government intervention in economic activity.
Friday, 4 November 2016
Good and bad news on the Parker fight
From Sam Richardson's Fair Play and Forward Passes blog comes some good news and some bad news with regard to the Joseph Parker fight. It turns out that despite what we were hearing last week that the fight was most likely to go overseas it will in fact take place in Auckland. Duco withdrew their application for government funding and so no central government money will be put into the fight.
First up the bad news, Sam Richardson writes,
Basically what Duco would be doing is capturing the surplus that consumers would otherwise get if they were to buy at the lower "official" price - what economists call consumer surplus - via price discrimination. Duco can charge different people different prices. An auction is a way of getting people to reveal their willingness to pay.
First up the bad news, Sam Richardson writes,
It is not 100% privately funded, though. One of the backers of the Parker camp is the Auckland City events arm ATEED, so there are already taxpayer dollars being funneled into the fight.Auckland ratepayers will be the losers here. As Sam writes,
Now that the fight is taking place in Auckland, the question becomes whether the fight will generate economic benefits for the city and for New Zealand. In short, the benefits are likely to be confined to Auckland city and are not likely to spill over outside the city boundaries. The extremely short-term nature of the event itself will likely mean that any impact is short and sharp - don't expect longer-term economic impacts - even if Parker happens to win the fight.Now for the good news,
In the Takam fight, Duco auctioned off 520 general admission tickets at $1 reserve on TradeMe. The intention of this experiment was an attempt to eliminate the possibility of scalping occurring with these tickets - people buying cheap and selling at higher prices.The use of an auction would be a great way to generate money for the promoter and deal with scalping. The reason for scalping is that tickets are, for whatever reason, priced at less than the market rate. Given that, it is obvious that money can be made by buying cheap and selling dear. That is, some people will be willing to pay a lot to get to go to the fight and scalpers who buy at the "official" price can resale to these high willingness to pay people at a much higher price. By auctioning off tickets Duco can capture most of the rents that the scalpers would otherwise get and in the process maximise the revenues they get from the fight. Note that this means there is less of a need for any public funding of the fight.
With interest in this fight likely to be significantly greater than what it was for the Takam fight, it will be very interesting to see if Duco try it again. If anything, they have more to gain from giving it another go - one would expect the willingness to pay for a title fight to be much greater than for a build-up fight. Yet there is always a risk that they may not make the money that they are seeking - but they are likely to sell the tickets and fill the venue. At the same time, charging a fixed price is not a sure bet either - people might decide that the price is simply too steep and there could be empty seats as a result. There is also the possibility that the price might be set too low - and scalping could occur.
Basically what Duco would be doing is capturing the surplus that consumers would otherwise get if they were to buy at the lower "official" price - what economists call consumer surplus - via price discrimination. Duco can charge different people different prices. An auction is a way of getting people to reveal their willingness to pay.
Wednesday, 2 November 2016
Anti Trump letter from 370 economists
A group of 370 economists, including eight Nobel laureates in economics, have signed a letter warning against the election of Donald Trump. The letter calls him a "dangerous, destructive choice" for the country. And given his stated views on trade he is likely a "dangerous, destructive choice" for the rest of the world as well.
A few of the letter's statements on trade:
A few of the letter's statements on trade:
He has misled voters in states like Ohio and Michigan by asserting that the renegotiation of NAFTA or the imposition of tariffs on China would substantially increase employment in manufacturing. In fact, manufacturing’s share of employment has been declining since the 1970s and is mostly related to automation, not tradeEconomist Letter 11012016 on Scribd
He has falsely suggested that trade is zero-sum and that the “toughness” of negotiators primarily drives trade deficits.
He has misled the public with false statements about trade agreements eroding national income and wealth. Although the gains have not been equally distributed—and this is an important discussion in itself—both mean income and mean wealth have risen substantially in the U.S. since the 1980s.
Is no competition policy the best competition policy?
Donal Curtin at the Economics New Zealand blog writes.
I'll guess that all those at the conference shared the view that a competition body is needed and that it should be a powerful player in its role as competition regulator. I would suggest that the first question the chief economist should ask is, Is this really right? May be competition policy does more harm than good. Would it be better to do away with it?
The idea behind competition law in New Zealand is, according to the Act, “to promote competition in markets for the long-term benefit of consumers”. This is to say, it is believed, by the Act's supporters, that markets left to themselves, without any oversight from regulators, without any regulation of prices, quantities, or structure, would be harmful to consumers. Such a view rests on the notion that there is a large danger of monopoly power being used to harm consumers and, therefore, competition is a state of affairs which must be regulated and managed by the authorities because undesirable situations of monopoly can emerge all the time.
Frederic Sautet, ex-economist at NZ Treasury and the Commerce Commission, makes the point that this thinking is wrong headed:
As far as empirical evidence goes it tends to suggest that competition policy does not improve consumer welfare by much. Robert W. Crandall and Clifford Winston look at the effects of antitrust enforcement in the US and ask Does Antitrust Policy Improve Consumer Welfare? And the short answer is, not much. Crandall and Winston write,
Such questions and arguments will not win friends within the likes of the Commerce Commission but perhaps it would be good for the soul of those within such such bodies to sometimes think about these issues. And coming up with an answer may even be fun.
Refs.:
The Sautet paper, which is well worth reading, is "The Shaky Foundations of Competition Law", New Zealand Law Journal, pp. 186-190, June 2007.
The Robert W. Crandall and Clifford Winston paper is "Does Antitrust Policy Improve Consumer Welfare? Assessing the Evidence", Journal of Economic Perspectives, 17(4) Fall 2003.
We had a session at last week's RBB Economics conference in Sydney on "How can a Chief Economist's team enhance competition law enforcement? - an examination of different approaches", with a panel made up of people who should know: Lilla Csorgo, chief economist on the competition side of our Commerce Commission; Graeme Woodbridge, chief economist for the whole caboodle at the ACCC; and RBB founding partner Simon Bishop to talk about the European Commission's experience.I want to suggest a question that I'm sure no one at the conference would dare ask, Should there be competition policy in the first place? After all if you make a living out of competition policy, for your own good, you will concentrate on technical issues such as how should economists be integration into the enforcement process rather than suggesting putting yourself (and others) out of a job.
One conclusion that emerged was that competition authorities had experimented over the years with various internal structures, ranging from a separate 'consultancy on call', through the EC's model of an internal quality check unit, through to integration (or at least close involvement in) the investigation teams. Of the various models, integration with the investigation teams, or, at a minimum, close and early involvement with the cases at hand, seemed to be working best.
I'll guess that all those at the conference shared the view that a competition body is needed and that it should be a powerful player in its role as competition regulator. I would suggest that the first question the chief economist should ask is, Is this really right? May be competition policy does more harm than good. Would it be better to do away with it?
The idea behind competition law in New Zealand is, according to the Act, “to promote competition in markets for the long-term benefit of consumers”. This is to say, it is believed, by the Act's supporters, that markets left to themselves, without any oversight from regulators, without any regulation of prices, quantities, or structure, would be harmful to consumers. Such a view rests on the notion that there is a large danger of monopoly power being used to harm consumers and, therefore, competition is a state of affairs which must be regulated and managed by the authorities because undesirable situations of monopoly can emerge all the time.
Frederic Sautet, ex-economist at NZ Treasury and the Commerce Commission, makes the point that this thinking is wrong headed:
At the end of the day, the problem assumed by competition law is only exacerbated by regulation, while economics shows that the entrepreneurial process solves it. So while there may be situations where competition law may seem warranted, in fact there is no crime at the crime scene. While competition law aims to protect consumers, the danger is that it may affect the self-correcting properties of the market system — an outcome worse than the disease it tries to cure.Much of the problem is due to the fact that competition law was established on an misunderstanding of the nature of competition. The law in New Zealand aims to achieve "workable competition" but the practice of competition law relies on the view of competition as a static (equilibrium) state of affairs - derived from the idea of perfect competition. However, actual competition is a rivalrous entrepreneurial process by which the knowledge enabling a better coordination of individual plans is discovered over time. Again, as Frederic Sautet points it
[...] it must be understood that the competitive process takes place within a set of institutions that guarantee the functioning of entrepreneurial discovery and the exploitation of business opportunities over time. These institutions and regulation must guarantee entry into any market to anyone desiring to compete.Sautet goes on to make the important point that
Under the disguise of consumer protection, competition law has in fact protected some producers from the greater efficiency of their potential competitors. Indeed, competition can be difficult for some incumbents who run the risk of being outcompeted. However, this process is necessary if the ultimate goal is to let consumers (indirectly) dictate the allocation of resources according to their preferences. The danger with competition law is that it interferes with the entrepreneurial process — a cure worse than the disease.Thus the danger of the Commerce Commission is that it may so damage or restrict the true competitive process that it harms the very people it set out to help, consumers, but helps the people it wished to control, producers. The law of unintended consequences strikes again.
As far as empirical evidence goes it tends to suggest that competition policy does not improve consumer welfare by much. Robert W. Crandall and Clifford Winston look at the effects of antitrust enforcement in the US and ask Does Antitrust Policy Improve Consumer Welfare? And the short answer is, not much. Crandall and Winston write,
In this paper, we argue that the current empirical record of antitrust enforcement is weak.and add
We then synthesize the available research regarding the economic effects of three major areas of antitrust policy and enforcement: changing the structure or behavior of monopolies; prosecuting firms that engage in anticompetitive practices, namely, price fixing and other forms of collusion; and reviewing proposed mergers. We find little empirical evidence that past interventions have provided much direct benefit to consumers or significantly deterred anticompetitive behavior.Overall I'm not sure that we really do want a strong interventionist Commerce Commission.
Such questions and arguments will not win friends within the likes of the Commerce Commission but perhaps it would be good for the soul of those within such such bodies to sometimes think about these issues. And coming up with an answer may even be fun.
Refs.:
The Sautet paper, which is well worth reading, is "The Shaky Foundations of Competition Law", New Zealand Law Journal, pp. 186-190, June 2007.
The Robert W. Crandall and Clifford Winston paper is "Does Antitrust Policy Improve Consumer Welfare? Assessing the Evidence", Journal of Economic Perspectives, 17(4) Fall 2003.
Tuesday, 1 November 2016
Kevin Bryan on Oliver Hart and the nature of the firm
Kevin Bryan writes at VoxEU.org on Oliver Hart's contribution to the theory of the firm.
Bryan writes,
Bryan continues by commenting on Hart's more recent work on the reference point approach to the firm,
Refs.:
Bryan writes,
Grossman and Hart (1986) instead argue that the distinction that really makes a firm a firm is that it owns assets. Why does ownership matter? They retain the idea that contracts may be incomplete – at some point, I will disagree with my suppliers, or my workers, or my branch manager, about what should be done, either because a state of the world has arrived not covered by our contract, or because it is in our first-best mutual interest to renegotiate that contract.As an aside Bryan writes,
They retain the idea that there are relationship-specific rents, so I care about maintaining this particular relationship. But rather than rely on transaction costs, they simply point out that the owner of the asset is in a much better bargaining position when this disagreement occurs. Therefore, the owner of the asset will get a bigger percentage of rents after renegotiation. Hence the person who owns an asset should be the one whose incentive to improve the value of the asset is most sensitive to that future split of rents.
Baker and Hubbard (2004) provide a nice empirical example: when on-board computers to monitor how long-haul trucks were driven began to diffuse, ownership of those trucks shifted from owner-operators to trucking firms. Before the computer, if the trucking firm owns the truck, it is hard to contract on how hard the truck will be driven or how poorly it will be treated by the driver. If the driver owns the truck, it is hard to contract on how much effort the trucking firm dispatcher will exert ensuring the truck isn’t sitting empty for days, or following a particularly efficient route.
The computer solves the first problem, meaning that only the trucking firm is taking actions relevant to the joint relationship that are highly likely to be affected by whether they own the truck or not. In Grossman and Hart’s ‘residual control rights’ theory, then, the introduction of the computer should mean the truck ought, post-computer, be owned by the trucking firm. If these residual control rights are unimportant – there is no relationship-specific rent and no incompleteness in contracting – then the ability to shop around for the best relationship is more valuable than the control rights provided by asset ownership.
Hart and Moore (1990) extend this basic model to the case where there are many assets and many firms, suggesting critically that sole ownership of assets that are highly complementary in production is optimal. Asset ownership affects outside options when the contract is incomplete by changing bargaining power, and splitting ownership of complementary assets gives multiple agents weak bargaining power and hence little incentive to invest in maintaining the quality of, or improving, the assets. Hart et al. (1997) provide a great example of residual control rights applied to the question of why governments should run prisons but not garbage collection.
[...] note the role that bargaining power plays in all of Hart’s theories. We do not have a ‘perfect’ – in a sense that can be made formal – model of bargaining, and Hart tends to use bargaining solutions from cooperative game theory like the Shapley value. After Lloyd Shapley’s Nobel prize alongside Alvin Roth in 2012, this makes multiple prizes heavily influenced by cooperative games applied to unexpected problems. Perhaps the theory of cooperative games ought still be taught with vigour in PhD programmes.I have to agree with Bryan here, coopertive game theory should be taught to all students. The guy that taught me game theory in my honours degree covered cooperative as well as non-cooperative game theory and the cooperative stuff was interesting with more applied applications than you would think. One of my first publications was on the application of cooperative game theory to cost allocation problems. How do you allocate fixed ad joint costs of a project to those agents undertaking the project? Cooperative game theory gives some nice solution to this problem. It also comes in handy when dealing with bargaining problems like those utilised in Hart's work. The two most commonly use solutions concepts are the Nash bargaining solution and the Shapley Value.
Bryan continues by commenting on Hart's more recent work on the reference point approach to the firm,
[...] he has been primarily working on theories which depend on reference points, a behavioural idea that when disagreements occur between parties, the ex ante contracts are useful because they suggest ‘fair’ divisions of rent, and induce shading and other destructive actions when those divisions are not given. These behavioural agents may very well disagree about what the ex ante contract means for ‘fairness’ ex post.Byran is correct when he says we have, as yet, no "believable, logically ironclad theory". As I note in Walker (2016: 160)
The primary result is that flexible contracts (for example, contracts that deliberately leave lots of incompleteness) can adjust easily to changes in the world but will induce spiteful shading by at least one agent, while rigid contracts do not permit this shading but do cause parties to pursue suboptimal actions in some states of the world.
This perspective has been applied by Hart to many questions over the past decade, such as why it can be credible to delegate decision-making authority to agents: if you try to seize it back, the agent will feel aggrieved and will shade effort (Hart and Holmström 2010). These responses are hard, or perhaps impossible, to justify when agents are perfectly rational, and of course the Maskin-Tirole critique would apply if agents were purely rational.
So where does all this leave us concerning the initial problem of why firms exist in a sea of decentralised markets? We have many clever ideas, suitable for particular contexts, but still do not have a believable, logically ironclad theory.
A perfect theory of the firm would need to be able to explain why firms are the size they are, why they own what they do, why they are organised as they are, why they persist over time, and why inter-firm incentives look the way they do. It almost certainly would need its mechanisms to work if we assumed all agents were highly, or perfectly, rational – foolishness is not a good justification for institutions employed by millions of organisations.
Since patterns of asset ownership are fundamental, it needs to go well beyond the type of hand-waving that makes up many ‘resource’ type theories. (Firms exist because they create a corporate culture! Firms exist because some firms just are better at doing X and can’t be replicated! These are outcomes, not explanations.)
While the post-1970 theory of the firm literature has began the task of developing a genuine understanding of the firm, and closely related issues, it has yet to coalesce around one model or even one group of models. Even within the contemporary mainstream there are a number of competing models, to say nothing of those we could add into the mix if we were to consider the heterodox literature.But if we had all the answers there would be no fun (or point) in working in the area.
As Bylund (2016: 1–2) explains,
[...] there are several notable theories that each provide a different explanation and rationale for the business firm. [...] [T]here are several different definitions of what the firm supposedly is. [...] But each one must necessarily be incomplete, since it doesn’t capture all of what the other definitions capture.One can be forgiven for thinking that the current situation with regard to the modelling of the firm is much like a group of blind men trying to describe an elephant, each man can tell you about the part he can feel while remaining unaware of the rest of the animal. Each of the current theories tells us something about the firm, but none can tell us everything.
Refs.:
- Baker, G, and T Hubbard (2004), ‘Contractibility and Asset Ownership: On-board Computers and Governance in US Trucking’, Quarterly Journal of Economics 119(4): 1443-79.
- Bylund, Per L. (2016). The Problem of Production: A New Theory of the Firm, London: Routledge.
- Grossman, S, and O Hart (1986), ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy 94(4): 691-719.
- Hart, O, and B Holmström (2010), ‘A Theory of Firm Scope’, Quarterly Journal of Economics 125(2): 483-513.
- Hart, O, and J Moore (1990) ‘Property Rights and the Nature of the Firm’, Journal of Political Economy 98(6): 1119-58.
Monday, 31 October 2016
Timeless words of wisdom?
A quote from Greg Mankiw's blog
I don't care who writes a nation's laws, or crafts its advanced treaties, if I can write its economics textbooks.Samuelson did of course write the nation's economic textbooks, for many, many years. His first year economics text has gone through at least 19 editions. It was first published back in 1948. But what I wonder is how much damage has been done by having him do so. In particular with regard to macroeconomics.
-- Paul A. Samuelson
Sunday, 30 October 2016
Maija Halonen-Akatwijuka on "Oliver Hart, Nobel laureate"
Maija Halonen-Akatwijuka writes on Oliver Hart, Nobel laureate at VoxEU.org. As is well known by now Oliver Hart has been jointly awarded the 2016 Nobel Prize in Economic Sciences with Bengt Holmstrom "for their contributions to contract theory". Halonen-Akatwijuka looks at Hart's contribution to contract theory. In particular incomplete contracts.
Halonen-Akatwijuka opens her discussion by noting,
One of the applications of the Grossman-Hart-Moore theory that Hart has written on is to privatisation. The reason for this application is that there is a close relationship between the theory of the firm and the theory of privatisation. As Hart himself has written,
Halonen-Akatwijuka points out that,
When she turns to Hart's more recent work Halonen-Akatwijuka writes about what is now referred to as the "reference points" approach to contracts,
Given this lack of discussion I will take a quick look the model given in Hart (2008) which presents a simple, intuitive, reference points model and applies it to the theory of the firm. What is presented below is a slightly modified version of Hart's model. I hope that you can tell the difference between the zero's and the theta's below.
Hart assumes that a seller, S, can provide a good, costing 10, to a buyer, B, who is willing to pay 20. Let us assume that we are talking about a public lecture on some aspect of microeconomics which B is organising and which B wants S to give. A successful lecture is worth 20 to B and it costs 10 for S to give the lecture.
At this stage Hart ignores the fact that B could engage other economists or that S could give lectures elsewhere. While trade could proceed smoothly, it is also possible that it will not. We will assume that B and S each have some discretion over the ‘quality’ of performance. For example, S could give a witty, lively, entertaining lecture or a very boring one. B on the other hand could treat S well, give her a nice dinner and pay quickly, or treat her badly.
In the language of Hart and Moore (2008) each party is able to provide basic (perfunctory) or exemplary (consummate) performance. It is further assumed that only the basic (perfunctory) level of performance can be legally enforced: exemplary (consummate) performance is entirely discretionary. It is assumed that each party is more or less indifferent between providing each level of performance − exemplary performance costs only a little more than basic or may even be slightly more pleasurable − and will provide exemplary performance if they feel they are being 'well treated' but not if they feel they are being 'badly treated'. Cutting back on exemplary performance is called ‘shading’. Such behaviour cannot be observed or punished by an outsider. Shading hurts the other party.
Hart emphasises that each party will feel 'well treated' if they receive what they think they are entitled to; that a contract between the parties is a reference point for perceived entitlements; and that should there be no reference point, then entitlements can diverge, wildly in some cases.
To return to the example above. First, we will add a time line. The time line tells us that B and S will write a contract some months before the lecture is given, at date 0, rather than at the last minute, date 1. One reason for this is that each party has more options earlier on. In fact it is assumed that there is a competitive market for sellers, at date 0.
Assume, further, that although B and S sign a contract at date 0, they leave the question of how much B will pay S open until the night before the lecture, date 1. This may seem a bad idea, and later it will be shown that it is. If no price is specified, then any p between 10 and 20 is possible. What might each party feel entitled to?
Hart and Moore (2008) take the view that entitlements can diverge. S may feel that the whole success of the talk will be due to her giving it and thus she feels entitled to p = 20. On the other hand B may have a somewhat different view of S’s abilities and likely contribution and thus feel that S is worth much less, say, p = 10.
Even though they disagree as to what p should be, they are rational enough to arrive at a compromise, say p = 15. According to Hart and Moore (2008) each party will feel short-changed and therefore aggrieved. Since B is aggrieved by 5, (15-10), B shades to the point where S’s payoff falls by 5θ, where θ is the constant of proportionality. And since S is also aggrieved by 5, (20-15), S shades to the point where the payoff for B falls by 5θ.
The end result of this is that if S and B leave the determination of the price until the night before the lecture, there will be a deadweight loss of 10θ due to the shading activities of each party. This reduces the value of the relationship between S and B from 10 to 10−10θ = 10(1−θ).
Next Hart asks the question: Can anything be done to avoid this deadweight loss? His answer is yes. But first note an answer that doesn’t do the job. Ex post Coasian bargaining at date 1 doesn’t work. The reason is that shading is not contractible and thus an agreement not to shade is not enforceable. Or to put this another way, if B offers to pay S more to reduce her shading, say B offers to pay p = 16 to S rather than 15, then this will indeed reduce S’s shading, from 5θ to 4θ, since S will now feel less aggrieved, but it will also increase B’s shading from 5θ to 6θ, since he now feels more aggrieved. Total deadweight loss does not change, it remains at 10θ. However there is a simple solution; the parties just put the price in the contract at date 0. Since it has been assumed that the market for lectures is competitive at date 0, B will be able to hire S for a price p = 10. With this price specified in the contract, there is nothing for B and S to disagree about at date 1. The fact that B and S may disagree about the contribution that S makes to the success of the lecture no longer matters. B and S have agreed that B will pay S 10, and neither B nor S will be disappointed or aggrieved when that happens. Importantly, agreeing in advance, at date 0, to a payment of 10 eliminates ex post argument and aggrievement, and thus both parties will be willing to provide exemplary performance. Here we have the first best being achieved and zero deadweight losses as a result. This does raise an obvious question: What changes between dates 0 and 1? Why does a date 0 contract that fixes p avoid aggrievement, whereas a date 1 contract that fixes p does not? The crucial point here is the role of the ex ante market at date 0. This market gives an objective measure of what B and S bring to the relationship. Given the assumption of a competitive date 0 market, there are many sellers willing to supply at p = 10 and thus S accepts that she cannot expect to receive more than 10, while B understands that he can’t expect to pay less, as no one would be willing to give the lecture for less. Thus, neither party is aggrieved by p = 10. This gives us a model of the contractual relationship between B and S, but, as Hart explains, we need one further ingredient to create a theory of the firm.
Now let us add a little more realism by assuming that not all of the details of the lecture can be anticipated at date 0. To keep things simple we will assume that two different lectures can be given.
Lecture 1 - say, a theory of the firm lecture - is the same as above, with a value of 20 and costs of 10. Lecture 2 - say, a microeconometrics lecture - yields value of 14 and costs of 8. Note that lecture 1 is more efficient in that it generates a greater surplus - 10 v's 6. Assume that the lectures can not be specified in the date 0 contract, since thinking about econometrics is sooooo boring that no one can stay awake long enough to write the contract! At date 1, however, the choice between them becomes clear.
Now we have to compare two organisational forms: an employment contract and an independent contractor. First, let B and S fix the price of the good at date 0, at say 10, and let B and S agree at date 0 that S will be an independent contractor. This is, in other words, a market exchange between two separate economics agents. Independent contractor means here that S gets to pick which lecture to give.
Hart then asks, What will S do? Given that the price has been fixed by the date 0 contract, S will pick lecture 2, since it is cheaper for her. But note this is inefficient. B will be aggrieved because S didn’t choose lecture 1, which B feels entitled to; B is short-changed by 6 (20-14), and he will therefore shade enough to reduce S’s payoff by 6θ. Total surplus in this case will be 6 − 6θ.
The second organisation form to be considered is an employment contract. B and S agree at date 0 that S is an employee of B. This we take to mean that S will work for B at a fixed wage, again assume 10. B, being the employer, has the right to decide on which lecture is to be given. As the wage is fixed B will choose lecture 1, as this gives him the greater value. This is efficient. S will be aggrieved since lecture 2 wan’t chosen, but S’s aggrievement is only 2. This induces S to shade by enough to reduce B’s payoff by 2θ. Total surplus is therefore 10 − 2θ.
Under the conditions specified, the employment contract is better. This is true for two related reasons. First, the lecture matters more to B than to S. B will lose 20 − 14 = 6 if his favoured lecture is not chosen while S only loses 10 − 8 = 2 if her favoured lecture is not chosen. This means it is efficient for B to choose the lecture. Second, and related, S’s aggrievement is low since she doesn’t care very much.
Hart now changes the numbers. Keep lecture 1 as it is, but change lecture 2 so while it still yields 14, it now costs only 2. Lecture 2 is now the more efficient (12 v’s 10). Under employment, lecture 1 will be chosen, yielding a total surplus of 10−8θ. If S is an independent contractor, lecture 2 will be chosen resulting in a total surplus of 12 − 6θ.
What this suggests is that employment is good if the lecture matters more to B than to S, while independent contracting is good if the lecture matters more to S than to B.
Hart goes on to say,
Halonen-Akatwijuka also notes that this reference point theory shifts the focus from ex ante investment incentives, as in the Grossman-Hart-Morre theory, to ex post inefficiencies caused by shading and, importantly, this approach is not subject to the Maskin and Tirole (1999) critique (see pages 110-113 of Walker (2016) for more on the critique and why it is a problem for the Grossman-Hart-Moore theory).
The basic ingredients of the reference point approach to contracts have been applied to the theory of the firm more fully in papers by Hart and Moore (2007), Hart (2009) and Hart and Holmstrom (2010). For more on these papers see Walker (2013).
Halonen-Akatwijuka and Hart (2016) have also applied the contracts as reference point approach continuing contracts.
Refs.
Halonen-Akatwijuka opens her discussion by noting,
The cornerstone of Hart’s contribution to incomplete contracts theory is his 1986 paper with Sandy Grossman on the costs and benefits of ownership. In this paper, they develop the formal theory of incomplete contracts and with it introduce the notions of control and power that have had great impact in many fields beyond the theory of the firm (see Aghion et al 2016).A point to note here is that this ideas of having a single owner for complementary assets helps explain by we most often see control rights and income right being bundled together. Income rights give people an incentive to use assets efficiently while control rights give them the ability to do so. Income and control rights are complementary.
Even in market economies, a significant proportion of transactions do not take place in the market but within firms. Grossman and Hart (1986) build on the foundations laid by previous Nobel laureates Ronald Coase and Oliver Williamson in asking what determines whether a transaction occurs inside the firm or in the market – that is, whether there is vertical integration or non-integration.
Coase’s (1937) answer was that both market and internal transactions have their costs and they are organised so that the transaction costs are minimised. Williamson (1975, 1985) emphasised a particular cost of transacting in the market: the hold-up problem. When a productive relationship requires an investment that has much lower value in other uses, the investor may only make the investment if the relationship is within the firm, since in the market, such relationship-specific investment is vulnerable to expropriation in bargaining when contracts are incomplete. Williamson was less clear about the costs of integration, which, in his view, related to bureaucratic decision-making.
Grossman and Hart (1986) formalised the analysis of the boundaries of the firm and provided a rationale not just for the benefits but also for the costs of vertical integration. When contracts are incomplete, a trading relationship can be governed by allocating the control rights – or power – to a party. Ownership of an asset brings with it control rights as the owner has the right to refuse to trade with a supplier/buyer (unless a prior contract is in place). The question then arises of not just whether the assets should be integrated or not, but also who should be the owner.
Ownership gives power to an agent in the sense that his default payoff is increased. If buyer B owns the asset that supplier S works with — and therefore S becomes B’s employee — B can get a higher share of the surplus in bargaining. The benefit of integration is that B’s incentives in relationship-specific investments are stronger. But the hold-up problem does not disappear inside the firm as he still needs to bargain with his employee to complete the production.
The cost of integration is the other side of the coin: S as an employee has weaker incentives than as an independent supplier. Given this trade-off, if one of the parties is a key investor, then it is optimal for him to become the owner of the integrated firm. That guarantees the best incentives for the key investment while the cost of weaker incentives for the party with less important investment is not significant.
Hart’s 1990 paper with John Moore developed the theory for a multi-asset and multi-party setting. Ownership – or power – is distributed among the parties to maximise their investment incentives. Hart and Moore show that complementarities between the assets and the parties have important implications. If the assets are so complementary that they are productive only when used together, they should have a single owner. Separating such complementary assets does not give power to anybody, while when the assets have a single owner, the owner has power and improved incentives.
Furthermore, if there are such strong complementarities between an asset and a party that the asset is productive only with that party, then this indispensable party should own the asset. Ownership of the asset would not give power to anybody else and the incentive effect would be wasted.I would, of course, recommend reading pages 98-107 of Walker (2016) for a brief introduction to the Grossman-Hart-Moore approach to the theory of the firm.
This theory of the firm is now known as Grossman-Hart-Moore (GHM) property rights theory. It has been applied in various fields, including corporate finance, public economics, political economy and international trade.
One of the applications of the Grossman-Hart-Moore theory that Hart has written on is to privatisation. The reason for this application is that there is a close relationship between the theory of the firm and the theory of privatisation. As Hart himself has written,
Let me begin by discussing the very close parallel between the theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms,A and B. A might be a car manufacturer and B might supply car-body parts. Suppose that there is some reason for A and B to have a long-term relationship (e.g., A or B must make a relationship-specific investment). Then there are two principal ways in which this relationship can be conducted. A and B can have an arms-length contract, but remain as independent firms; or A and B can merge and carry out the transaction within a single firm. The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents a firm supplying the government or society with some service. B could be an electricity company (supplying consumers) or a prison (incarcerating criminals).Then again, there are two principal ways in which this relationship can be conducted. A and B can have a contract, with B remaining as a private firm, or the government can buy (nationalise) B.Also,
[...] the issues of vertical integration and privatisation have much more in common than not. Both are concerned with whether it is better to regulate a relationship via an arms-length contract or via a transfer of ownership.Thus, we can think about the nationalisation/privatisation decision of the government in a similar way to the integration/spin-off decision of the private firm, conceptually both decisions are about determining the boundaries of an organisation.
Halonen-Akatwijuka points out that,
Hart’s 1997 paper with Andrei Shleifer and Robert Vishny applies the property rights theory to privatisation of tax-funded welfare services, such as schools, prisons and refuse collection. Government contracts with a service provider but the contract is incomplete, particularly regarding the quality of the service. The provider can invest in cost reduction but the owner has the control rights to decide whether the cost innovation will be implemented.
Under privatisation, the provider has the control rights and will implement cost innovation even if it damages the quality of the service. Since the provider gets the full benefit from cost-cutting and ignores the quality-reducing effect, his incentives for cost reduction are too strong.
Under public ownership, the provider needs government approval for any innovations, and therefore a quality-damaging innovation would not go ahead. This means that the provider will take into account the quality-reducing effect but has generally weak incentives to reduce costs.
Privatisation is therefore not desirable for services where cost reduction can damage quality. Hart and his co-authors argue that prisons meet this condition reasonably well. Federal authorities in the US are indeed ending the use of private prisons partly because of quality issues.
In contrast, privatisation works well for services where the quality-reducing effect is likely to be trivial, such as refuse collection. Finally, for some welfare services such as schools, competition can discipline quality-damaging cost-cutting, and therefore there is a reasonably valid case for privatisation.
When she turns to Hart's more recent work Halonen-Akatwijuka writes about what is now referred to as the "reference points" approach to contracts,
In recent work, Hart has introduced the theory of contracts as reference points (Hart and Moore 2008). The basic idea is that the role of a contract is to shape the parties’ expectations and to get them ‘on the same page’ to avoid future misunderstandings. Misunderstandings cause parties to feel aggrieved and lead to shading in ex post performance, causing deadweight losses.This approach has yet to get much attention in economics textbooks, but see pages 113-117 of Walker (2016) for more.
The benefit of a rigid contract is that it fixes expectations, avoiding arguments. But it may not perform well when there is uncertainty. A flexible contract can adjust to the state of nature, but there is also room for arguments.
Given this lack of discussion I will take a quick look the model given in Hart (2008) which presents a simple, intuitive, reference points model and applies it to the theory of the firm. What is presented below is a slightly modified version of Hart's model. I hope that you can tell the difference between the zero's and the theta's below.
Hart assumes that a seller, S, can provide a good, costing 10, to a buyer, B, who is willing to pay 20. Let us assume that we are talking about a public lecture on some aspect of microeconomics which B is organising and which B wants S to give. A successful lecture is worth 20 to B and it costs 10 for S to give the lecture.
At this stage Hart ignores the fact that B could engage other economists or that S could give lectures elsewhere. While trade could proceed smoothly, it is also possible that it will not. We will assume that B and S each have some discretion over the ‘quality’ of performance. For example, S could give a witty, lively, entertaining lecture or a very boring one. B on the other hand could treat S well, give her a nice dinner and pay quickly, or treat her badly.
In the language of Hart and Moore (2008) each party is able to provide basic (perfunctory) or exemplary (consummate) performance. It is further assumed that only the basic (perfunctory) level of performance can be legally enforced: exemplary (consummate) performance is entirely discretionary. It is assumed that each party is more or less indifferent between providing each level of performance − exemplary performance costs only a little more than basic or may even be slightly more pleasurable − and will provide exemplary performance if they feel they are being 'well treated' but not if they feel they are being 'badly treated'. Cutting back on exemplary performance is called ‘shading’. Such behaviour cannot be observed or punished by an outsider. Shading hurts the other party.
Hart emphasises that each party will feel 'well treated' if they receive what they think they are entitled to; that a contract between the parties is a reference point for perceived entitlements; and that should there be no reference point, then entitlements can diverge, wildly in some cases.
To return to the example above. First, we will add a time line. The time line tells us that B and S will write a contract some months before the lecture is given, at date 0, rather than at the last minute, date 1. One reason for this is that each party has more options earlier on. In fact it is assumed that there is a competitive market for sellers, at date 0.
Assume, further, that although B and S sign a contract at date 0, they leave the question of how much B will pay S open until the night before the lecture, date 1. This may seem a bad idea, and later it will be shown that it is. If no price is specified, then any p between 10 and 20 is possible. What might each party feel entitled to?
Hart and Moore (2008) take the view that entitlements can diverge. S may feel that the whole success of the talk will be due to her giving it and thus she feels entitled to p = 20. On the other hand B may have a somewhat different view of S’s abilities and likely contribution and thus feel that S is worth much less, say, p = 10.
Even though they disagree as to what p should be, they are rational enough to arrive at a compromise, say p = 15. According to Hart and Moore (2008) each party will feel short-changed and therefore aggrieved. Since B is aggrieved by 5, (15-10), B shades to the point where S’s payoff falls by 5θ, where θ is the constant of proportionality. And since S is also aggrieved by 5, (20-15), S shades to the point where the payoff for B falls by 5θ.
The end result of this is that if S and B leave the determination of the price until the night before the lecture, there will be a deadweight loss of 10θ due to the shading activities of each party. This reduces the value of the relationship between S and B from 10 to 10−10θ = 10(1−θ).
Next Hart asks the question: Can anything be done to avoid this deadweight loss? His answer is yes. But first note an answer that doesn’t do the job. Ex post Coasian bargaining at date 1 doesn’t work. The reason is that shading is not contractible and thus an agreement not to shade is not enforceable. Or to put this another way, if B offers to pay S more to reduce her shading, say B offers to pay p = 16 to S rather than 15, then this will indeed reduce S’s shading, from 5θ to 4θ, since S will now feel less aggrieved, but it will also increase B’s shading from 5θ to 6θ, since he now feels more aggrieved. Total deadweight loss does not change, it remains at 10θ. However there is a simple solution; the parties just put the price in the contract at date 0. Since it has been assumed that the market for lectures is competitive at date 0, B will be able to hire S for a price p = 10. With this price specified in the contract, there is nothing for B and S to disagree about at date 1. The fact that B and S may disagree about the contribution that S makes to the success of the lecture no longer matters. B and S have agreed that B will pay S 10, and neither B nor S will be disappointed or aggrieved when that happens. Importantly, agreeing in advance, at date 0, to a payment of 10 eliminates ex post argument and aggrievement, and thus both parties will be willing to provide exemplary performance. Here we have the first best being achieved and zero deadweight losses as a result. This does raise an obvious question: What changes between dates 0 and 1? Why does a date 0 contract that fixes p avoid aggrievement, whereas a date 1 contract that fixes p does not? The crucial point here is the role of the ex ante market at date 0. This market gives an objective measure of what B and S bring to the relationship. Given the assumption of a competitive date 0 market, there are many sellers willing to supply at p = 10 and thus S accepts that she cannot expect to receive more than 10, while B understands that he can’t expect to pay less, as no one would be willing to give the lecture for less. Thus, neither party is aggrieved by p = 10. This gives us a model of the contractual relationship between B and S, but, as Hart explains, we need one further ingredient to create a theory of the firm.
Now let us add a little more realism by assuming that not all of the details of the lecture can be anticipated at date 0. To keep things simple we will assume that two different lectures can be given.
Lecture 1 - say, a theory of the firm lecture - is the same as above, with a value of 20 and costs of 10. Lecture 2 - say, a microeconometrics lecture - yields value of 14 and costs of 8. Note that lecture 1 is more efficient in that it generates a greater surplus - 10 v's 6. Assume that the lectures can not be specified in the date 0 contract, since thinking about econometrics is sooooo boring that no one can stay awake long enough to write the contract! At date 1, however, the choice between them becomes clear.
Now we have to compare two organisational forms: an employment contract and an independent contractor. First, let B and S fix the price of the good at date 0, at say 10, and let B and S agree at date 0 that S will be an independent contractor. This is, in other words, a market exchange between two separate economics agents. Independent contractor means here that S gets to pick which lecture to give.
Hart then asks, What will S do? Given that the price has been fixed by the date 0 contract, S will pick lecture 2, since it is cheaper for her. But note this is inefficient. B will be aggrieved because S didn’t choose lecture 1, which B feels entitled to; B is short-changed by 6 (20-14), and he will therefore shade enough to reduce S’s payoff by 6θ. Total surplus in this case will be 6 − 6θ.
The second organisation form to be considered is an employment contract. B and S agree at date 0 that S is an employee of B. This we take to mean that S will work for B at a fixed wage, again assume 10. B, being the employer, has the right to decide on which lecture is to be given. As the wage is fixed B will choose lecture 1, as this gives him the greater value. This is efficient. S will be aggrieved since lecture 2 wan’t chosen, but S’s aggrievement is only 2. This induces S to shade by enough to reduce B’s payoff by 2θ. Total surplus is therefore 10 − 2θ.
Under the conditions specified, the employment contract is better. This is true for two related reasons. First, the lecture matters more to B than to S. B will lose 20 − 14 = 6 if his favoured lecture is not chosen while S only loses 10 − 8 = 2 if her favoured lecture is not chosen. This means it is efficient for B to choose the lecture. Second, and related, S’s aggrievement is low since she doesn’t care very much.
Hart now changes the numbers. Keep lecture 1 as it is, but change lecture 2 so while it still yields 14, it now costs only 2. Lecture 2 is now the more efficient (12 v’s 10). Under employment, lecture 1 will be chosen, yielding a total surplus of 10−8θ. If S is an independent contractor, lecture 2 will be chosen resulting in a total surplus of 12 − 6θ.
What this suggests is that employment is good if the lecture matters more to B than to S, while independent contracting is good if the lecture matters more to S than to B.
Hart goes on to say,
[o]ne point worth emphasizing is that in neither of the above examples is the following contract optimal: to leave the choice of price and method until date 1, i.e. to rely on unconstrained Coasian bargaining. This would always yield the efficient method, but the aggrievement costs would be high. In [Table not shown] the parties would agree on method 1; however, since there are 10 dollars of surplus to argue over, shading costs equal 10θ: net surplus = 10(1 − θ), which is less than that obtained under the employment contract. In [Table 171.1] there are 12 dollars of surplus to argue over and net surplus = 12(1 − θ), which is less than that obtained under independent contracting.Clearly the examples above are toy ones, but Hart argues they contain the basic ingredients of a theory of the firm in that they consider the choice between carrying out a transaction in the market, using an independent contractor, and 'inside the firm', via an employment contract. This was the trade-off at the heart of Coase (1937).
Halonen-Akatwijuka also notes that this reference point theory shifts the focus from ex ante investment incentives, as in the Grossman-Hart-Morre theory, to ex post inefficiencies caused by shading and, importantly, this approach is not subject to the Maskin and Tirole (1999) critique (see pages 110-113 of Walker (2016) for more on the critique and why it is a problem for the Grossman-Hart-Moore theory).
The basic ingredients of the reference point approach to contracts have been applied to the theory of the firm more fully in papers by Hart and Moore (2007), Hart (2009) and Hart and Holmstrom (2010). For more on these papers see Walker (2013).
Halonen-Akatwijuka and Hart (2016) have also applied the contracts as reference point approach continuing contracts.
Refs.
- Aghion, P, M Dewatripont, P Legros and L Zingales (eds) (2016), The Impact of Incomplete Contracts on Economics, Oxford University Press.
- Coase, Ronald Harry (1937). ‘The Nature of the Firm’, Economica, n.s. 4(16) November: 386–405.
- Grossman, Sanford J. and Oliver D. Hart (1986). ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy, 94(4): 691–719.
- Halonen-Akatwijuka, M and O Hart (2016), ‘Continuing Contracts’, mimeo.
- Hart, Oliver D. (2008). ‘Economica Coase Lecture: Reference Points and the Theory of the Firm’, Economica, 75(299) August: 404–11.
- Hart, Oliver D. (2009). ‘Hold-up, Asset Ownership, and Reference Points’, Quarterly Journal of Economics, 124(1) February: 267–300.
- Hart, Oliver D. and Bengt Holmstrom (2010). ‘A Theory of Firm Scope’, Quarterly Journal of Economics, 125(2) May: 483–513.
- Hart, Oliver D. and John Moore (1990). ‘Property Rights and the Nature of the Firm’, Journal of Political Economy, 98(6): 1119–58.
- Hart, Oliver D. and John Moore (2007). ‘Incomplete Contracts and Ownership: Some New Thoughts, American Economic Review, 97(2) May: 182–6.
- Hart, Oliver D. and John Moore (2008). ‘Contracts as Reference Points’ Quarterly Journal of Economics, 123(1) February: 1–48.
- Hart, O, A Shleifer and R Vishny (1997), ‘The Proper Scope of Government: Theory and an Application to Prisons’, Quarterly Journal of Economics 112(4): 1127-61.
- Walker, Paul (2013). ‘The ‘Reference Point’ Approach to the Theory of the Firm: An Introduction’, Journal of Economic Surveys, 27(4) September: 670–95.
- Williamson, Oliver (1975), Markets and Hierarchies, Free Press.
- Williamson, Oliver (1985), The Economic Institutions of Capitalism, Free Press.
Saturday, 29 October 2016
Trump vs Friedman - trade policy debate
Import tariffs v. free trade, argued by Donald Trump and Milton Friedman.
One of these two guys knows about economics ..... and the other is Donald Trump.
One of these two guys knows about economics ..... and the other is Donald Trump.
Thursday, 27 October 2016
Sam Richardson weighs in on economics of Parker bout
From Morning Report this morning. A specialist in sports event economics, Dr Sam Richardson of Massey University, says the economic argument for Duco to get Major Events funding for Joseph Parker's forthcoming world heavyweight boxing fight is "not particularly strong".
See here for the interview.
See here for the interview.
Analysing the extent and effects of occupational regulation in New Zealand
A new paper, by Simon James Greenwood and Andrea Kutinova Menclova, has been published online for New Zealand Economic Papers on the above topic.
The abstract reads,
The abstract reads,
This study is the first to our knowledge to document the extent and correlates of occupational regulation in New Zealand. Using data from the Census and the Survey of Working Life, we estimate that 28% of workers’ primary jobs are affected by occupational regulation. This is lower than the 35% reported for the US but identical to UK estimates of 28%. Furthermore, we find that holding observable factors constant, occupational regulation is associated with a wage premium of 5%. This is lower than the 18% licensing premium found for the US but within the range of estimates for the UK.I would love to see evidence on the distribution of the wage premium since I'm sure there are groups out there getting a hell of a lot more than a 5% premium! The other side of this coin is that there must be groups for whom occupational regulation results in little of the way of a premium. Does the form of regulation play a role here?
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