Rational smoking

For non-economists the idea of rational addition seems weird but there is data that supports the theory. From the Economic Logic blog comes this discussion of the effects of smoking bans on smokers: it makes some of them worse off.

Timothy Hinks and Andreas Katsaros provide some evidence that could further validate the rational addiction theory by looking at public smoking bans in England, Wales and Northern Ireland. Using the British Household Panel Survey, which includes questions about happiness and smoking, they find that those who reduced their smoking show no change in happiness compared to those who did not change their smoking. But once public smoking bans were imposed, those who reduce smoking, in particular heavy smokers, exhibit decreases in happiness. In other words, they were forced to reduce smoking by being chased away from public places, and feel worse for it. That is consistent with the rational addiction theory in that imposing an unanticipated constraint makes people worse off.

A message from your friendly tax department

(HT: Turbulence Ahead.)

I am confused, again (updated)

According to this news report:

A new study by Canterbury University's GeoHealth Laboratory showed fast-food outlets were 5 1/2 times more likely to be clustered around schools than other areas and three times more likely to be in poorer areas than rich.

and

Day studied the clustering of fast-food and convenience stores around schools in Christchurch, North Shore, Waitakere, Lower Hutt and Wellington.

So do fast-food outlets cluster around schools or do schools cluster around fast-food outlets or is some other factor causing the clustering? An example of the last point would be that both schools and fast-food outlets occur in areas of high population density. And how did the researchers check for causation?

And as for the fact that fast-food outlets more likely to be in poorer areas than rich, could this be because their food is cheaper? 5-star restaurants in poor areas may be nice but it seems unlikely that there would be enough demand to keep them going.

And if there is a "childhood-obesity epidemic sweeping the Western world" (proof?) whose job is it to bring up the kids with sensible eating habits? The fast-food manger or the parents? The problem here may not be the distribution of fast-food outlets but rather the parents teaching of their kids.

Update: Kiwiblog comments here, Eternal Lacking here. This comments makes the point that may be rents are lower in poor areas which may attract fast food type business.

Why China missed the industrial revolution?

It should be obvious that China has been one of the world's most dynamic economies in recent decades, but why did it need to play catchup with the west. How did China fall so far behind Europe in the first place? This column at VoxEU.org argues that the industrial revolution occurred in Europe rather than China because European entrepreneurs were eager to adopt machines to cut down on high labour costs. China didn’t “miss” the industrial revolution – it didn’t need it.

Jan Luiten van Zanden writes on "Before the Great Divergence: The modernity of China at the onset of the industrial revolution". He argues

The industrial revolution was a process of mechanisation in which expensive labour was substituted for by machines driven by coal – as Bob Allen (2009) has demonstrated. Chinese factor costs were not at all conducive to such a change.

Whereas entrepreneurs in Europe were very eager to develop new technologies that increased labour productivity via the capital-labour ratio, Chinese businesses barely had any incentive to do so. That the industrial revolution emerged in England was therefore not accidental or the result of luck, but the long-run effect of its fundamentally different factor prices, reflecting its different economic and institutional trajectory.

Can't help but think that the likes of Joel Mokyr may say there is more to it than this.

• Allen, Robert C (2009), The British Industrial Revolution in Global Perspective, Cambridge University Press.

Capitalism v. communism: the Korean peninsula example (updated)

The cool picture below comes from a posting by Laura Freschi at the Aid Watch blog. The idea is that the amount of light that can be seen from outer space acts as an interesting proxy for GDP growth. See the NBER working paper, Measuring Economic Growth from Outer Space by J. Vernon Henderson, Adam Storeygard and David N. Weil for details.

The picture shows the Korean peninsula in 1992 and 2008. It highlights the very dramatic contrast in long term growth, as measured by light, between North and South Korea, and gives a picture of how quickly South Korea has developed over the last two decades and the south's growth relative to the north.

Update: Tim Worstall got here first, he thinks Economists Are Beginning to See the Light.

Krugman v's Krugman

Paul Krugman recently wrote in the New York Times that,

It’s true that we’d have more jobs if we exported more and imported less.

But is this the same Paul Krugman who wrote,

It should be possible to emphasize [...] that the level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with microeconomic policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency, not in terms of phony numbers about jobs created or lost.

The trade economist Douglas Irwin has this to say on the matter of trade and jobs,

The claim that trade should be limited because imports destroy jobs has been around at least since the sixteenth century. And imports do indeed destroy jobs in certain industries: [...]

But just because imports destroy some jobs does not mean that trade reduces overall employment or harms the economy. [...]

Since trade both creates and destroys jobs, a frequently asked question is whether trade has any effect on overall employment. Unfortunately, attempts to quantify the overall employment effect of trade are I exercises in futility. This is because the impact of trade on the total number of jobs in an economy is best approximated as zero.

So who's right? The first Krugman seems to want to say that the number of jobs does depend on international trade while the second Krugman (and Doug Irwin) seems to want to say that the number of jobs doesn't depend on trade. They can't both be right. So is it Krugman or Krugman who's right? Does Krugman know?

I'm confused

According to the University of Otago,

Scientists at the University of Otago have found that regular consumption of school milk significantly reduced the risk of bowel cancer in adulthood. (emphasis added)

So if you drink milk at home it has no effect?

Incentives matter: rational crime file

Mark Perry at Carpe Diem writes,

Paul Kedrosky reported yesterday that copper thefts are rising again, due to the all-time record high prices in recent months.

Copper prices were US$1.40 per pound at the end of 2008 and are now approaching US$4.50 per pound. Perry continues,

According to a Google News search, there have been 545 news stories in just the last week containing the phrase "copper theft," and that compares to 665 stories during the entire year of 2009 when copper prices were between $1.50-$3.00 per pound, and 1,750 stories last year as prices rose above $4 per pound by the end of the year.

So even criminals respond to incentives.

Thoughts on the firm

Eric Crampton points me to this piece by Kevin Dick at the Emergent Fool blog on Thoughts on the Theory of the Firm. On a quick read of the posting I noted a couple of things. First,

Thus the standard approach to explaining firms starts with the Transaction Cost theory (typically attributed to Coase). Whenever the cost of a market-based mechanism is higher than a firm-based mechanism, a firm will end up coordinating production. Of course, to anyone who has ever started a new firm or worked any length of time at a large one, this explanation is not terribly satisfying. How do you know the relative costs in the first place and then explain the apparently wasted resources at large companies?

Yes the transaction cost approach is due to Coase, Coase (1937): The Nature of the Firm, to be exact. How do you know the relative costs? The same way you know any costs, you look and see what others are doing and what there costs are and make a judgement as to what you think the relative costs are. This one of the important activities that an entrepreneur undertakes. Second once you have made your decision you put it to the test by actually producing and the market will tell you, via profits or losses, whether your judgement was right. As to the resources wasted in companies, the waste may be more apparent than real but the really important question is one about relative waste. Companies may waste resources but to survive they just have to waste less than the alternative. That is, they just have to be more efficient than either another firm or a market transaction.

The other point I found strange was this:

Typically, economic theory defines a firm in terms of its production function.

Well no.

Ever since the aforementioned Coase (1937) paper the whole point of the theory of the firm is that a firm isn't just a production function. To see a firm as a production function is to suffer from what Oliver Williamson calls "technological determinism", that is, technology is assumed to be uniquely determinative of economic organization. As Williamson (1993: 4) has noted the boundaries of the firm is an issue 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.

As Oliver Hart points out

[t]o put it in stark terms . . . neoclassical theory [production function 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).

Thus the production function tells us little about the boundaries of a firm and so the modern theory of the firm sees the firm as more than just a production function.

EconTalk this week

Steve Fazzari of Washington University in St. Louis talks with EconTalk host Russ Roberts about the economics of Keynesian stimulus. They discuss the stimulus package passed in February 2009 and whether it improved the economy and created jobs. How should claims about its impact be evaluated? What can we know as economists about causal relationships in a complex world? The conversation includes a discussion of the underlying logic of Keynesian stimulus and the effect of the financial crisis on economic research and teaching.

Phillipson on Adam Smith

In this Cato Institute book forum Nicholas Phillipson, Honorary Research Fellow in History, University of Edinburgh, talks about his book Adam Smith: An Enlightened Life. Comment are made by James R. Otteson, Professor of Philosophy and Economics, Yeshiva University, Charles G. Koch Senior Fellow, The Fund for American Studies. The discussion is moderated by John Samples, Director, Center for Representative Government, Cato Institute.

Greg Mankiw's reflections on graduate education

At his blog Mankiw offers his comments on the paper “Completion Rates and Time-to-Degree in Economics PhD Programs” by Wendy A Stock, John J. Siegfried, and T. Aldrich Finegan.

Mankiw writes

This paper is a contribution to an important line of work. As economists, we often remind policymakers that their decisions should be based on objective, empirical research rather than uninformed supposition. Yet when we are the decision makers, as we are when we run our own educational programs, we often have little data-driven analysis on which to base on our judgments. This kind of research should, over time, lead to a better educational system.

I would like to take note of two facts highlighted in this study and to tentatively discuss what they might mean. The first fact is that it is taking longer for students to earn their PhDs in economics. The second fact is that a sizeable percentage of students who start PhD programs do not finish.

It is tempting to interpret these facts as a sign of educational failure. After all, students enter these graduate programs to earn a PhD. If the successful ones are taking longer to finish, and many others are not getting their degrees at all, then it might seem that we are doing something wrong.

But it is far from obvious that these facts are symptoms of a problem. Perhaps longer times to completion and some amount of dropping out are optimal.

Consider time to completion. There is no doubt that economics is still a young science and there is much we do not know. But there is also no doubt that research is continually adding to our stock of knowledge. Perhaps students are taking longer to earn PhDs because there is more for them to learn. It may well be optimal to spend six rather than five years in graduate school before our profession releases students into the world with our highest level of certification.

Another relevant fact is that most students, when they get their first academic jobs, end up at colleges and universities with lower ranked departments than where they earned their PhDs. Why hurry the process of moving to a less vibrant intellectual environment? It may well be better for the professional development of the candidate to spend an extra year or so in graduate school.

Consider now the fact that many students drop out of graduate school without a PhD in hand. While many of these students are disappointed by this outcome, it is likely that in many cases their choice to drop out is optimal. They entered graduate school without fully knowing what it was like and whether it was a good match for them. After a couple of years, they decided it wasn’t. In light of the inherent uncertainty when choosing a path in life, a bit of experimentation is desirable.

My own life is a case in point. When I left college, I was unsure what career path I wanted to take. I therefore enrolled in two graduate programs—the PhD program in economics at MIT and the law program at Harvard Law School—thinking I might finish both. In the end, however, I dropped out of law school after three semesters. Looking back, the decisions to enter and drop out of law school were the right choices. I started because I thought a legal career might be best path for me, and I stopped when I learned it wasn’t.

The question we face as designers of educational programs is how to structure them in light of the longer times that PhDs take and the fact that some students who start these programs may rationally choose not to complete them. The answer may be to divide current PhD programs into two chunks. The first chunk would be a two-year master’s degree focused on taking advanced courses. The second chunk—appropriate for only a subset of master’s students—would be a research degree culminating in the PhD.

Many programs in effect already do that. But the master’s degree is too often viewed as a consolation prize for a PhD dropout. Perhaps we should instead encourage people to view the master’s degree in economics as a fully respectable terminal degree. Moreover, having finished a master’s degree, PhD candidates would be treated as professionals—more like the most junior faculty and less like the most senior students.

Many students leave college wanting to learn a bit more economics. But a PhD may be more than they want or need for their careers. An expansion of master’s programs in U.S. economics departments may offer many students the stepping stone they need.

The fact that it is taking longer for students to earn their PhDs in economics and that a sizeable percentage of students who start PhD programs do not finish are interesting results and I wonder how New Zealand compares to the US in this regard. One explanation for both results would be that the student entering economics PhD program just aren't as good as those students entering other programs, but this should be easy to check.

I do like Mankiw's idea that

The answer may be to divide current PhD programs into two chunks. The first chunk would be a two-year master’s degree focused on taking advanced courses. The second chunk—appropriate for only a subset of master’s students—would be a research degree culminating in the PhD.

The research "chunk" is not needed for many jobs that economists do, so why make students do it? A, say, Master of Economics degree which covers the two years of graduate papers would be attractive and useful for many students who want to work as economists but do not want to be researchers themselves. I'm sure there is market niche here.

Somethings never change

In this book “Adam Smith” (well worth a read) Gavin Kennedy writes

His [Smith's] criticism highlights his common theme about the eighteenth-century Europe: special-interested groups sought political and legal powers to enhance their interests at the expense of the public. Self-interest is not always benign.

I had two thoughts on reading this. First, how does the 18th century Europe differ from any other time or place? Public choice theory, I would think, tells that using political power to enhance ones own interests is the story of all centuries and all places. It would as true today (and tomorrow) as it was in Adam Smith’s time. Second, self-interest is benign, as I’m sure Smith would tell us, in the right institutional framework. In particular competition is the enemy of market power and having government limited to a few key roles so that it cannot provide protection for those who wish to prevent the forces of competition and economic change from undermining their position of privilege is also necessary.

Otteson on Adam Smith

In this brief (around ten minutes) podcast, from the Cato Institute, noted Adam Smith scholar James R.Otteson talks about on Adam Smith as a moral philosopher.

Worth a listen.

I'm all for the division of labour but ......

This is from Physical Review Letters 105, 252303 (2010).

Title: Observation of a Centrality-Dependent Dijet Asymmetry in Lead-Lead Collisions at √sNN=2.76  TeV with the ATLAS Detector at the LHC

Abstract: By using the ATLAS detector, observations have been made of a centrality-dependent dijet asymmetry in the collisions of lead ions at the Large Hadron Collider. In a sample of lead-lead events with a per-nucleon center of mass energy of 2.76 TeV, selected with a minimum bias trigger, jets are reconstructed in fine-grained, longitudinally segmented electromagnetic and hadronic calorimeters. The transverse energies of dijets in opposite hemispheres are observed to become systematically more unbalanced with increasing event centrality leading to a large number of events which contain highly asymmetric dijets. This is the first observation of an enhancement of events with such large dijet asymmetries, not observed in proton-proton collisions, which may point to an interpretation in terms of strong jet energy loss in a hot, dense medium.

Authors: Aad G, Abbott B, Abdallah J, Abdelalim AA, Abdesselam A, Abdinov O, Abi B, Abolins M, Abramowicz H, Abreu H, Acerbi E, Acharya BS, Ackers M, Adams DL, Addy TN, Adelman J, Aderholz M, Adomeit S, Adragna P, Adye T, Aefsky S, Aguilar-Saavedra JA, Aharrouche M, Ahlen SP, Ahles F, Ahmad A, Ahsan M, Aielli G, Akdogan T, Akesson TP, Akimoto G, Akimov AV, Alam MS, Alam MA, Albrand S, Aleksa M, Aleksandrov IN, Aleppo M, Alessandria F, Alexa C, Alexander G, Alexandre G, Alexopoulos T, Alhroob M, Aliev M, Alimonti G, Alison J, Aliyev M, Allport PP, Allwood-Spiers SE, Almond J, Aloisio A, Alon R, Alonso A, Alonso J, Alviggi MG, Amako K, Amaral P, Amelung C, Ammosov VV, Amorim A, Amorós G, Amram N, Anastopoulos C, Andeen T, Anders CF, Anderson KJ, Andreazza A, Andrei V, Andrieux ML, Anduaga XS, Angerami A, Anghinolfi F, Anjos N, Annovi A, Antonaki A, Antonelli M, Antonelli S, Antos J, Anulli F, Aoun S, Aperio Bella L, Apolle R, Arabidze G, Aracena I, Arai Y, Arce AT, Archambault JP, Arfaoui S, Arguin JF, Arik E, Arik M, Armbruster AJ, Arms KE, Armstrong SR, Arnaez O, Arnault C, Artamonov A, Artoni G, Arutinov D, Asai S, Silva J, Asfandiyarov R, Ask S, Asman B, Asquith L, Assamagan K, Astbury A, Astvatsatourov A, Atoian G, Aubert B, Auerbach B, Auge E, Augsten K, Aurousseau M, Austin N, Avramidou R, Axen D, Ay C, Azuelos G, Azuma Y, Baak MA, Baccaglioni G, Bacci C, Bach AM, Bachacou H, Bachas K, Bachy G, Backes M, Badescu E, Bagnaia P, Bahinipati S, Bai Y, Bailey DC, Bain T, Baines JT, Baker OK, Baker S, Baltasar Dos Santos Pedrosa F, Banas E, Banerjee P, Banerjee S, Banfi D, Bangert A, Bansal V, Bansil HS, Barak L, Baranov SP, Barashkou A, Barbaro Galtieri A, Barber T, Barberio EL, Barberis D, Barbero M, Bardin DY, Barillari T, Barisonzi M, Barklow T, Barlow N, Barnett BM, Barnett RM, Baroncelli A, Barr AJ, Barreiro F, Barreiro Guimarães da Costa J, Barrillon P, Bartoldus R, Barton AE, Bartsch D, Bates RL, Batkova L, Batley JR, Battaglia A, Battistin M, Battistoni G, Bauer F, Bawa HS, Beare B, Beau T, Beauchemin PH, Beccherle R, Bechtle P, Beck HP, Beckingham M, Becks KH, Beddall AJ, Beddall A, Bednyakov VA, Bee C, Begel M, Behar Harpaz S, Behera PK, Beimforde M, Belanger-Champagne C, Bell PJ, Bell WH, Bella G, Bellagamba L, Bellina F, Bellomo G, Bellomo M, Belloni A, Belotskiy K, Beltramello O, Ben Ami S, Benary O, Benchekroun D, Benchouk C, Bendel M, Benedict BH, Benekos N, Benhammou Y, Benjamin DP, Benoit M, Bensinger JR, Benslama K, Bentvelsen S, Berge D, Bergeaas Kuutmann E, Berger N, Berghaus F, Berglund E, Beringer J, Bernardet K, Bernat P, Bernhard R, Bernius C, Berry T, Bertin A, Bertinelli F, Bertolucci F, Besana MI, Besson N, Bethke S, Bhimji W, Bianchi RM, Bianco M, Biebel O, Biesiada J, Biglietti M, Bilokon H, Bindi M, Bingul A, Bini C, Biscarat C, Bitenc U, Black KM, Blair RE, Blanchard JB, Blanchot G, Blocker C, Blocki J, Blondel A, Blum W, Blumenschein U, Bobbink GJ, Bobrovnikov VB, Bocci A, Bock R, Boddy CR, Boehler M, Boek J, Boelaert N, Böser S, Bogaerts JA, Bogdanchikov A, Bogouch A, Bohm C, Boisvert V, Bold T, Boldea V, Boonekamp M, Boorman G, Booth CN, Booth P, Booth JR, Bordoni S, Borer C, Borisov A, Borissov G, Borjanovic I, Borroni S, Bos K, Boscherini D, Bosman M, Boterenbrood H, Botterill D, Bouchami J, Boudreau J, Bouhova-Thacker EV, Boulahouache C, Bourdarios C, Bousson N, Boveia A, Boyd J, Boyko IR, Bozhko NI, Bozovic-Jelisavcic I, Bracinik J, Braem A, Brambilla E, Branchini P, Brandenburg GW, Brandt A, Brandt G, Brandt O, Bratzler U, Brau B, Brau JE, Braun HM, Brelier B, Bremer J, Brenner R, Bressler S, Breton D, Brett ND, Bright-Thomas PG, Britton D, Brochu FM, Brock I, Brock R, Brodbeck TJ, Brodet E, Broggi F, Bromberg C, Brooijmans G, Brooks WK, Brown G, Brubaker E, Bruckman de Renstrom PA, Bruncko D, Bruneliere R, Brunet S, Bruni A, Bruni G, Bruschi M, Buanes T, Bucci F, Buchanan J, Buchanan NJ, Buchholz P, Buckingham RM, Buckley AG, Buda SI, Budagov IA, Budick B, Büscher V, Bugge L, 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(HT: Marginal Revolution)

Partial privatisation

Over at his blog Roger Kerr discuses privatisation and partial privatisation in particular. He notes a point made by Phil Barry

... partial privatisation has significant disadvantages compared with full privatisation. Ownership of partially privatised companies is often widely held (outside the government’s stake) and control is not readily contestable; private investors have limited incentive to monitor the company, relying instead on the ‘deep pockets’ of the government to bail out the company if it gets into difficulty; and the company remains open to political interference. Further, governments, as owners, may be unable to agree for long as to why they own the company, thus making it difficult for the company to develop and implement a strategic direction.

The empirical evidence supports the view that partial privatisation is not a desirable long-run state. Most studies indicate that there is no lasting difference between the performance of fully state-owned and partially state-owned enterprises: that is, that full private control is necessary to achieve sustained performance gains.

The kinds of problems that mixed ownership can bring can been seen from the New Zealand experience with the SOEs. While many are not in actual mixed ownership, the pressures that such ownership can bring about can, nevertheless, be seen in our recent history with the SOEs.

The SOE Act states that SOEs, basically, have to be run like normal non-government owned firms. In effect this requirement is the same as you could get if private owners have a stake in a firm. The private owners would, we assume, wish to maximise profits, but the government may not. And you see this with SOEs. The government often wishes to intervene in the running of SOEs to get them to carry out not profit maximising activities, just as it would if it had a partial stake in a mixed ownership firm. This problem of having SOEs (or mixed ownership firms) trying to serve two masters was noted more than 10 years ago by Spicer, Emanuel and Powell in their book "Transforming Government Enterprises: Managing Radical Organisational Change in Deregulated Environments" (The Centre for Independent Studies, 1996). They warned that there are two pressures on SOE's: the first being towards privatisation since the productivity and efficiency gains achieved by SOE are in danger of being eroded over time. Privatisation is a way of both cementing in the commercial orientation of enterprises and wringing out further gains resulting from the high powered incentive and control mechanisms which can be bought to bear in privately owned and publicly traded companies. The second pressure on SOEs is towards being pulled back into the public sector where social and political objectives can be more readily be meet. What we saw under the Clark government was the second of these pressures being very strong. But not for socially useful reasons. Most interventions seem to be more politically motivated.

These pressures would also be there for a mixed ownership firms and help explain why they don't do as well as fully privately owned firms. For example, Aidan Vinning and Anthony Boardman in "Ownership and Performance in Competitive Environments: A Comparison of the Performance of Private, Mixed, and State-Owned Enterprises", Journal of Law and Economics vol. XXXII (April 1989) conclude 'The results provide evidence that after controlling for a wide variety of factors, large industrial MEs [mixed enterprises] and SOEs perform substantially worse than similar PCs [private corporations].' The basic problem is that partial government ownership politicises the firm. We just have to hope we don't see a move in this direction in New Zealand. Full privatisation is the better option.

Why you shouldn't talk to people in the pub

or the staff club. Today I got an email from a guy in the Psychology Department saying that I had talked to him about something in the staff club last month. He assures me that what I said seemed quite plausible at the time - to be honest this may have a lot to do with the amount we had had to drink - and did I want to work on it. And of course I do .... if only I could remember what I had been going on about!

There is a lesson here: either take carefully notes of everything you say at the pub or just don't talk to anyone!

The upside to all this is that I now have to meet the guy again at the staff club to workout what we said the last time we were there. I can see this research taking a very long time .... but being a lot of fun!

EconTalk this week

Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts on some of the common misunderstandings people have about prices, money, inflation and deflation. They discuss what is harmful about inflation and deflation, the importance of expectations and the implications for interest rates and financial institutions.

Here is part of the transcript of the beginning of the interview. It makes some simple but important points about prices changes, inflation and deflation.

Intro. [Recording date: January 10, 2011.] Inflation and deflation. Let's talk about inflation, what is usually meant and what we mean as economists. You asked the right question to begin. The definitions of inflation and deflation have changed over time, and in ways that are significant. The original meaning of inflation was an increase iin the money supply. There are still a few people today who hold out for that definition. I'm much more of a spontaneous order guy when it comes to language--words mean what people take them to mean. In fact, inflation today means, to the average person here, even the typical well-informed professional economist who uses it, not an increase in the money supply, but a sustained increase in the general price level--a sustained increase in average prices. But it's important to remember what inflation originally meant, because there's a connection of course between changes in the money supply and changes in the price level. Similarly with deflation. Deflation originally meant a decrease in the supply of circulating medium, and now it means a general decrease in the price level. Let's start with one of the common confusions. Much of the confusion about these two topics of inflation and deflation--really one topic, the average level of prices and their movements--one of the sources of confusion is how the media writes about it. Want to talk about two issues. One is they'll often talk about inflation in one price or deflation in one price. Generally, economists are very careful to distinguish between inflation--which is the average level of prices going up--as opposed to one particular price going up. That's one important confusion; think comes from misuse of the word "inflation" in the media. The other, which is related, is the media often reports, and the government sometimes collects--or always collects, I don't know--the core level of inflation, where they'll exclude certain goods. I think the core level is the level of inflation not including energy prices and food, say. Yeah, I've never understood that. It's a meaningless concept. And yet, it's commonly used. Why is it a meaningless concept? First, let's talk about the first issue--the difference between changes in the average level of prices, general level of prices, and changes in individual prices. It is important to distinguish between changes in individual prices--changes in one price relative to the price of something else--and changes in the price level. The concept to keep our eye on is--we have to ask why does the price change? Inflation becomes salient, becomes a meaningful and interesting concept to study when we recognize that prices are changing not because of any changes in real resource constraints, real consumer demands in the economy, real shifts in consumers' preferences for savings as opposed to consumption--but changes simply caused by exogenous increases in the supply of money. That is inflation. You are correct--a lot of the time people use the term "inflation" quite mistakenly to talk about individual price increases: "The price of gasoline is inflating." Or: "There's been a lot of inflation in the energy sector this year." That's quite confusing and nonsensical talk. If what is meant by "There's been a lot of inflation in the energy sector this year" simply means that the price of energy has risen relative to other goods, all that means is that the supply of energy resources has fallen and/or the demand for those resources to increase, which of course causes their relative price to increase--and their relative price should increase to reflect those underlying real changes in the economy. There's nothing about changes in the money supply that we would expect to show up exclusively in the energy sector, or any other individual sector for that matter. Similarly, the idea that they could somehow on their own ripple through the economy and cause inflation in the absence of a monetary change is unlikely and not really economics, the way you and I were taught it. Underlying what we are going to talk about today is the Milton Friedman sentence that "Inflation is everywhere and always a monetary phenomenon." It used to be people had many theories as to why the average level of prices would increase or decrease. It may be one of the few if not the only area of economics where decisive empirical evidence established a theory that virtually all economists--mainstream and out-of-the-mainstream--accept. In the 1960s there was an idea of wage-push or cost-push, even into the 1970s--this idea that unions could push up the price of labor and since labor is in every commodity. What the monetarists responded was--well, some prices will go up more than others because of their labor component, but sectors that are not unionized would then have decreases in prices in the absence of a monetary change. Just to take another example from the news, I think you often hear people say: What's all this talk of inflation? TVs are getting cheaper! TVs and other electronic goods--there's so much technological improvement in the production of those goods that their relative price has fallen dramatically. Had there not been inflation, it would have fallen even more. The nominal price would have fallen even more. If the average price level had been unchanging--if there had been no inflation over the last 25 years--then the goods that had the most technological increases would have even bigger nominal--meaning the dollar amount that we actually see that is not corrected for any kind of inflation, the actual number written on the price tag in America, say--would be even lower. But if there's inflation--if the money supply had increased enough over the last 25 years--you could have TVs and other goods getting more expensive in nominal terms--that is, the price written--but relative to other things getting dramatically cheaper, which they have, because of the technological changes. That concept is very tricky. Hard for people not used to thinking that way to see it. The real changes you are talking about get tangled up with these overall changes in prices as a whole because of changes in the money supply.

Bureaucracy to drive Adam Smith mad

Bill Jamieson writes in The Scotsman of 16 January on the plight of Panmure House:

LIKE so many dreams that turn to nightmares, it seemed a good idea at the time. Three years ago this spring, the Edinburgh Business School offshoot of Heriot-Watt University appeared to have pulled off a coup.

It won a bid to buy the house, just off Edinburgh's Royal Mile, where Adam Smith spent his last years. Panmure House in the Canongate, close by the churchyard where the philosopher is buried, had fallen on bad times. Edinburgh City Council was glad to be shot of it – and the contingent costs of saving it from its dilapidated state.

Panmure House and its heritage is one of Scotland's treasures, and its neglect a national scandal. This was not just a home to one of Scotland's greatest thinkers and philosophers. It was the epicentre of the Scottish Enlightenment. Smith's dinner guests at Panmure House on Sunday evenings included Adam Ferguson, widely regarded as a pioneer of sociology; William Robertson, Principal of Edinburgh University and Moderator of the Church of Scotland; Joseph Black, a chemist who discovered Latent Heat; Edmund Burke, philosopher and politician; John Hume, playwright and brother of Smith's famous friend, the moral philosopher and historian, David; John Adams, architect and designer of splendid Georgian buildings in Edinburgh, and John Playfair, Professor of Mathematics at Edinburgh.

Here was an opportunity for an ambitious restoration befitting the greatest contributor to the Scottish Enlightenment, one that would bring the building back to life as a research and meeting centre.

Heriot-Watt, which paid £800,000, quickly saw that here was a building that could be used, not just displayed, that would be a centre for debate and discussion, not just a storage archive. And that absolutely suited the council's stipulation that the building be used for educational purposes.

The intervention was widely hailed in Scotland. And news travelled fast round the academic world. The American Economics Association expressed keen interest. Before long, Heriot-Watt had attracted offers of help towards refurbishment totalling a potential £3 million. Here at last, not only would the author of The Wealth of Nations be properly honoured, but the university would also have a research centre and seminar facility in the heart of the capital that would attract visitors from across the world.

Today, almost three years later, not a brick has been laid or even a path cleared. Panmure House remains padlocked and abandoned. The best-laid plans have come to nothing. And Heriot-Watt is now staring into a financial black hole. Panmure House is on the brink of turning into a doomed and disastrously expensive foray into heritage bureaucracy. The fate of the project – delayed by obstacles, clashes and delays – now hangs precariously on the outcome of a public inquiry on 3 March.

How has it come to this? It is an irony that Adam Smith himself would have appreciated, that a gesture to rescue and revive a building abandoned and forgotten for years has suddenly attracted health and safety, heritage and aesthetic interventions bringing delay and despair. Heriot-Watt, says Sir Alan Peacock, economics guru and co-author with Gavin Kennedy, Emeritus Professor at the Edinburgh Business School of a paper on the cultural importance of Panmure House, "has been put through all the hoops".

Barely had the university begun considering outline plans for refurbishment and renewal than building inspectors insisted on appropriate facilities for disabled access. Heriot-Watt's architects EK:JN duly obliged. By March 2009 they presented plans for a new octagonal stair tower and a turret, offering disabled access, modelled on Ford House in Midlothian.

Enter Historic Scotland. It made a site visit and immediately wrote to the city council expressing "strong concerns" over the plans. EK:JN then submitted further proposals in July of that year for the extension of the building. This featured a glass atrium extension to enable it to be used as a meeting place with lecture facilities, in compliance with the council's stipulation. This, as Keith Lumsden, director of the Edinburgh Business School at Heriot-Watt explained, fulfilled both functional requirements and opening up the original stonework to view.

Historic Scotland again objected. Steven Robb, senior inspector of historic buildings, wrote that the atrium and stair would affect the character and special interest of the building "to an unacceptable degree". The plan, he said, would alter the entrance elevation, adding that an external stair was not essential to its reuse. These concerns were repeated in a further letter by Historic Scotland to the council in August of that year. But these objections, Lumsden argued, would make it impossible to develop the house as a seminar centre and meeting place with all the facilities that would be required.

Six months later, in March 2010, Heriot-Watt's plans were formally considered by the city council. Its planning department had recommended refusal. But the planning committee overturned this after a site visit, voting decisively 11 to one in favour.

Barely had the applicants time to celebrate this progress than on 13 August Scottish ministers called in the proposals for examination. Heriot-Watt, sensing that this would prove not the beginning of the end but the end of the beginning, demanded a public inquiry. It believes it has a cast-iron case and a compelling proposal that would bring the crumbling Panmure House back to life, providing an academic magnet at the heart of the city.

What lies at the heart of Historic Scotland's objections? Is it being over fussy, or are there valid concerns? Panmure House was built between 1691 and 1693 by Lt Col George Murray, who sold it in 1696 to James Maule, 4th Earl of Panmure. It passed to the Earl of Dalhousie, a relation. Adam Smith rented the building from 1778 until his death in 1790. It was a two-storey building with basement and attic. A rental agreement of 1753 describes it as having a large dining room and drawing room (ground floor), three good bedchambers with closets and conveniences on the same floor and a basement kitchen below.

As a building it has since been through the wars and there is little now that has survived the time of Smith's occupancy. In the 1840s the northern wing was removed. When the area became industrialised, the grounds were occupied by the Panmure Iron Foundry. By the 1950s the building, according to a Historic Scotland summary, "was ruinous, vandalised and only stone stubs of the internal stair remained." In the mid 1950s the architect John Wilson Paterson converted it for use as a home for delinquent boys, the floors at ground and first floor having already disappeared.

In 1970 the building was Category A listed.

Historic Scotland's concerns are not without merit. This is a rare example of a 17th-century town house within the historic Old Town. The original stone structure presents a sturdy frame. But virtually everything that was within at the time of Smith's occupancy has long gone. It was abandoned, then made over in the 1950s, then abandoned again. What's left is less artefact than association. The case for preservation cannot rest on architectural merit: the building has been internally gutted. So how much of this objection is on heritage grounds – and how much on aesthetics?

The surrounding built environment is very mixed and cannot be said to hold to a particular style or vernacular. The building is shielded from the Canongate by a circa-1930 tenement block providing undistinguished, if not grim, "infill" development. There are also some tenements by Sir Basil Spence, an acquired enthusiasm for many. As Panmure House is not visible from the Canongate, its appearance does not bear on the thrilling Hanseatic style of the Royal Mile as one looks up towards St Giles. As for looking down to Holyrood, there is of course the Scottish Parliament: a building that will forever struggle to avoid that most searing thunderball of condemnation in the entire Edinburgh lexicon of put-down: "inappropriate".

There is the gem of a charming little garden nearby in Dunbar Close, laid out in the formal 17th-century style by Seamus Filor in 1976, but barely known or visited. A refurbished Panmure House would bring fresh interest.

Historic Scotland does have an important role to ensure that as much as possible of the original building is preserved. But specifying what should constitute "re-use" is surely not in its bailiwick. And the dismissal of the disabled-access turret smacks of subjective judgement.

The key point here surely is that this is a historic building transferred on the understanding that it would be used for educational purposes. It has to cater for events and meetings and not just be an archival museum. Heriot-Watt paid £800,000 in good faith and has mustered funds to meet that obligation. What it has submitted is no golden arches McDonald's restaurant or a sprawling and distraught Catalan indulgence, but a refurbishment and extension that serves functionality while opening up the building to wonder and inspection. It has stepped up to provide an immense enrichment to the legacy of Adam Smith where a neglected structure now stands. And it would be an inspiring addition to the city's cultural meeting points that would draw international attention. But the fate of the entire project now dangles at the end of a planning inquiry. The Wealth of Nations offers no guidance on the conduct and function of such inquiries. But I suspect the author would have looked on this three-year episode at the heart of Scotland's capital city – and wept.

If the bureaucracy in Scotland is anything to go by it seems the Scottish Enlightenment is well and truly over! :-(

(HT: Gavin Kennedy)

The crash from an Austrian perspective

Steven Horwitz gave a talk at the Adam Smith Institute in London on "An Austrian perspective on the great recession of 2008-09". The following 6 points come from notes taken by a reporter from the Spectator and which appeared in their "Coffeehouse" column.

1. The Austrian Business Cycle Theory is necessary but not sufficient to explain the recession. Think of it as a car pile-up. Imagine we see an enormous rise in the number of traffic accidents in a major city. Cars keep colliding at intersections as drivers all seem to make the same sorts of mistakes at once. Is the most likely explanation that drivers have irrationally stopped paying attention to the road, or would we suspect that something is wrong with the traffic lights? Even with completely rational drivers, malfunctioning traffic signals will lead to lots of accidents. Keeping interest rates artificially low is like getting all the lights stuck on green.

2. The crash has nothing to do with greed. Or, rather, greed is no more to blame for these bad mortgages than gravity is to blame for plane crashes. Gravity is always present, just like greed.

3. Blame artificially low interest rates. They may create a feel-good factor, as people fill their homes with cheap stuff. But they wrongly incentivise borrowing, causing a boom followed by a bust.

4. Deregulation was not the culprit. From 1980-2009 in the US, there were 4 new regulatory policies for every 1 deregulatory policy.

5. Lessons for recovery. Bailouts and stimuli are not the answer. We need to let the healing take place and encourage savings that create capital and wealth. We do not need a “recovery plan” – recession is the recovery.

6. So what can we do? In the short-run: encourage hiring across the board (e.g. in the US, suspend payroll tax). We can suspend capital gains tax to encourage investment. We can sell off government stakes in GM and the banks, and stop bashing profit-seeking behaviour. And in the long-run: limit the powers of the central bank. Consider stronger thresholds for major fiscal policy decisions (e.g. supermajorities or balanced-budget requirements). And, finally, end subsidies.

What happens to R&D in domestic multinationals after foreign acquisition?

With foreign ownership of domestic companies becoming increasingly common, questions are mounting as to the what the consequences of said ownership are. One area of concern is the effect on research and development. This new column from VoxEU.org by Roger Bandick, Holger Görg and Patrik Karpaty presents new evidence from Sweden, where flagship firms such as Volvo and Saab are now foreign owned, that it hopes will reassure policymakers, and others.

The money quote from the article would be:

The key policy implication of the analysis is that foreign acquisitions can have beneficial effects for domestic R&D activity. Hence, there is no need for fears and therefore no need for policymakers to start thinking about limiting international merger and acquisition activity. Quite the contrary, foreign acquisitions may be an important way to generate new knowledge and contribute to boosting the level of technology in the domestic economy.

So them foreign types may not be so bad after all. Just don't tell Winston Peters.

Just for fun: reference points, property rights and transaction costs

Hart (2008: 406) argues that shading costs are akin to "haggling costs". The modelling of haggling costs can be seen as a move towards the modelling (however imperfectly) of transaction costs. Hart and Moore (2008: 4-5) argue that "[ ... ] the costs of flexibility that we focus on--shading costs--can be viewed as a shorthand for other kinds of transaction costs, such as rent-seeking, influence, and haggling costs." Exactly how similar the reference point and transaction-cost explanations are is, however, open to debate. There is also the question of the relationship between these two approaches to the firm and the property rights approach.

In a discussion of the differences between the Grossman-Hart-Moore (GHM) theory of the firm and the transaction-cost approach, Williamson (2000: 605-6) argues that the most important difference between them is that GHM introduce inefficiencies at the ex ante investment stage while the transaction-cost approach emphasises that ex post haggling and maladaptation drive inefficiencies. There are no ex post inefficiencies in GHM due to their assumption of common knowledge and ex post costless bargaining. Gibbons (2010: 283) explains it this way:

"[t]he model in question is Grossman and Hart's (1986), which explores an alternative to Williamson's (2000, p. 605) emphasis that "maladaptation in the contract execution interval is the principal source of inefficiency". Instead, in the Grossman-Hart model, there is zero maladaptation in the contract execution interval, and the sole inefficiency is in endogenous specific investments.

It is striking how different the logic of inefficient investment can be from the logic of inefficient haggling. In their pure forms envisioned here, the two can be seen as complements. For example, the lock-in necessary for Williamson's focus on inefficient haggling could result from contractible specific investments chosen at efficient levels. But by assuming efficient bargaining and hence zero maladaptation in the contract execution interval, Grossman and Hart focused attention on non-contractible specific investments and hence discovered an important new determinant of the make-or-buy decision: in the Grossman-Hart model, an important benefit of non-integration is that both parties have incentives to invest; in Williamson's argument, an important cost of non-integration is inefficient haggling. In short, the two theories are simply different."

This emphasis on ex post haggling and maladaptation can be interpreted as reflecting a view that internal organisation is better at reconciling the conflicting interest of the parties to a transaction and facilitating adaptation to changing supply and demand conditions when such cost are high.

The reference point approach can be seen as a movement away from the ex ante GHM approach and back towards transaction cost thinking in so much as contracting is not perfectly contractible ex post. This fact, as Hart (2008: 294) points out "[ ... ] is a significant departure from the standard contracting literature. The literature usually assumes that trade is perfectly enforceable ex post (e.g. by a court of law). Here we are assuming that only perfunctory performance can be enforced: consummate performance is always discretionary", and thus inefficiencies can arise ex post. The development of a tractable model of contracts and organisational form that exhibits ex post inefficiency is one of motivations for advancing the reference point approach in the first place. (Hart and Moore 2008: 4).

The reference point approach also highlights the importance of Williamson's notion of the "fundamental transformation". Hart and Moore argue that the move from an ex ante competitive market to an ex post bilateral setting--what Williamson (1985: 61-3) terms the fundamental transformation--provides a rationale for the idea that contracts are reference points. "A competitive ex ante market adds objectivity to the terms of the contract because the market defines what each party brings to the relationship. HM assume that the parties perceive a competitive outcome as justified and accept it as a salient reference point." (Fehr, Hart and Zehnder 2009: 562). This is an idea which finds experimental support: see Fehr, Hart and Zehnder (2008), Fehr, Hart and Zehnder (2009) and Hoppe and Schmitz (forthcoming).

But we must also be aware that important features of the transaction-cost theory may still have been left out. How fully shading costs capture the costs of ex post maladaptation and haggling is an open question. When discussing some opportunities for the future of transaction-cost economics, Robert Gibbons (2010: 283) notes that "[ ... ] it may be that Hart and Moore's (2008) "reference points" approach is a productive path. Time will tell [ ... ]".

• Fehr, Ernst, Oliver D. Hart and Christian Zehnder (2008). `Contracts as reference points - experimental evidence', National Bureau of Economic Research, NBER Working Paper: 14501, November.
• Fehr, Ernst, Oliver D. Hart and Christian Zehnder (2009). `Contracts, Reference Points, and Competition-Behavioral Effects of The Fundamental Transformation', Journal of the European Economic Association, 7(2-3) April-May: 561-72.
• Gibbons, Robert (2010). `Transaction-Cost Economics: Past, Present, and Future?', Scandinavian Journal of Economics, 112(2): 263-88.
• 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.
• 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.
• Hoppe, Eva I. and Patrick W. Schmitz (forthcoming). `Can contracts solve the hold-up problem? Experimental evidence', Games and Economic Behavior.
• Williamson, Oliver E. (1985). The Economic Institutions of Capitalism, New York: The Free Press.
• Williamson, Oliver E. (2000). `The New Institutional Economics: Taking Stock, Looking Ahead', Journal of Economic Literature, 38(3) September: 595-613.

Interview with Professor Ronald Coase

Here is an interview by Wang Ning of Ronald Coase and his views on China.

An interesting question asked was about what separates good economics from bad. And it all comes down to the importance of transaction costs, which is the central message of  Coase's two most famous papers - The Nature of the Firm and The Problem of Social Cost:

WN: You mentioned many times that you do not like the term, "Coasean economics", and prefer to call it simply the "right economics" or "good economics". What separates the good from bad, the right from wrong?

RC: The bad or wrong economics is what I called the "blackboard economics". It does not study the real world economy. Instead, its efforts are on an imaginary world that exists only in the mind of economists, for example, the zero-transaction cost world.

Ideas and imaginations are terribly important in economic research or any pursuit of science. But the subject of study has to be real.

EconTalk this week

Bruce Caldwell of Duke University and the General Editor of the Collected Works of F. A. Hayek, talks with EconTalk host Russ Roberts about Hayek, his life, his ideas, his books, and articles. The conversation covers Hayek's intellectual encounters with Keynes, Hayek's role in the socialist calculation debate, Hayek's key ideas, and a discussion of which of Hayek's works are most accessible.

Why Not Socialism?

is the title of the last book by the late political philosopher G. A. Cohen. Adam Smith scholar James R. Otteson offers a review of the book in the Independent Review. He writes

Defending socialism is a tall order these days, so it is a bit surprising to see an unabashed attempt. The late G. A. Cohen was a distinguished political philosopher at All Souls College, Oxford, and an important critic of libertarianism. His 1995 book Self-Ownership, Freedom, and Equality, for example, is a challenging and searching Marxist criticism of Nozickean libertarianism. Distinguished philosophers such as Hillel Steiner and Jonathan Wolff have offered high praise for Why Not Socialism? Thus, if anyone can defend socialism successfully, perhaps Cohen can in this book.

The book’s brevity—only ninety-two very small pages—and its largely jargonfree writing suggest that it is meant for nonspecialist readers. One presumes that it is intended for classroom use, and for that purpose I suppose it can be useful. But Cohen’s argument in this book is so weak that the book’s main effect, I fear, would be to show that socialism has no plausible defense.

While I can't see an economic defense of socialism; Mises, Hayek, Robbins et al put paid to that, I am surprised/disappointed that Cohen can not offer a wider philosophic/moral/ethical defense. If only because of the standard of Cohen's past works.

Households as corporate firms

In this audio form VoxEU.org Robert Townsend talks about his recent book, co-authored with Krislert Samphantharak, that analyses household finance in developing countries using integrated household surveys. Townsend describes how to create new and more comprehensive household ‘accounts’, and use them to analyse productivity, capital structure and liquidity in households.

The General Theory after 75 years

There is a new NBER Working Paper out by Matthew N. Luzzetti and Lee E. Ohanian on "The General Theory of Employment, Interest, and Money After 75 Years: The Importance of Being in the Right Place at the Right Time".

The abstract reads:

This paper studies why the General Theory had so much impact on the economics profession through the 1960s, why that impact began to wane in the 1970s, and why many economic policymakers cling to many of the tenets of the General Theory. We discuss three key elements along these lines, including the fact macroeconomic time series through the 1960s seemed to conform qualitatively to patterns discussed in the General Theory, that econometric developments in the area of simultaneous equations made advanced the General Theory to a quantitative enterprise, and that the General Theory was published during the Great Depression, when there was a search for alternative frameworks for understanding economic crises.

Perhaps the sadist point Luzzetti and Ohanian make is

The GT [General Theory] will continue to have a large audience among policymakers as long as governments are pressed to boost nominal spending during periods of crisis, whether or not those efforts are effective.

EconTalk this week

Robin Hanson of GMU talks with EconTalk host Russ Roberts about the idea of a technological singularity--a sudden, large increase in the rate of growth due to technological change. Hanson argues that it is plausible that a change in technology could lead to world output doubling every two weeks rather than every 15 years, as it does currently. Hanson suggests a likely route to such a change is to port the human brain into a computer-based emulation. Such a breakthrough in artificial intelligence would lead to an extraordinary increase in productivity creating enormous wealth and radically changing the returns to capital and labor. The conversation looks at the feasibility of the process and the intuition behind the conclusions. Hanson argues for the virtues of such a world.

Two letters and a speech

Don Boudreaux writes to the New York Times on Packaging Insanity while Greg Mankiw goes further and writes to the President to give advice.

On the packaging issue, retired Coca-Cola executive Harry Teasley gives a great speech.

Alfred Kahn has died

Peter Cramton writes at his blog that

Alfred Kahn died on Monday, 27 December 2010, in his Ithaca home at the age of 93. Fred lived a wonderful life and contributed enormously to society and all those who knew him. As a market design he was a pioneer. It takes a special person to be named chairman of an organization, the Civil Aeronautics Board in his case, and eliminate it. Fred recognized that the CAB served only to insulate airlines from competition. Fred’s action led the way to a deregulation movement that introduced competition into many industries, reducing prices and spurring innovation.

Yes Kahn actually did away with a part of the US government! We need more such people.

The New York Times obituary is here, the Houston Chronicle's here, Cornell University's here.