Just for fun: the theory of the firm 6

The neoclassical theory of the firm. The only model of the "firm" that most students meet and that found in most microeconomic textbooks, isn't a "theory of the firm" in any meaningful sense. The output side of the standard neoclassical model is a theory of supply rather than a true theory of the firm. In neoclassical theory, the firm is a 'black box' there to explain how changes in inputs lead to changes in outputs. It is a black box in the sense that inputs go in and outputs come out, without any explanation of how one gets turned into the other. The firm is taken as given; no attention is paid to how it came into existence, the nature of its internal organisation, where the boundary between one firm and another is or between a firm and the market; or whether anything would change if two firms merged and called themselves a single firm. The firm is a conceptualisation that represents, formally, the actions of the owners of inputs who place their inputs in the highest value uses, and makes sure that production is separated from consumption. The firm produces only for outsiders, there is no on-the-job or internal consumption, no self-sufficiency. In fact there are no managers or employees to indulge in on the job consumption and as production is separated from consumption, no self-sufficiency. Production for outsiders is, according to Demsetz (1995), the definition of a firm in the neoclassical model:

"[w]hat is needed is a concept of the firm in which production is exclusively for sale to those formally outside the firm. This requirement defines the firm (for neoclassical theory), but it has little to do with the management of some by others. The firm in neoclassical theory is no more or less than a specialized unit of production, but it can be a one-person unit" (Demsetz 1995: 9).

As inputs are combined in the optimal fashion by the actions of independent owners of inputs motivated solely by market prices, there is no need for `management of some by others', there is no role for managers or employees. Also note that as competition assures the absence of profits and losses in equilibrium, there is no need to have a residual claimant. This means that, in one sense at least, there are no owners of the firm. Hansmann (1996), for example, states

"[a] firm's "owners," as the term is conventionally used and as it will be used here, are those persons who share two formal rights: the right to control the firm and the right to appropriate the firm's profits, or residual earnings (that is, the net earnings that remain with the firm after it has made all payments to which it is contractually committed, such as wages, interest payments, and prices for supplies)." (page 11)

He later adds

"[n]ot all firms have owners. In nonprofit firms, in particular, the persons who have control are barred from receiving residual earnings." (page 12).

As there are no physical assets controlled by the firm, there are no (residual) control rights over these assets to allocate. This implies there are no owners of the firm in the Grossman Hart Moore sense.

The neoclassical production function is a way of representing the (efficient) black box conversion of inputs into outputs but tells us little about the inner workings of the black box. The production function is independent of the institutional framework of output creation. It can be given two interpretations: it can represent the production method of a single firm, of which all known firms are just divisions or, equally, it could represent the outcome of a series of purely market based transactions which give rise to the observed outputs. Thus it represents the 'firm' without explaining the 'firm'. The boundaries of the firm is an issue described by Williamson (1993: 4) as one of

"[...] make-or-buy. What is it that determines which transactions are executed how? That posed a deep puzzle for which the firm-as-production function approach had little to contribute."

Hart (1995: 17) criticises the neoclassical model based on three characteristics of the theory. First, he notes that the theory completely ignores incentive problems within the firm. The firm is a perfectly efficient `black box'. Second, the theory has nothing to say about the internal organisation of the firm. Nothing is said about the hierarchical structure, how decisions are made, who has authority within a firm. Third, the theory tells us nothing about how to pin down the boundaries of the firm. The theory is as much a theory of plant or division size as firm size. As Hart points out

"[t]o put it in stark terms [...] neoclassical theory is consistent with there being one huge firm in the world, with every existing firm [...] being a division of this firm. It is also consistent with every plant and division of an existing firm becoming a separate and independent firm" (Hart 1995: 17).

Cyert and Hedrick (1972) addressed similar points. They argue that in the neoclassical system the firm doesn't exist, that no real world problems of firms are considered, that there are no organisational problems or any internal decision-making process at all.

"In one sense the controversy over the theory of the firm has arisen over a non-existent entity. The crux of microeconomics is the competitive system. Within the competitive model there is a hypothetical construct called the firm. This construct consists of a single decision criterion and an ability to get information from an external world, called the "market" [8, Cyert and March, 1963, pp. 4-16]. The information received from the market enables the firm to apply its decision criterion, and the competitive system then proceeds to allocate resources and produce output. The market information determines the behavior of the so called firm. None of the problems of real firms can find a home within this special construct. There are no organizational problems nor is there any room for analysis of the internal decision-making process" (Cyert and Hedrick 1972: 398).

Thus within the neoclassical model of the price system, the firm's only role is to allow input owners to convert inputs into outputs in response to market prices. Firms have no internal organisation since they have no need of one, they have no owners since there is nothing to own. Questions about the existence, definition and boundaries of the firm are to a large degree meaningless within this framework since firms, by any meaningful definition of that term, don't really exist. As Foss, Lando and Thomsen (2000: 632) summarise it:

"The pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist" (Foss, Lando and Thomsen 1998: 1-2).

Another way to think of why the neoclassical firm is just a phantom is follow Coase (1937) and note that the neoclassical model in one of zero transaction costs, and as Martin Ricketts has noted,

"If market transaction were costless there would be no rationale for the existence of firms." (Ricketts 1999: 50, note 15)

Given there is no serious modelling of the firm within the neoclassical framework it is not surprising that there are no organisational problems or any internal decision-making process, in fact, that there is no organisational structure at all. And thus there is no role for managers, employees or owners. There are no boundaries to the firm, we can't say where one "firm" begins or ends or where firms end and markets begin because they are all one and the same. In short, there are no firms.

References:

• Coase, Ronald Harry (1937). 'The Nature of the Firm', Economica, n.s. 4 no. 16 November: 386-405.
• Cyert, Richard M. and Charles L. Hedrick (1972). 'Theory of the Firm: Past, Present, and Future; An Interpretation', ournal of Economic Literature, 10(2) June: 398-412.
• Cyert, Richard M. and James G. March (1963). A Behavioral Theory of the Firm, Englewood Cliffs, New Jersey: Prentice-Hall, Inc.
• Demsetz, Harold (1995). The Economics of the Business Firm: Seven Critical Commentaries, Cambridge: Cambridge University Press.
• Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics, Volume III, Cheltenham U.K.: Edward Elgar Publishing Ltd.
• Hansmann, Henry (1996). The Ownership of Enterprise, Cambridge, Mass.: Harvard University Press.
• Hart, Oliver D. (1995). Firms, Contracts, and Financial Structure, Oxford: Oxford University Press.
• Ricketts, Martin (1999). The Many Ways of Governance: Perspectives on the control of the firm, London: The Social Affairs Unit.
• Williamson, Oliver E. (1993). 'Introduction'. In Oliver E. Williamson and Sidney G. Winter (eds.), he Nature of the Firm: Origins, Evolution, and Development, New York, Oxford: Oxford University Press.

The broken window fallacy: Robert Barro on 'cash for clunkers'

Robert Barro comments on the "cash for clunkers programme" in the US:

The most ludicrous (though, fortunately, small) intervention thus far has to be the cash-for-clunkers program. It’s not surprising that subsidising people to destroy old cars would raise GDP, because measured GDP includes the replacement cars but not the value lost from destruction. Why not also blow up houses and factories and then enjoy the expansion of GDP from the replacement investment? (Actually, it’s best cosmetically to blow up refrigerators and other consumer durables because GDP does include rental income on houses and factories.)

Hogan on Wolak

At the Offsetting Behaviour blog Seamus Hogan has three useful posts on the Wolak report. This was the report the Commerce Commission had done into electricity markets in New Zealand. The result that got all the headlines was the $4.3b figure that the electricity companies ostensibly have overcharged everyone. See Did electricity companies really overcharge by $4.3b? Part 1, Did electricity companies really overcharge by $4.3b? Part 2 and Did electricity companies really overcharge by $4.3b? Part 3 to understand what the report actually said and how it came to its very dubious conclusions.

Life among the Econ

The single greatest work in the history of Econological research is available on line. Life Among the Econ by Axel Leijonhufvud is available here. This is a must read for anyone who wishes to understand the vast bleak and dismal territory that the Econ tribe occupies in the far North. It is one a the very few studies that tries to understand the social structure and ways of life of the Econ tribe. The information that we do have indicates that, for such a primitive people, that social structure is quite complex but this information is fragmentary and not well validated. Further study is much needed.

(HT: The Austrian Economists)

Supply really doesn't move (updated)

Below I have reproduced a diagram and explanation from a posting - Padding pockets, not houses - by Marty G at The Standard.

In the real world, it’s different. A new supply curve (S1) can be plotted that is the amount of the subsidy below the original supply line. Where the new supply line intersects with D gives the new level of price and quantity – note, it’s not as low as the full subsidy and quantity is less than what would be demanded if the full subsidy was passed on. (emphasis added)

What is wrong with Marty G's analysis? In short, S1 is not, as he claims, a supply curve.

I have redrawn Marty G's diagram below with an extra point on it, P2. Let us assume that we are at the new equilibrium P1,Q1. At this point the quantity traded is Q1 and the price paid by the consumer is P1. Question: If Q1 is to be supplied, what price must the producer receive? We know that the consumer price and the producer price must differ by the amount of the subsidy and that the consumer pays P1. Thus the producer receives P1 + the subsidy, which equals P2 on my diagram. But note that the P2,Q1 combination corresponds to the curve S, NOT the curve S1. That is, to induce the firm to supply an amount Q1 it must receive the price P2. Therefore S is the supply curve after the subsidy is introduced, as well as before it is. But if S is the supply curve both pre and post subsidy, then S1 is NOT the supply curve in either case. That is, the supply does not move with the introduction of the subsidy.

If we don't move the supply curve from S to S1, how do we find the new quantity traded, Q1, when the subsidy is put on? Note that the consumer and producer prices differ by the amount of the subsidy, so we increase the quantity traded starting from Q until the vertical distance between the supply and demand curves is equal to the amount of the subsidy. This is will give Q1 without having to move the supply curve.

Update: Matt Nolan over at TVHE has some additional issue with Subsidises and complaints.

Tyler Cowen interview

From Bloggingheads.TV, comes this interview of Tyler Cowen by Will Wilkinson. They discuss human neurodiversity and Cowens new book Create Your Own Economy.

EconTalk this week

Eric Hanushek of Stanford University's Hoover Institution talks with EconTalk host Russ Roberts about the current state of education and education policy. Hanushek summarizes the impact of No Child Left Behind and the current state of the charter school movement. Along the way, he and Roberts discuss the role of testing as a way of measuring achievement. The conversation concludes with a discussion of school finance, the role of the court system, and suggestions for improving finance to create better incentives.

Just for fun: the theory of the firm 5

The incentive-system theory. This approach to the theory of the firm was developed by Holmstrom and Milgrom (1991, 1994); Holmstrom and Tirole (1991) and Holmstrom (1999) and has been described by Gibbons (2005: 206) as an "accidental theory of the firm". The reason for Gibbons's description is that the focus of these papers was not on the make-or-buy problem of the transaction cost or Grossman/Hart/Moore approaches but rather on a multi-task, multi-instrument principal-agent problem and its application to the firm was an "accidental" outcome of this endeavour.

To analyse this approach to the firm, we will take advantage of Gibbons (2005: 210-2) "stick-figure rendition" of the theory. In the simple Gibbons model, there is a technology of production which is a linear combination of the agent's actions: $y=f_1a_1+f_2a_2+\varepsilon$ where the $a_1$ and $a_2$ are actions chosen by the agent and $\varepsilon$ is a noise term. Evaluation of performance by the agent is based on an indicator $p$ which is a different linear combination of the agent's actions: $p=g_1a_1+g_2a_2+\phi$, where $\phi$ is another noise term. Gibbons assumes that both parties are risk-neutral, $\omega$ is the total compensation paid by the principal to the agent and $c(a_1,a_2)$ represents the agent's cost function. Gibbons makes the assumption that:

\begin{equation}c(a_1,a_2)=\frac{1}{2}a^2_1+\frac{1}{2}a^2_2.\nonumber\end{equation}

In addition, Gibbons assumes that the principal and the agent sign a linear contract, $\omega=s+bp$, based on the performance indicator $p$.

To provide a theory of the firm, this model has to be extended to include physical capital, a machine, which is used by the agent during the production of $y$. Post production this capital has a value determined by a third linear combination of the agent's actions: $v=h_1a_1+h_2a_2+\xi$ where $\xi$ is a third noise term. The choice variables in the model are therefore the agent's actions $a_i, i=1,2$ and $b$ the slope of the optimal contract. As a point of comparison, note that the first-best actions of the agent are those which maximise the expected total surplus, that is, they will maximise the expected value of the sum of the principal's payoff, $y-\omega$, the agent's payoff, $\omega-c(a_1,a_2)$, and the value of the physical asset, $v$.

\begin{eqnarray}TS^{FB}&=&E(y-\omega+\omega-c(a_1,a_2)+v)\nonumber\\&=&E(y+v)-c(a_1,a_2)\nonumber\\&=&E(f_1a_1+f_2a_2+\varepsilon+h_1a_1+h_2a_2+\xi)-c(a_1,a_2)\nonumber\\&=&f_1a_1+f_2a_2+h_1a_1+h_2a_2-c(a_1,a_2)\nonumber~~\textrm{assuming}~E(\varepsilon)=E(\xi)=0\\&=&f_1a_1+f_2a_2+h_1a_1+h_2a_2-\left(\frac{1}{2}a^2_1+\frac{1}{2}a^2_2\right)\nonumber\end{eqnarray}

and therefore $a^{FB}_1=f_1+h_1$ and $a^{FB}_2=f_2+h_2$. $TS^{FB}$ is independent of the value of $b$.

If the principal owns the machine, then the agent is an employee of his firm and the principal's payoff is $y+v-\omega$, while the agent's payoff is $\omega-c$. In this case, the agent's optimal actions maximise

\begin{eqnarray*}E(\omega)-c(a_1,a_2)&=&E(s+bp)-\left(\frac{1}{2}a^2_1+\frac{1}{2}a^2_2\right)\\&=&E(s+b(g_1a_1+g_2a_2+\phi))-\left(\frac{1}{2}a^2_1+\frac{1}{2}a^2_2\right)\\&=&s+bg_1a_1+bg_2a_2-\left(\frac{1}{2}a^2_1+\frac{1}{2}a^2_2\right)~~\textrm{assuming}~E(\phi)=0.\end{eqnarray*}

The optimal actions are therefore, $a^\star_{1E}(b)=bg_1$ and $a^\star_{2E}(b)=bg_2$. The efficient contract slope, $b^\star_E$, maximises the expected total surplus, $E(y+v)-c(a_1,a_2)$ or

\begin{equation}TS_E(b)=(f_1+h_1)a^\star_{1E}(b)+(f_2+h_2)a^\star_{2E}(b)-\left(\frac{1}{2}a^\star_{1E}(b)^2+\frac{1}{2}a^\star_{2E}(b)^2\right).\nonumber\end{equation}

Alternatively, the machine can be owned by the agent. Gibbons interprets this case as the agent being an independent contractor. In this situation, the payoffs for the principal will be $y-w$ and for the agent they are $w+v-c$. The optimal actions for the agent will therefore be, $a^\star_{1C}(b)=g_1b+h_1$ and $a^\star_{2C}(b)=g_2b+h_2$. For this case, the efficient slope, $b^\star_C$, will maximise the expected total surplus of

\begin{equation}TS_C(b)=(f_1+h_1)a^\star_{1C}(b)+(f_2+h_2)a^\star_{2C}(b)-\left( \frac{1}{2}a^\star_{1C}(b)^2+\frac{1}{2}a^\star_{2C}(b)^2\right).\nonumber\end{equation}

Gibbons (2005: 211) summaries the analysis so far as:

"[...] having the agent own the asset causes the agent to respond to a given contract slope $(b)$ differently than when the agent does not own the asset, so the make-or-buy problem amounts to determining which of the agent's best-response functions $-$ that of the employee, $(a^\star_{1E}(b), a^\star_{2E}(b))$, or that of the independent contractor, $(a^\star_{1C}(b), a^\star_{2C}(b))$ $-$ allows the parties to achieve greater total surplus."

The discussion so far has relied on an implicit assumption that the value of the asset is not contractible and therefore the owner of the asset receives its value. Since the asset's value is not contractible, putting ownership in the hands of the agent provides him with incentives that cannot be replicated via a contract. But providing the agent with the incentive to increase the value of the asset may or may not help the principal control the agent's incentives via contract. That is, if the agent owns the asset, he has two sources of incentives, the asset's post-production value and the contracted for performance. Without ownership, he concentrates solely on the contracted for performance. Integration would be efficient, that is, having the principal own the asset is efficient, when having the agent do so hurts the principal's efforts to create incentives via contract.

In sum, the distinctive point of the incentive-system approach to the firm is that asset ownership can be one instrument in a multi-task incentive problem. Asset ownership has two sets of effects; one it provides incentives via the value of the asset itself and two it provides incentives via changes induced in the optimal incentive contract. Joint optimization over asset ownership and contract parameters illustrates the system approach to incentive problems. in line with the property-rights approach, the incentive-system theory has the advantage of providing a unified account of both the costs and benefits of integration. In addition the incentive-system theory counters one problems of the property-rights theory in that workets now face incentives, they are no longer act like robot drones.

There are some problems with this approach however. First, most employees are not governed by formal incentive contracts. We just don't see, in the real world, the type of contract the incentive system suggest should be written. Second, and perhaps even more importantly, the elemental incentive system theory omits one of the central and appealing aspects of the rent-seeking and property-rights theories: control. That is, in the elemental incentive-system theory, whether the agent owns the asset affects only the agent's payoff function, it does not effect the agent's action space.

References:

• Gibbons, Robert (2005). 'Four formal(izable) theories of the firm?', Journal of Economic Behavior and Organization, 58(2) October: 200-45.
• Holmstrom, Bengt (1999). 'The Firm as a Subeconomy', Journal of Law, Economics, and Organization, 15(1) April: 74-102.
• Holmstrom, Bengt and Paul Milgrom (1991). 'Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design', Journal of Law, Economics, and Organization, 7(Special Issue): 24-52.
• Holmstrom, Bengt and Paul Milgrom (1994). 'The Firm as an Incentive System', American Economic Review, 84(4) September: 972-91.
• Holmstrom, Bengt and Jean Tirole (1991). 'Transfer Pricing and Organizational Form', Journal of Law, Economics, and Organization 7(2) Fall: 201-28.

Jeanette meet economics .... (updated)

Jeanette Fitzsimons needs to do a bit of reading on economics as this posting at the frogblog shows,

Electricity is unique among industries. With shoes or toothpaste, increased demand gives economies of scale and tends to bring prices down. With electricity, which cannot effectively be stored on any scale, and where the cheapest sites for hydro and wind and geothermal are always built first, and the price of fossil fuels is rising, increased demand raises prices.

First, economies of scale are determined by the costs of firms, not by the demand they face. Put simply if the average cost curve of a firm is declining then you have economies of scale, if it is increasing you have diseconomies of scale. Demand is not in the picture. Second, demand will enter the picture when price is determined. As demand increases the price tends, in general, to increase, not decrease. If there is a natural monopoly then price changes resulting from demand increases could be negative as costs will be decreasing. But here the regulation that the firm is under will be a big determinant in prices changes. Third, the cheapest methods of production are always built first. This is true in general, and not just for electricity. Fourth, as just noted, if there is a natural monopoly then increased demand could decrease prices. But electricity production is more likely a natural oligopoly and thus increased demand could increase prices, independently of fuel price increases. Fifth, increased fossil fuel prices will tend to increased the cost of production, and for a given level of demand this will also increase the price of electricity. If demand was however to fall enough then prices could fall, and if both demand and fuel prices increased then price would tend to rise more than they would with only one of the two increases. In other words it is supply and demand that determines price not just one of them. Last, electricity is not unique among industries in that it has large fixed (sunk) costs. There are many industries with this property.

Update: Tom M comments in a similar manner when he suggests Supply, Meet Demand.

Correlation is not causation.

From an article in the New York Times,

For example, in the late 1940s, before there was a polio vaccine, public health experts in America noted that polio cases increased in step with the consumption of ice cream and soft drinks, according to David Alan Grier, a historian and statistician at George Washington University. Eliminating such treats was even recommended as part of an anti-polio diet. It turned out that polio outbreaks were most common in the hot months of summer, when people naturally ate more ice cream, showing only an association, Mr. Grier said.

Statistics can be bad for your health, or at least bad for your utility. Just how often do we mistake correlation for causation?

Happiness: the impact of growth, inequality and recession

From VoxEU.org comes this interview with Justin Wolfers of the University of Pennsylvania’s Wharton School in which he talks to Romesh Vaitilingam about happiness economics – the state of knowledge; the explosion of data; the debate about the Easterlin paradox; the impact of inequality and the business cycle on people’s happiness; and the implications for public policy.

The good old days weren't that good

Or so says Bryan Caplan. Caplan documents one way that life for children in America, at least, today is far better than it was during the so-called "golden years" of the 1950s.

Incentives matter: medical file

This from MacDoctor: Mercenary-medicine,

The reason so many young doctors (and a few of us oldies) are willing to endure such terms in exchange for extra money is because the difference in money is substantial. In case anyone thinks it is not an issue primary of pay, let me point out that Waitakere hospital has all but closed its ED in the evenings because they cannot staff it, yet there is a 24 hour Whitecross A&M just down the road that appears to be managing to staff the place just fine, despite the current shortage of locum doctors. The only difference is about a 60 dollar an hour difference in pay scales.

In addition, there is not much of a disincentive for junior doctors to locum. As the report points out, the junior doctors in hospital positions, work long, dangerous hours, get little continuing medical education and even less in-house training. So, apart from sick leave provision, hardly a big concern for fit, healthy young doctors, the DHBs are offering nothing except markedly lower pay.

And then they wonder why junior doctors leave and become full-time locums.

May be they just don't understand about incentives.

Buy American?

From Reason TV comes this great video exposing the destructive and nonsensical claims of the 'buy American' clause in the US stimulus bill.

Interesting blog bits

1. Eric Crampton on Further on the price elasticity of demand for alcohol. The Law Commission's report claims that youth are particularly price sensitive and that heavy drinkers are no less price sensitive than moderate drinkers. As noted a couple of days ago, the latter claim is absolute nonsense.
2. Brad Taylor on Coherence versus Political Reality. Politics as it’s practised on the ground isn’t a competition between alternative coherent worldviews, but competing myths, symbols, and identity groups.
3. Save the Humans on Bin City Blows $19m on Recycling in a Recession. What on earth is going on in the People's Republic? The council has purchased a company which processes recycling material that no one wants.
4. Philip Salter asks, Should taxpayers fund the arts? My answer, in short, no.
5. John Blundell asks Should the government cut arts funding? Yes, he says.
6. Matt Nolan gives us a Cartoon: Night classes.
7. José Cuesta asks Are policymakers better equipped for the next food price crisis? The food crisis caught some policymakers off guard. Will they be ready next time? This column argues that most studies of the crisis offer little in the way of tractable policy responses. This knowledge gap leaves policymakers unprepared to prevent or mitigate the next food price crisis.

Because, Your Majesty, no one could predict it

Queen Elizabeth famously asked why economists did not predict the financial crisis. The best answer I have seen so far comes from Bill Easterly, who offers us the Idiot’s Guide to answering the Queen. Easterly writes,

First, Your Majesty, economists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it. The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices. If you think it is useless to be told you cannot predict the market, then you should change your Palace investment advisor. This knowledge will protect you from a lot of investment scams like Mr. Madoff’s and will also provoke a serious discussion of how to protect your Royal Wealth against risk in an uncertain world.

Second, economists did just fine pointing to fundamentals that were creating large risks of a financial crisis. Even an outsider like me heard long before the crisis hit about the dangers of opaque instruments like derivatives, excessive mortgage lending and leverage, and the bubble in housing prices. Economists have contributed a lot to understanding bubbles, but we can’t time exactly when they will burst (see EMH above).

Easterly ends his guide by suggesting,

So please tell your subjects in poor countries to keep studying basic mainstream economics. This economics not only survived the crisis, it also is the proven set of ideas that get countries out of poverty.

Well said that man.

Just for fun: the theory of the firm 4

One of the standard approaches to the theory of the firm today is the property-rights view of the firm associated with the work of Grossman and Hart (1986), and Hart and Moore (1990). What is important in these papers is the ownership of, or (residual) control over, non-human assets. Such control generates the indirect influence that a "boss" has over his workers. Note that human capital is assumed to be inalienable. The influence the "boss" has, is due to him owning and controlling the physical assets which are important to the workers' productivity.

First up an obvious question is, What does the 'ownership' or 'control' of a physical asset entail? The Grossman/Hart/Moore approach borrows from the transaction-cost literature the ideas that contracts are typically incomplete: there are always unforeseen states of nature - or certain actions, such as making specific investments - that cannot be contracted upon. This in turn arises the question: Who decides how physical assets should be used in uncontracted-for eventualities? This is how ownership is defined. An owner of an asset has residual control rights, to use the asset in any way he sees fit except to the extent that particular usages have been specified in some initial contract. In particular, an owner of an asset has the right to deny access to anyone else.

This brings us to the issue of a definition of a firm. A firm is identified with the collection of physical assets over which the owner - the boss - has the residual control rights. Note that the boss exerts authority over workers because, in the event of a dispute, the boss can deny the worker access to important non-human assets. Moore (1992: 497) explains the importance of this,

I am going to show that if an agent does not own an asset, then his actions will depend on who does own it. For example, it will matter to the workers of a firm if their firm is taken over by another firm. The costs and benefits of integration can be understood primarily in terms of the (aggregate) effects on the incentives of the workers of the firms involved.

A simple example from Moore (1992) will help show this.

Suppose there is just one asset, a luxury yacht. There are three agents: agent 1, a chef; agent 2, a skipper; and agent 3, a tycoon. At date 1, agents 1 and 2 provide agent 3 with a service, gourmet seafare. We consider three models, with increasing degrees of complexity:

Model A. For the service to be useful, at date 0 the chef must take an action - say the preparation of a particular cuisine. This is a private effort decision, and cannot be contracted over. No other yachts are sailing nearby; hence the action is nontransferable. There are many other (potential) skippers at date 1; that is, agent 2 is dispensable. However, the tycoon is indispensable (only he can afford to fly to these waters). The cost to the chef of his action equals 100. The benefit to the tycoon equals 240. Finally, transactions costs prevent the writing of any long-term contracts at date 0.

So the question is, Will the chef take his action? Note that the action is socially efficient, since 240>100. The answer depends on who owns the yacht, the main non-human asset. If either the chef or the tycoon owns the yacht, then the date 1 (gross) surplus of 240 will be bargained over and split between the two of them, since each of them is crucial to the generation of the surplus (the chef has to provide the meal, and the tycoon is the only customer). Moore assumes that bargaining leads to both parties getting a half share, i.e., 120. The skipper receives none of the surplus, since he is dispensable. Since the chefs anticipated private return of 120 at date 1 exceeds his private cost of 100, he will take his action at date 0.

The other possible owner is the skipper. If he owns the yacht, then the surplus must be divided among all three of them (now the skipper is important, by virtue of his controlling access to the crucial asset). Here Moore assumes that three-way bargaining leads to each party getting a third, i.e., 80. Anticipating a private return of only 80 at date 1, the chef will not take his action at date 0 given that the cost is 100.

From this, one important point should be noted. The chef is more likely to take an action specific to the tycoon if the tycoon is his boss than if the skipper is his boss. A worker puts more weight on his boss's requirements than on someone else's. An employer indirectly gains 'authority' over an employee as a result of owning an important asset.

Model B. Modify Model A so that at date 0, the skipper also has an action-say to learn the history of the local islands to plan a better itinerary. Assume that the chef as well as the skipper is dispensable. The cost to the skipper of his action equals 100. The additional benefit to the tycoon equals 240. (So if both the chef and the skipper take their respective actions, there will be a total surplus of 480 to divide.)

In this case the question becomes, Will the chef, the skipper, or both take their respective action? Applying the same logic as in Model A, we can conclude:

	Chef's share of his 240	Chef act?	Skipper's share of his 240	Skipper act?
Chef owns yacht	120	Yes	80	No
Skipper owns yacht	80	No	120	Yes
Tycoon owns yacht	120	Yes	120	Yes

The main result that can be seen from Model B is that when both the chef and skipper take actions specific to the tycoon, it is strictly better for the tycoon to own the yacht. That is, it may be efficient to give ownership of assets to agents who are indispensable even though they make no important effort or investment decisions.

Model C. As Model B, except that now the yacht comprises two pieces, the galley and the hull. These are strictly complementary, in that one is useless without the other. Also modify Model B so that the chef and skipper's actions are no longer specific to this tycoon; he too is dispensable. Finally, suppose that at date 0 the tycoon also has an action - say wooing business people to attend dinner parties aboard the yacht. The cost to agent i of his own action equals ci (i=1,2,3). The benefit of each agent's action to the tycoon equals 240 (making a total potential gross surplus of 720).

In this case Moore compares non-integration, that is, the chef owns the galley, and the skipper owns the hull with integration, that is, the chef owns the entire yacht (both galley and hull).

Applying the logic of Model A to this cases results in:

	Chef acts iff	Skipper acts iff	Tycoon acts iff
Integration	c1<=120	c2<=120	c3<=80
Non-integration	c1<=240	c2<=120	c3<=120

Moore (1992: 499) writes,

For example, under nonintegration, for the tycoon to enjoy the additional 240 (gross) surplus arising from his own action, he must bargain with both the chef and the skipper since they each own a piece of the yacht. Accordingly, the tycoon's private return will be only 80. However, if the chef owned the entire yacht (integration), the tycoon would only need to bargain with one owner, and would obtain a private return of 120. Notice that the skipper's incentives to act are not diluted by losing control to the hull of the chef. The reason is that under nonintegration, the skipper has to bargain with the chef anyway (who owns the strictly complementary asset, the galley), and so it makes no difference to the skipper's incentives that the chef owns both pieces. The conclusion from Model C is that giving both pieces of the yacht to one agent (the chef in this case) leads to fewer hold-ups and greater efficiency. That is, assets that are strictly complementary should be owned together.

Importantly what Model C suggests to us is that complementary assets should be owned together, that is they should be integrated to form a single firm. A general proposition to this effect appears in Hart and Moore (1990: Proposition 8). There is a corresponding proposition, Hart and Moore (1990: Proposition 10), which tell us that asset that are economically independent should be owned separately owned, that is, they should not be part of a single firm. This is simply because from the viewpoint of the workers of the firm which has be bought, integration would amount to little more than bringing in an 'outside' owner who does nothing but dilute the incentives they face. This, then, means we have an explanation for the U-shaped average cost curve. Firms initially have increasing returns (stemming from the coordination of complementary assets) and then decreasing returns (stemming from the loss in incentives from outside control) - i.e. we have a theory for ,the optimal size of a firm based on transactions and technology.

Moore (1992: 500-1) makes a few comments on the theory developed above.

First, great emphasis is placed on ex ante (date 0) inefficiencies - i.e., underinvestment. We believe, however, that we may be picking up some of the same effects as one might obtain in a model in which there were ex post inefficiencies - due to the difficulty of striking bargains at date 1, particularly in a multilateral context such as this. For example, as in Model B, an agent who is crucial to the generation of ex post surplus (the tycoon) should have control rights, because agreement has to be reached with him anyway, so why increase the number of agreements necessary by giving control rights to others? It would be highly desirable to analyse the consequences of ex post inefficiencies in a systematic manner.

The next comment is related. The theory has no discussion of coordination, or information flows, at date 1. A boss never has to tell a worker what to do; the worker simply figures it out for himself. Equally, there is no discussion of hierarchy and delegation of decision making. A very important topic for future research is to extend the model to incorporate coordination, hierarchy and delegation.

Finally, the theory assumes that there is a date 0 market for assets which works perfectly, and that there are no wealth constraints. For example, in Model C, if the chef arrived at the date 0 market owning the galley, and the skipper arrived owning the hull, what would happen if the chef did not have the cash available to buy the hull? Remember, it is efficient for the chef to own both the galley and the hull,' so it is tempting simply to say that the chef borrows the money from a bank. But what security can the bank be offered in a world in which the chef has no resources except for his human capital - which, we have argued, is inalienably his?

References:

• 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) August: 691-719.
• Hart, Oliver D. and John Moore (1990). 'Property Rights and the Nature of the Firm', Journal of Political Economy, 98(6) December: 1119-58.
• Moore, John (1992). 'The Firm as a Collection of Assets', European Economic Review, 36(2-3) April: 493-507.

Horwitz on the family, love and choice

In his interview from The Motorhome Diaries, Steve Horwitz discusses topics such as the family, love, choice, and independence in relationship to free markets.

USPS v's kiwifriut

Justin Ross at The Perfect Substitute blog has a post comparing the United States Postal Service to kiwifruit grown here in New Zealand. No, it wasn't an obvious comparison to me either. Read the posting here.

Fairtrade?

Patrick Hayes writing at spiked says Sorry, but Fairtrade is a political issue. Hayes writes,

But what ‘support’ do communities in the developing world receive as a result of all this Fairtrade business in Britain and elsewhere in the West? The idea is that Fairtrade-stamped products only use ingredients that are created and traded fairly in the developing world. Yet in 2005, the youth education charity WORLDwrite produced a film called The Bitter Aftertaste, which highlighted the severe limitations of the Fairtrade movement. The Fairtrade movement has no policy on mechanisation in farming, for example, and its restrictions on the use of pesticides in any product from the Third World that it licenses means that many Africans are locked into back-breaking cheap labour as they cull weeds by hand rather than being able to destroy them with chemicals.

In The Bitter Aftertaste, Alex Singleton of the Adam Smith Institute highlighted the tendency of those involved in the Fairtrade movement to believe that ‘there’s something romantic and attractive about agriculture’. Actually, Singleton argued, the Fairtrade movement squanders labour, locking workers in developing countries into labour-intensive methods of farming: ‘In Guatemala you have 500 people producing the same amount that in Brazil five people are able to produce.’ (10) It is this unproductive labour, the use of primitive forms of technology and no fertilisers, which makes the end product, ‘natural’ and ‘fair’, desirable to some Western consumers.

As well as encouraging certain forms of farming, the Fairtrade industry in the West keeps parts of the developing world in a non-diversifying, non-developing straitjacket. The Economist has pointed out that if there is a price guarantee on Fairtrade goods, then there is little incentive to diversify or move on amongst poor Third World communities. Indeed, the salary increases for Third World farmers if they adopt Fairtrade methods – which are very small salary increases, but nonetheless desirable for already very poor farming communities – encourage farming communities always to focus on producing the same thing, with the same methods, rather than to venture into other forms of agriculture or grow other crops (11). The Fairtrade Foundation says it ensures the ‘sustainability’ of small, local industries in the developing world – yes, but largely by taking away any incentive to grow and do farming differently.

Furthermore, as The Economist observes, ‘[Fairtrade] certification is available only to co-operatives of small producers, who are deemed to be most likely to give workers a fair deal when deciding how to spend the Fairtrade premium’. Small, for the Fairtrade Foundation, is beautiful. Indeed, rather than looking for ways to increase large-scale production of crops in order to mitigate future food shortages, like those we saw last year, the future, according to the Fairtrade Foundation report The Global Food Crisis and Fairtrade: Small Farmers, Big Solutions?, is small. As Harriet Lamb, CEO of the Fairtrade Foundation, said: ‘We’re calling on all major players to put smallholders at the heart of their agricultural policies.’ (12) This militates against any collectivisation of labour power or shift towards large-scale production – the kind of developments that occurred in Western nations more than a hundred years ago and upon which modern societies are largely built.

The breakdown of the Fairtrade Foundation’s expenditure is telling. In 2008, it spent £2,128,000 on ‘public education and awareness’, more than it gave to producer and product support (13). This sums up what Fairtrade is really all about: educating the public and making us feel better rather than significantly changing conditions in the developing world. As one Fairtrade slogan puts it: ‘Good Coffee, Good Feeling.’ Fairtrade is really about flattering Western consumers, making us feel like we are making a difference; as one newspaper put it when Cadbury’s announced it was going Fairtrade: ‘Good news: eating bars of Dairy Milk is no longer greedy – it’s snacking with a social conscience.’ (14)

That's what Fairtrade is really about, giving a bunch of rich Western consumers a whole lot of warm fuzzes. To hell with what it does to the third world.

University administrators: born or made?

At the Organizations and Markets blog, Nicolai Foss writes,

In “Congratulations or Condolences? The Role of Human Capital in the Cultivation of a University Administrator” (here; scroll down), John McDowell, Larry Singell, and Mark Stater argue that this also holds for universities. They develop and test a probit model of the decision between administration (from dept. head all the way to university pres.) and the pure academic career. The model is conditioned by training, career background, and (juicy!) academic performance. The data are drawn from the American Economic Association directories. Among the findings: economists with doctoral degrees from less prestigious universities are more likely to select into admin. Women and foreigners are less likely to become administrators. The experience level also positively influences the probability of getting into admin.

I am not convinced that the authors truly capture the specialized versus general human capital dimension. Some of their measures (e.g., whether the PhD degree was awarded by a top-35 PhD institution or not) are measures of quality rather than of the degree of specialization (in fact, this may be consistent with the view that many “pure” academics hold of admins!). Nevertheless, definitely worth a read and good ammo for harassing your local dean!

Harassing your Dean? What about your Head of Department?!! Much more fun.

The abstract of the paper reads:

Administrative skill is essential to organizational effectiveness. Yet, few studies examine how human capital investments over a career affect selection into administration. We use panel data for economists to estimate the probability of choosing administration over a pure academic track. The results show that, while research-specific human capital reduces the probability of becoming an administrator, general human capital increases it. There are also inferior administrative opportunities for women that have not improved over time and variation in the role of human capital according to institutional research mission. Thus, our results suggest academic leaders are not merely born, but cultivated through their human capital investments.

Oil speculators lower the price of oil

From the Fortune Investor Daily

If Congress or the CFTC forces through stiff curbs on futures trading by so-called "speculators" -- i.e. investors who use futures to bet on future price movements but don't buy actual oil -- it may lead to higher, not lower, oil prices over the long term.

Why? Imagine you're an oil company CEO thinking about drilling a new oil well that won't produce until 2011. Given the high upfront costs of drilling, you're going to be more likely to undertake the project if you can use the futures market to lock in oil prices in 2011 that will justify your drilling costs. The buyer on the other end of your futures trade is probably an investor -- someone who will commit to paying you $75 a barrel for oil in 2011 because he believes actual price in 2011 will be even higher.

However, if fewer investors are allowed to take the other side of your trade, you will have a harder time locking in a good price for your 2011 oil. That could make it harder for you to justify the upfront cost of building the new well. Less investment in new oil wells means less future supply, and less supply means higher oil prices.

Strange uses for economics textbooks ...

This from Megan McArdle:

But the fact that he mistakes his ignorance for a fact about the universe makes me wonder if pharmacoeconomics is what my college boyfriend's roommate used to do with a few grams of cocaine and a copy of Mankiw's Principles.

The impact of wage subsidies

An interesting post from Economic Logic on The impact of wage subsidies

Several European countries, including Germany, have wage subsidies to encourage employer to hire unemployed workers. While there is no doubt that, at the margin, this can reduce unemployment, the real question is whether those hired with a subsidy also stay employed after the subsidy expires, and have longer employment spells than those hired without a subsidy.

Gesine Stephan looks at the German case and finds the subsidy works in the sense that after 3.5 years the cumulated wages are higher for the subsidized workers. But does it work well enough to justify the cost of the subsidy. On average, the subsidy amounts to €2500 to €3000. This results in cumulative wages increased by €2200 to €5000. Is this worthwhile? First, this generates more tax and social security income, second, less needs to be spent on unemployment insurance. In a carefully worded appendix, Stephan argues it looks like wages subsidies are fiscally beneficial at least to a first approximation. While this result is subject to all sorts of qualification, I am glad that, for once, a cost-benefit analysis of a policy is performed, instead of only showing that something is statistically significant.

One question I would ask is, Given that the subsidy has to be funded out of taxation, does the study take into account the full effects of raising the necessary taxation? After all if you didn't have the subsidy and reduced the tax take by the amount of the subsidy the money would get spent or invested which would also increase employment. Thus does having the subsidy really raise employment more than not having it?

Incentives matter: stimulus file

This from the Wall Street Journal. Given the "right" incentives, one level of government will lobby another level of government to get other peoples' money,

Strapped local and state governments are still spending on at least one activity: seeking stimulus money.

Towns, cities, counties and states across the country spent a total of $21.4 million on lobbyists between April and June, up 2.7% from the first quarter of the year and in line with spending levels through 2008, according to data provided by the nonpartisan Center for Responsive Politics. Almost 1,000 different governments reported paying representatives to pursue their agenda. About a quarter reported lobbying specifically about the stimulus package.

Palmer on alcohol .....

Thanks to the Inquiring Mind for this Tom Scott cartoon,

Do away with the Fed?

That's what George Selgin argues for in an article, End the Fed? A not-so-crazy idea, in The Christian Science Monitor. Selgin writes - note that the Fed as established in 1913,

But consider: the US economy has actually grown less rapidly since 1914 than it did before. And inflation has been much worse, despite both the Civil War, which featured the nation's worst inflation, and the Great Depression, which featured its severest deflation!

What's more, the frequent downturns before 1914 were due, not to the lack of a central bank, but to foolish government regulations. Topping the list were bans on branch banking, initiated by state governments and then incorporated into federal banking law. The bans propped up thousands of undercapitalized and under-diversified banks – banks unfit to survive major local shocks, let alone macroeconomics ones. They also caused bank notes – competitively supplied counterparts of today's Federal Reserve notes – to trade at discounts whenever they traveled far from the solitary offices of banks that issued them.

And here is an interesting comparison - asset currency is the issue of banknotes not secured by government bonds but based on the assets of the issuing banks,

Would asset currency have been any better? Canada's was: Between 1929 and 1933, for instance, 6,000 US banks failed, and a third of the US money stock was wiped out. In contrast, and despite a fixed Canadian-US dollar exchange rate, Canada's money stock shrank by just 13 percent, and no Canadian bank failed.

But the Canadian government had to fix what wasn't broken,

Notwithstanding this superior outcome, the Canadian government itself abandoned asset currency in favor of central banking in 1935, to placate a growing Canadian movement for easy money.

Now, What use is the RBNZ?

Microfinance and commitment contracts

At VoxEU.org, Dean Karlan of Yale University talks to Romesh Vaitilingam about his research programme on microfinance, which uses experimental methodologies to examine what kinds of products work and why. They also discuss his work on ‘commitment contracts’, which people can use to try to modify their own behaviour.

EconTalk this week

Paul Graham, essayist, programmer and partner in the y-combinator talks with EconTalk host Russ Roberts about start-ups, innovation, and creativity. Graham draws on his experience as entrepreneur and investor to discuss the current state of the start-up world and how that world has changed due to improved technology that makes it easier to start a software company. Graham talks about his unusual venture firm, the y-combinator, and how he and his partners work with start-ups to get them ready for more advanced funding. Along the way, Graham discusses why hackers are like painters and how to survive high school.

Health and safety

Strategic asset or strategic blunder?

In the July 2009 issue of Competition and Regulation Times put out by the New Zealand Institute for the Study of Competition and Regulation (ISCR) the question is asked, Kiwirail: strategic asset or strategic blunder? The article summaries an ISCR research paper "The history and future of rail in New Zealand" by Dave Heatley.

My view has, for awhile, been nearer the blunder end of the scale than the asset end. The Times article and the research paper argue along similar lines. Heatley opens his Times article by noting that back in 1999 one of the first projects undertaken by the ISCR was a study of the long-term economic performance of New Zealand railways.

Public rail ownership was characterised by declining performance, beginning in the 1920s and culminating in a very poor prognosis in the 1990s. There were signs that since 1993, privatisation had led to improved productivity and profitability; however, the business was still far from achieving financial sustainability. The ISCR report predicted that private-sector ownership would result in better incentives for productivity-enhancing decision making, but in the long run it was unlikely that in its current form the business would be able to generate returns sufficient to cover the costs of the very large sums of capital employed. Given these facts, a rational private owner would likely rationalise services and reduce the scale of the network to the point where it constituted a sustainable long-run business. Revenues freed up from repeated cycles of historic government-funded capital injections and operating subsidies could then be applied to more productive uses, to the wider benefit of the New Zealand economy.

Given that rail is again in the hands of the government it is timely to re-examine the assumption that government ownership will result in superior long-term outcomes for the long suffering taxpayer owners. Heatley writes

The 2009 analysis reveals little evidence to suggest that overall the economic outlook for rail has improved since 1999. Despite gains in operational productivity, rail's share of the land freight task has declined over the period examined. Profitability has remained poor, suggesting an ongoing lack of competitiveness vis-a-vis other freight modes.

and continues

Rail networks offer benefits from economies of density (increasing use of existing tracks), but not necessarily from economies of size (increasing size of the network).' In a rail network with uneven patterns of use, such as New Zealand's, the economics of density means that the closure of lightly used lines will, in general, improve the overall economic performance of the network.

Importantly Heatley notes that

It proved difficult for private owners to rationalise the size of the network efficiently, due to poorly aligned incentives and political intervention in operational decisions such as exiting from the provision of certain long-distance passenger services.

The retention of land ownership by the Crown at the time of privatisation muted private incentives to rationalise the network as the private operator was unable to access the potential land-sale benefits from closing unprofitable lines. Private-sector owners have been incentivised to persevere with a strategy (originating under public ownership) of retaining otherwise uneconomic lines for their current income-generating potential, but refraining from investing in replacement infrastructure such as sleepers, tracks and bridges.

A return to integrated land, infrastructure and operational ownership resolves the incentive misalignment, enabling its new owners to rationalise network infrastructure efficiently. Yet perversely, extensive recapitalisation has followed re-nationalisation. The government has invested $2.9 billion in rail since 2002, and has committed a further $0.9 billion through to 2013. It is unlikely that the government will earn a reasonable financial return on this investment, as the strong incentives of private owners for ongoing productivity improvements will likely be muted under government ownership, and the scope for political intervention in strategic and operational activities has increased.

The consequences of political intervention are evidenced in the targets set for a modal shift from road to rail freight in the New Zealand Transport Strategy. Any increases in rail freight's share must ultimately come from substitution at the margins away from competing transport modes. Extensive competition from both road and sea freight restrains the ability of rail to set prices. Rail exhibits few apparent cost advantages, even with subsidies from the written-off opportunity cost of capital. So modal shift can only be driven by increasing the level of subsidies in order to lower prices artificially and therefore induce movement of marginal freight away from more efficient road and sea freight. Such shifts will be to the detriment of the overall economic performance of the transport sector and the wider New Zealand economy.

There is little evidence that the real costs of the current government ownership and investment strategy have been adequately assessed in terms of foregone benefits in other taxpayer-funded areas, such as health and education.

After this, an obvious question to ask is, Is there light at the end of the tunnel? Heatley comments,

The 2009 analysis confirms that the issues identified in 1999 still remain, and are unlikely to be addressed by recent changes in governance, ownership and policy direction. Yet rail still remains a viable transport medium for those segments to which it is intrinsically well-suited - long-haul carriage of heavy, bulky freight (coal, logs, manufactured goods, etc.) and high volume urban commuter services. The challenge for rail's new owners is to find a viable subset of the current rail network. Given current and projected freight and passenger types and volumes, it appears a viable subset exists at around 1500-2000 kilometres in length - less than half the present size. Line closures and land sales could fund upgrading of the core network to 21st-century standards.

So, rail makes sense for a small portion of the current network. However I can't see the changes in government policy and public perceptions need for rationalisation of the network coming to pass any time soon. So the taxpayer gets stuck with yet another white elephant.

Incentives matter: natural resources file

Many poor countries are suffer from corruption, low human capital and an economy mostly based on natural resources. Iván Aldave and Cecilia García-Peñalosa put forward the argument that the "blessing" of natural resources gives the wrong incentives: why get educated when the soil is rich without effort? This results in low human capital for natural resource rich countries. This is something we already knew, see for example how rich, countries without natural resources can become, eg Japan. So we have a link between natural resources and human capital.

But the paper goes on to argue for a link from natural resources to corruption. This is more intriguing. Natural resources are generally state owned, thus more prone to rent seeking than, say, manufacturing. The more natural resources, the more you want to invest in political capital to the detriment of other forms of capital. Again, the wrong incentives.

(HT: Economic Logic)

Happy birthday Milton

Another birthday I missed. The late, great Milton Friedman was born on the 31st July 1912.

(HT: Cafe Hayek)

Just for fun: the theory of the firm 3

In a previous post on the 'reference point' approach to the theory of the firm, Just for fun: the theory of the firm 2, it was noted that

The behavioural assumptions on which the analysis is based are undoubtedly strong, and although they are broadly consistent with a number of ideas in the behavioural economics literature, there is no single model or experiment that appeal can be made to that supports precisely what is done.

It turns out there is some experimental evidence to support 'what is done'. In particular there are two papers which look at aspects of the 'reference point' approach to incomplete contracts which underlies the approach taken to the theory of the firm.

The first of these paper is Contracts as Reference Points – Experimental Evidence by Ernst Fehr, Oliver Hart, and Christian Zehnder, Working Paper, November 2008. The abstract reads,

In a recent paper, Hart and Moore (2008) introduce new behavioral assumptions that can explain long term contracts and important aspects of the employment relation. However, so far there exists no direct evidence that supports these assumptions and, in particular, Hart and Moore’s notion that contracts provide reference points. In this paper, we examine experimentally the behavioral forces stipulated in their theory. The evidence confirms the model’s prediction that there is a tradeoff between rigidity and flexibility in a trading environment with incomplete contracts and ex ante uncertainty about the state of nature. Flexible contracts – which would dominate rigid contracts under standard assumptions – cause a significant amount of shading on ex post performance while under rigid contracts much less shading occurs. Thus, although rigid contracts rule out trading in some states of the world, parties frequently implement them. While our results are broadly consistent with established behavioral concepts, they cannot easily be explained by existing theories. The experiment appears to reveal a new behavioral force: ex ante competition legitimizes the terms of a contract, and aggrievement and shading occur mainly about outcomes within the contract.

The second paper is Contracts, Reference Points, and Competition—Behavioral Effects of the Fundamental Transformation by Ernst Fehr, Christian Zehnder and Oliver Hart, Journal of the European Economic Association, April–May 2009 7(2–3): 561–572. The abstract reads

In this paper we study the role of incomplete ex ante contracts for ex post trade. Previous experimental evidence indicates that a contract provides a reference point for entitlements when the terms are negotiated in a competitive market. We show that this finding no longer holds when the terms are determined in a non-competitive way. Our results imply that the presence of a “fundamental transformation” (i.e., the transition from a competitive market to a bilateral relationship) is important for a contract to become a reference point. To the best of our knowledge this behavioral aspect of the fundamental transformation has not been shown before.

Heterogeneous resources and the financial crisis

Rajshree Agarwal, Jay B. Barney, Nicolai J. Foss and Peter G. Klein have a new paper, "Heterogeneous Resources and the Financial Crisis: Implications of Strategic Management Theory", that discusses the financial crisis and the policy response to it from the perspective of strategic management theory that focuses on the heterogeneity of capital and labour resources within the firm. They discuss why the bailouts and other policy responses won't work due to them being at a too high a level of aggregation. There are a number of citations to the relevant Austrian literature. The abstract reads:

Macroeconomic theory assumes that factors of production in the economy are homogeneous and fungible. As a result, it is poorly suited for analyzing and developing policy responses to the recent financial crisis. Theories of strategic management and organization, with their emphasis on heterogeneous resources and capabilities, are better positioned. We provide examples of how macroeconomic theory may lead policies astray, and how theories of strategic management provide insight into the nature and causes of the financial crisis and the appropriate policy response.

(HT: Steve Horwitz)

Interesting blog bits

1. Seamus Hogan asks Oh Treasury, Why Hast Thou Forsaken Us? A good question given this statement: "Within existing constraints then, the best proxy for a progressive Pigouvian tax is an alcohol excise that equates to the net costs of the consumption of alcohol for society as a whole."
2. Eric Crampton on And further on price elasticity. Relative elasticities matter. Heavy drinkers are less price sensitive than moderate drinkers. Just don't tell Brian Easton.
3. Claude Barfield on Presidential leadership and trade. Six months into his presidency, Barack Obama has failed to grasp the nettle on trade and investment policy. Barfield argues Obama has been weak and indecisive in the face of deep divisions within the Democratic Party over international economic policy. His deference to Congress has resulted in poor policymaking.
4. BK Drinkwater on Murphy's Law And The Perception Of Media Bias. Bias is in the eye of the reader?
5. Willem Buiter asks Should Fed chairmen go around kissing babies? Central bank governors should serve one non-renewable term. An interesting idea.
6. Tyler Cowen has a few Sentences to ponder. "The collective optimization of individual driving routes by drivers using realtime traffic maps slows everyone down."

Just for fun: the theory of the firm 2

Having tried to outline aspects of some of the new thinking on the theory of the firm in the posting Just for fun: the theory of the firm, I want, in this post, to look, briefly, at some of the problems with the 'reference point' approach to the firm and some extensions of this work. First lets note one advantage of the reference point approach. It gets round some foundational weaknesses of the standard incomplete contracts theory. In particular a benefit of this approach is that we are able to avoid (and with luck go beyond) the 'Maskin-Tirole' foundational critique of models of incomplete contracts (see Maskin and Tirole (1999)).

However, to do so it is necessary to introduce a number of somewhat ad hoc features. Let us take a quick look at some of the behavioural assumptions that could - and should - be refined and relaxed. The 'reference point' model has a number of "black box" behavioural features. The behavioural assumptions on which the analysis is based are undoubtedly strong, and although they are broadly consistent with a number of ideas in the behavioural economics literature, there is no single model or experiment that appeal can be made to that supports precisely what is done. These strong and ad hoc assumptions have to do with entitlements, self-serving biases, and shading behaviour. The important point here is that these have not been derived from first principles. Opening up the behavioural black box and showing that these assumptions are consistent with utility-maximizing behaviour is a must for future research.

The reference point approach - here I'm thinking in particular of Hart (2009) - helps understand the advantages of vertical integration. The model, where costly hold-up typically occurs with positive probability under uncertainty, seems relevant for understanding the costs of nonintegration and why vertical integration - interpreted here as a transfer of assets - can help. But it is less clear that Hart's model can be applied directly to understand the costs of integration.

Another issue that needs additional research is the internal make-up of the firm and why authority is used to resolve disagreement rather than, say, bargaining between the parties. The literature on the theory of the firm based around incomplete contracts and firm boundaries (not discussed here) has supposed that ex post efficiency is achieved through bargaining. Obviously in many cases this is not the case and problems such as hold-ups and other disagreements are often resolved by parties exercising their rights to make decisions, that is, by authority.

There is a recent paper, Hart and Holmstrom (2009), in which a model is developed, based on contracts as reference points and aggrievement, in which authority has a central role. The paper considers two units that have a horizontal or lateral relationship. The units take decisions that affect each other; for example, they may be deciding on whether to adopt a common standard. Each decision is ex ante non-contractible but ex post contractible. The 'boss' has the right to make the decision; however, aggrieved parties may shade. Each unit generates two kinds of benefit: monetary profit, which is transferable with ownership, and private benefits of managers and workers, which are non-transferable. Hart and Holmstrom show that non-integrated firms fail to account for the external effects that their decisions have on other firms. An integrated firm can internalize such externalities, but it does not put enough weight on private benefits. They also show that the aggrievement assumption introduces a friction that permits an analysis of delegation.

References:

• 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 (2009). 'A Theory of Firm Scope', Working Paper, July 13.
• Maskin, Eric and Jean Tirole (1999). 'Unforeseen Contingencies and Incomplete Contracts,' Review of Economic Studies, 66: 83–114.

Just for fun: the theory of the firm

In a posting over at TVHE Matt Nolan discussed the The basic frame of a firm: Cournot. In the comments to this post I said,

[...] that the standard perfectly competitive, oligopoly and monopoly models don’t have firms in them, they are more models of industries rather than models of firms. This follows from Coase 1937. As Martins Rickets put it “If market transactions were costless there would be no rationale for firms”. In other words, in a model with zero transaction costs, which the standard models are, firms need not exist. Production takes place over the market since it is costless to organise it that way.

Thus for a theory of the firm to make sense in terms of a theory of a definite organisational entity, you need to deal with a positive transaction cost world and move away from the first and second year textbook discussion of the firm. There is now a well known literature which does this, most of which originates from Coase (1937). So for fun I thought I would discuss some new ideas to do with the firm, in particular those ideas based around recent work by Oliver Hart concerning 'reference points' and the theory of the firm. This work by Hart is in turn based on joint work between Hart and John Moore.

One obvious question for the theory of the firm is where is the boundary between markets and firms. Or when are transactions carried out via the market (using an independent contractor) or carried out 'in house' (within a firm using an employment contract)? It is this question that the discussion below addresses.

The basic ideas underlying the 'reference point' approach to the firm can be gathered from a simple example based on Hart (2008). 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 been '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, see Figure 1 below. 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.

Figure 1

Date 0..........................................................................Date 1
|----------------------------------------------------------------------------------|

Parties meet.................................................................Lecture given

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 $5\theta$, where $\theta$ 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 $5\theta$.

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 $10\theta$ due to the shading activities of each party. This reduces the value of the relationship between $S$ and $B$ from $10$ to $10-10\theta=10(1-\theta)$.

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 $5\theta$ to $4\theta$, since $S$ will now feel less aggrieved, but it will also increase $B$'s shading from $5\theta$ to $6\theta$, since he now feels more aggrieved. Total deadweight loss does not change, it remains at $10\theta$. 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 not 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 with values and costs as given in Case 2.

Case 2 gives the payoffs and costs of each lecture. Lecture 1 has a value of 20, costs of 10 giving a surplus of 10. Lecture 2 has a value of 14, costs of 8 giving a surplus of 6.

So 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. 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. That is $S$ has the residual control rights.

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 $6\theta$. Total surplus in this case will be $6-6\theta$.

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 shape by enough to reduce $B$'s payoff by $2\theta$. Total surplus is therefore $10-2\theta$.

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 chose the lecture. Second, and related, $S$'s aggrievement is low since she doesn't care very much.

Hart now changes the numbers in Case 2 to create Case 3.

Case 3, again, gives the payoffs and costs of each lecture. Lecture 1 has a value of 20, costs of 10 giving a surplus of 10. Lecture 2 has a value of 14, costs of 2 giving a surplus of 12.

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 $10-8\theta$. If $S$ is an independent contractor, lecture 2 will be chosen resulting in a total surplus of $12-6\theta$.

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

One 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 [Case 2] the parties would agree on method 1; however, since there are 10 dollars of surplus to argue over, shading costs equal $10\theta$: net surplus $= 10(1-\theta)$, which is less than that obtained under the employment contract. In [Case 3] there are 12 dollars of surplus to argue over and net surplus $= 12(1-\theta)$, which is less than that obtained under independent contracting. (Hart 2008: 409.)

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 tradeoff at the heart of Coase (1937).

References:

• Coase, Ronald Harry (1937). 'The Nature of the Firm', Economica, n.s. 4 no. 16 November: 386-405.
• Hart, Oliver D. (2008). 'Economica Coase Lecture: Reference Points and the Theory of the Firm', Economica, 75(299) August: 404-11.
• Hart, Oliver D. and John Moore (2008). 'Contracts as Reference Points', Quarterly Journal of Economics, 123(1) February: 1-48.