More on PPPs: theory this time

The basic problem with PPPs is the writing of the contract for whatever project is being undertaken. Depending on what can be contracted on and what can't, PPPs may or may not be the way to go. To, hopefully, make this a little clearer a look at a paper by Oliver Hart is useful.

In Hart (2003) Hart put forward a simple incomplete contracts model of PPPs. Consider a situation where, for example, a government wants a new prison built and run. Lets assume there are two periods, the “build” period followed by the “operate” period. There are (unverifiable) social benefits from the prison which we will call B. The (unverifiable) costs of the prison are denoted C. Both B and C are affected by investments that the builder can make. There are two forms of investment available to the builder, i and e. An increase in i increases B and decreases C and so is beneficial all round, while an increase in e decreases both B and C. This means the builder gains from e and “society” doesn’t. Therefore we will call i productive investment and e unproductive investment. The total costs of investment for the builder are i+e. i and e are unverifiable and thus can not be contracted on.

Now consider types of contracts for building and operating the prison. First, separate contracts for building and operating the prison. Call this unbundling. Second, a PPP contract, where the builder both builds and runs the prison. This is bundling. Under unbundling, the builder sets i=e=0. That is the builder builds the cheapest prison possible while staying within the contract. Under bundling the builder sets the marginal decrease in his costs, C, due to an increase in both e and i each equal to 1.

The trade-off between unbundling and bundling is simple. Under unbundling, the builder internalises neither the social benefit B nor the operating cost C. By setting i=e=0, he does too little of the productive investment, i, but the right amount of the unproductive investment, e. In contrast, under bundling or PPP, the builder again does not internalise B, but does internalise C. As a result, he does more of the productive investment, although still too little, but also more of the unproductive investment.

The model yields a simple conclusion. Conventional provision (‘unbundling’) is good if the quality of the building can be well specified, whereas the quality of the service cannot be. Under these conditions, inderinvestment in i under conventional provision is not a serious issue, whereas overinvestment in e under PPP may be. In contrast, PPP is good if the quality of the service can be well specified in the initial contract (or, more generally, there are good performance measures which can be used to reward or penalise the service provider), whereas the quality of the building cannot be. Under these conditions, underinvestment in i under conventional provision may be a serious issue, while overinvestment in e under PPP is not.

The upsot of all of this is that the choice between a conventional unbundled contract and a PPP bundled contract turns on whether it is easier to write contracts on the operating phase of the prisons life than on the building phase. So the usefulness of PPPs depends on what can or can't be contracted on.

• Hart, Oliver (2003). ‘Incomplete Contracts and Public Ownership: Remarks, and an Application to Public-Private Partnerships’, The Economic Journal, 113 (March), C69-C76.

PPPs

At his blog Roger Kerr asks PPPs: Do They Work? His answer discusses an article on public-private partnerships by economic consultant, Phil Barry, of Taylor Duignan Barry Ltd.

Kerr writes

But do PPPs work? Here is Phil Barry’s assessment:

The formal studies that have been undertaken generally provide a qualified “yes” to that question. I say qualified because the PPPs don’t always work. And even when they do work, the PPPs are by no means perfect.

A study by the UK National Audit Office [...] provided one of the most comprehensive independent evaluations of PPPs. That study found PPPs had their flaws: of the 37 PPP projects evaluated, 9 of the projects (24%) were late and the projects incurred cost-overruns, on average, of 22%. But the experience in the public sector was a lot worse: 70% of the projects were delivered late and the cost overruns averaged 73%.

Back in 2009 I said this about the UK's experience with PPPs

Public-private partnerships (PPPs) seem to offer a solution to a common problem for economies which have been hampered by the poor quality of their infrastructure. PPPs mean, it is argued, that private capital would be used to fund much-needed projects, whether it be in transport, education, health or whatever. Better still, it was further argued, private companies could build and operate the new infrastructure, bringing large cost savings.

At the IEA website Richard Wellings discusses the British experience with PPPs. He explains Why PPPs may offer poor value for money.

Wellings writes that in the UK,

The first modern PPPs were began in the 1980s under what became known as the Private Finance Initiative (PFI). Their numbers grew during the early-mid 1990s, with several design, build, finance and operate (DBFO) road schemes, as well as the construction of a number of privately-operated prisons. These projects were generally viewed as successful within government - a higher proportion were delivered on time and on budget than would have been expected using traditional procurement methods.

Building on these foundations, the election of a New Labour government saw a rapid expansion in the number of PPPs. The model fitted well with Labour’s ‘Third-Way’ approach to the economy. Instead of outright nationalisation, with its well-documented ineffiencies, the dynamism of the private sector would be harnessed for social objectives.

By 2003/04 PPP schemes accounted for 39% of capital spending by UK government departments. And by January 2008 there were over 500 operational PPP projects with a total capital value of around £44 billion and a further number in the pipeline. Their scope was also widened, with a higher proportion used to build new schools and hospitals. Public transport became a major investment priority rather than roads.

But Wellings argues this expansion of PPPs may have been misguided. Indeed, it was arguably when partnerships started to go wrong. In particular, unlike the earlier schemes, the new projects were more likely to be in fields marked by a high level of political sensitivity. Wellings gives as an example of the problems, the London Underground PPP. He writes,

This huge project, designed to upgrade the Tube, required an annual subsidy of £1 billion. Fiercely resisted by the Greater London Authority under Ken Livingstone, who favoured an alternative bond finance scheme, it was imposed on the capital by central government with heavy Treasury backing. So even before it started the process was marked by a high level of controversy.

Extremely complex 30-year contracts were drawn up, at a cost of £455 million in consultancy fees, and the Rail Regulator was appointed as ‘PPP Arbiter’ to adjudicate any disputes. Two consortiums were selected to upgrade and maintain different sections of the network.

In 2003 the Metronet consortium began a £17 billion project covering nine out of twelve tube lines. It soon got into difficulties. In April 2004 it was fined £11 million for poor performance, but this was just the start.

Further fines followed and in June 2007 Metronet, concerned about cost escalation, requested an extraordinary review by the PPP Arbiter. A short-term cost overrun of £551 million was predicted, rising to £2 billion by 2010, and this was blamed on additional demands made by Transport for London.

But the Arbiter had a different view – most of the cost escalation could be explained by Metronet’s inefficiency and only a small fraction of the requested extra payments would be forthcoming. Faced with huge losses, the company went into administration.

The government tried to find private bidders for the Metronet contracts but failed – unsurprisingly given the uncertainty concerning costs. The public sector then became responsible for the upgrades and maintenance. Taxpayers would now pick up the bill for any cost overruns.

The events just described illustrate a key weakness of PPPs. When they involve essential infrastructure that government will not allow to fail (too big to fail?), it is clear that a high proportion of a project’s risk remains with the public sector. But such an acknowledgment undermines one of the major rationales for having PPPs in the first place, that they are good value for money despite apparently higher financing costs, because of their ability to transfer risk to private investors. A transfer that doesn't appear to have taken place.

Wellings goes on to explain that the UK experience thus far suggests that PPP schemes have failed to live up to their early promise. He offers several explanations for this:

Firstly, comparisons with public finance may understate the true cost of government funding. While it may be possible to borrow at low interest rates this is only because potential risks and losses have been offloaded on to taxpayers.

Secondly, a high proportion of recent PPPs have been plagued by high ‘transaction costs’. They have involved tortuous bidding processes and the creation of complex contractual agreements and regulatory frameworks, which have created additional costs and risks for the private-sector partners involved. Value for money has been reduced as a result.

Finally, the operation and outputs of PPP schemes have often been subject to substantial political and bureaucratic intervention. As seen with some of the public transport PPPs, a hostile relationship may develop between the counterparties. There can even be politically-motivated attempts to subvert the viability of projects. This makes it more difficult both to raise private finance and transfer risk. Investors are more likely demand a premium and contractual guarantees if they perceive political risks as high.

Wellings concludes by saying,

Accordingly, PPPs may not be a suitable funding model for some projects. The risks are particularly high in situations when government is unwilling to take a ‘hands-off’ approach. At the same time, if government will stand aside, perhaps after setting a loose regulatory framework, then depoliticisation through full-blooded privatisation may be the best option.

So overall, there are warnings from the UK experience of PPPs for countries like New Zealand who may be thinking of going down this route. PPPs do not always work and much thought must go into when and why they are used. Hopefully these warnings will be heeded. If they are there is no reason that PPPs could be a good model for some projects.

More McCloskey

A video of Deirdre McCloskey’s recent talk at George Mason University about her new book Bourgeois Dignity.

The future of macroeconomic policy (updated)

In a column at VoxEU.org Olivier Blanchard offers up nine tentative conclusions about the future of macroeconomic policy:

1. We’ve entered a brave new world, a very different world in terms of macroeconomic policymaking.

2. In the age-old discussion of the relative roles of markets and the state, the pendulum has swung – at least a bit – toward the state.

3. There are many distortions relevant for macroeconomics, many more than we thought was the case earlier. We had largely ignored them, thinking they were the province of the microeconomist. As we integrate finance into macroeconomics, we’re discovering that distortions within finance are macro-relevant. Agency theory – about incentives and behaviour of entities or “agents” – is needed to explain how financial institutions work or do not work and how decisions are taken. Regulation and agency theory applied to regulators themselves is important. Behavioural economics and its cousin, behavioural finance, are central as well.

4. Macroeconomic policy has many targets and many instruments (that is, the tools we use or variables to implement policy). Many examples were discussed at the conference. Here are two:

* Monetary policy has to go beyond inflation stability, adding output and financial stability to the list of targets and adding macro-prudential measures to the list of instruments.
* Fiscal policy is more than just “G minus T” and an associated “multiplier” (the proportion or factor by which changes in government spending or taxes affect other parts of the economy). There are potentially dozens of instruments, each with their own dynamic effects that depend on the state of the economy and other policies. Bob Solow made the point that reducing discussions about fiscal policy to what is the right multiplier does not do service to the issue.

5. We may have many policy instruments, but we are not sure how to use them. In many cases, we are uncertain about what they are, how they should be used, and whether or not they will work. Again, many examples came up during the conference:

* We don’t quite know what liquidity is, so a liquidity ratio is one more step into the unknown.
* It was clear that some people believe capital controls work and some don’t.
* Paul Romer made the point that, if you adopt a set of financial regulations and keep them unchanged, the markets will find a way around, and ten years later, you’ll have a financial crisis.
* Michael Spence talked about the relative roles of self-regulation and regulation. Both are needed, but how we combine them is unclear.

6. While these instruments are potentially useful, their use raises a number of political economy issues.

* Some instruments are politically hard to use. Take cross-border flows. Putting in place a multilateral regulatory structure will be very difficult. Even at the domestic level, some macro-prudential tools work by targeting specific sectors, sets of individuals, or firms, and may lead to strong political backlash by those groups.
* Instruments can be misused. It was clear from the discussion that a number of people think that, while there may be an economic case for capital controls, governments could use them instead of choosing the right macroeconomic policies. Dani Rodrik argued for using industrial policy to increase the production of tradable goods without getting a current-account surplus. But in practice we know the limits of industrial policy, and they haven’t gone away.

7. Where do we go from here? In terms of research, the future is exciting. There are many topics on which we should work – namely macro issues with, as Joe Stiglitz suggests, the right micro foundations.

8. Things are harder on the policy front. Given we don’t quite know how to use the new tools and they can be misused, how should policymakers proceed? While we have a good sense of where we want to get to, a step-by-step approach is probably the way to go.

* Take inflation targeting. We can’t, from one day to the next, just give it up and have, say, a system with five targets and seven instruments. We don’t know how to do it and it would be unwise. We can, however, introduce gradually some macro-prudential tools, testing the water to see how they work.
* Increasing the role of Special Drawing Rights (SDRs) in the international monetary system is another example. If we go in that direction, we can move slowly from, say, creating a market in private SDR bonds to exploring the possibility for the IMF to issue SDR bonds to the private sector and then, if feasible, issuing them to mobilise funds in times of systemic crisis.

Pragmatism is of the essence. This was a general theme that came up, for example, in Andrew Sheng’s discussion of the adaptive Chinese growth model. We have to try things carefully and see how they work.

9. We have to keep our hopes in check. There are going to be new crises that we have not anticipated. And, despite our best efforts, we could have old-type crises again. That was a theme in Adair Turner’s discussion of credit cycles. Can we, using agency theory and the right regulations, get rid of credit cycles? Or is it basic human nature that, no matter what we do, they will come back in some form?

Don't know how many people are going to buy into these conclusions. I think of any number of economists who will not. For example, I don't see number 2 as particularly useful given that many of the problems we have faced over the last few years are due to state actions, so even more state involvement in the economy doesn't seem like a good response. And as for 7, I do worry as to what Stiglitz would see as the "right micro foundations" for macro.

Blanchard see these ideas as the beginning of a conversation. Well it could be a conversation which, as is normal for macro, produces much heat but very little light.

Update: Matt Nolan is depressed by all of this.

The problem with price gouging laws

The Spring 2011 issue of the journal Regulation contains an article "The Problem with Price Gouging Laws" by Michael Giberson.

As far as I can see the problem with such law is that they exist.

Giberson writes

Economists and policy analysts opposed to price gouging laws have relied on the simple logic of price controls: if you cap price increases during an emergency, you discourage conservation of needed goods at exactly the time they are in high demand. Simultaneously, price caps discourage extraordinary supply efforts that would help bring goods in high demand into the affected area. In a classic case of unintended consequences, the law harms the very people whom lawmakers intend to help. The logic of supply and demand, so clear to economists, has had little effect on price gouging policies.

(HT: Knowledge Problem)

BPEA is now online

It turns out that you can now access the current issue and complete archive of Brookings Papers on Economic Activity on line, which some people may think is cool.

I know that its just macro, but there some people out there who mistake macro for economics. Sad but true.

Walter Williams interview

From Reason.tv comes this interview with Walter Williams. Among the topics that gets discussed is Williams's recent autobiography, Up From the Projects.

Deirdre McCloskey at Aid Watch

Aid Watch has very short interview with Deirdre McCloskey, author of the fascinating new book Bourgeois Dignity. Well worth the couple minutes it takes to read.

EconTalk this week

Diane Coyle, author of The Economics of Enough, talks with EconTalk host Russ Roberts about the future and the ideas in her book. Coyle argues that the financial crisis, the entitlement crisis, and climate change all reflect a failure to deal with the future appropriately. The conversation ranges across a wide range of issues including debt, the financial sector, and the demographic challenges of an aging population that is promised generous retirement and health benefits. Coyle argues for better measurement of the government budget and suggests ways that the political process might be made more effective.

Why economists have no friends

The Coase Theorem in action

Simple models of a human-capital based firm: a reference point approach

A new working paper on "Simple models of a human-capital based firm: a reference point approach" is available below. The abstract reads,

We apply the reference point approach to contracts to the modelling of a human-capital based firm. First a model of firm scope is offered which argues that the organisation of a human-capital based firm depends on the “types” of human capital involved. Having a homogenous group of human capital leads to a different form than that of a firm which involves a heterogenous group of human capital. Second a simple model of a human-capital based firm is discussed. Three organisational forms are considered: an investor owned firm, a labour owned firm and a market transaction involving the use of an independent contractor. Results are given that show when each of these forms are optimal. The effects of a firm’s size and scope on organization are considered as is the question of Why are there conversions to investor ownership?

Simple models of a human-capital based firm: a reference point approach

Got to say I really don't like the paper, it just doesn't work for me. Will have to think more about how to improve it.

One advantage of competition is .....

it makes consumers better off by lowering the prices they pay. Obvious really. Well not if you are a member of the Metro-DC Democratic Socialists of America's steering committee. Mark Perry at the Carpe Diem blog gives us this example of socialist economic thing. The quote comes from the editorial "Walmart's Arrival a Bad Deal for District," which appears in the current edition of the Dupont Current (p. 11), a neighborhood paper in Washington, D.C.

So we force consumers (workers) to pay higher prices than they otherwise would by stopping Walmart from introducing competition into the local area. And this helps workers how?

Sue Kedgley milks it

Sue Kedgley’s maths are on a par with her economics. From an article at Stuff

Kedgley says the report failed to address the central issue of lack of competition in the domestic market.

"It doesn't tell us how the price of milk is set. Farmers say they receive less than 30 per cent of the price of milk, but it fails to shed any light on what makes up the other 60 per cent," she says.

Apart from the 100-30= 60 bit, Kedgley should realise that the price of milk in New Zealand will be the world price. For a tradable good like milk the market is the world market and the price is set by supply and demand conditions in the world market. So the correct question for Sue Kedgley to ask is, Are we paying the world price?

Lomborg on the ethanol catastrophe

In Slate Bjørn Lomborg writes more, if you really needed it, on The Ethanol Catastrophe: Biofuels aggravate global warming and cause hunger. Why won't the U.S. stop subsidizing them? The question in the subtitle is a good one. Lomborg writes,

Spectators at February's Daytona 500 in Florida were handed green flags to wave in celebration of the news that the race's stock cars now use gasoline with 15 percent corn-based ethanol. It was the start of a seasonlong television marketing campaign to sell the merits of biofuel to Americans.

On the surface, the self-proclaimed "greening of NASCAR" is merely a transparent (and, one suspects, ill-fated) exercise in "greenwashing" for the sport. But the partnership between a beloved American pastime and the biofuel lobby also marks the latest attempt to sway public opinion in favor of a truly irresponsible policy.

and continues,

The United States spends about $6 billion a year on federal support for ethanol production through tax credits, tariffs, and other programs. Thanks to this financial assistance, one-sixth of the world's corn supply is burned in American cars. That is enough corn to feed 350 million people for an entire year.

Government support of rapid growth in biofuel production has contributed to disarray in food production. Indeed, as a result of official policy in the United States and Europe, including aggressive production targets, biofuel consumed more than 6.5 percent of global grain output and 8 percent of the world's vegetable oil in 2010, up from 2 percent of grain supplies and virtually no vegetable oil in 2004.

The results of all of this?

This year, after a particularly bad growing season, we see the results. Global food prices are the highest they have been since the United Nations started tracking them in 1990, pushed up largely by increases in the cost of corn. Despite the strides made recently against malnutrition, millions more people will be undernourished than would have been the case in the absence of official support for biofuels.

Why would anyone back such a policy?

Biofuels were initially championed by environmental campaigners as a silver bullet against global warming. They started to change their minds as a stream of research showed that biofuels from most food crops did not significantly reduce greenhouse gas emissions – and in many cases, caused forests to be destroyed to grow more food, creating more net carbon-dioxide emissions than fossil fuels.

Some green activists supported mandates for biofuel, hoping they would pave the way for next-generation ethanol, which would use non-food plants. That has not happened.

Today, it is difficult to find a single environmentalist who still backs the policy. Even former U.S. Vice President and Nobel laureate Al Gore—who once boasted of casting the deciding vote for ethanol support—calls the policy "a mistake." He now admits that he supported it because he "had a certain fondness for the [corn] farmers in the state of Iowa"—who, not coincidentally, were crucial to his 2000 presidential bid.

It is refreshing that Gore has now changed his view in line with the evidence. But there is a wider lesson. A chorus of voices from the left and right argue against continued government support for biofuel. The problem, as Gore has put it, is that "it's hard once such a program is put in place to deal with the lobbies that keep it going."

So rent seeking is the reason for the continuation of a very bad policy. Again politics trumps economics and millions of people-all of them suffering needlessly-pay the price.

Nuclear power problems in Japan

Offsetting Behaviour argues People are strange in their reaction to the problems in nuclear power plants in Japan. Jeffrey Miron make a nice point on this issue as well.

[...] one point about nuclear power is beyond dispute: it always receives substantial subsidy from government. This consists of both direct payments toward the costs of building plants, along with insurance against full liability for accidents.

So a simple way to evaluate competing claims over safety is to eliminate both kinds of subsidy and find out whether the private sector really think nuclear power is profitable, if investors bear all construction and insurance costs.

Markets provide useful information, when they are allowed to work free of government interference. I do wonder just how many nuclear plant would be built in a truly free market.

Don't discuss economics with pirates

More on pirates. One of the many things you should keep in mind when your boat is boarded by pirates is

And unless you’re certain you can discuss politics, religion, and economics to useful conversational ends, most sources say, pick other topics.

This piece of wisdom comes from here. As I don't know what a "useful conversational end" is when discussing economics I guess just handing over the booty is the optimal strategy.

(HT: Market Power.)

The law of demand

Price really does matter. A nice example from the Carpe Diem blog:

MOGADISHU, March 13 (Reuters) - "Somali pirates said they would lower some of their ransom demands to get a faster turnover of ships they hijack in the Indian Ocean. Armed pirate gangs, who have made millions of dollars capturing ships as far south as the Seychelles and eastwards towards India, said they were holding too many vessels and needed a quicker handover to generate more income."

If you charge too much people just won't buy. I do wonder what the own price elasticity is for hijacked ships.

Interesting looking NBER working paper

Matching Firms, Managers and Incentives by Oriana Bandiera, Andrea Prat, Luigi Guiso and Raffaella Sadun, NBER Working Paper No. 16691. Issued in January 2011.

The abstract reads:

We exploit a unique combination of administrative sources and survey data to study the match between firms and managers. The data includes manager characteristics, such as risk aversion and talent; firm characteristics, such as ownership; detailed measures of managerial practices relative to incentives, dismissals and promotions; and measurable outcomes, for the firm and for the manager. A parsimonious model of matching and incentive provision generates an array of implications that can be tested with our data. Our contribution is twofold. We disentangle the role of risk-aversion and talent in determining how firms select and motivate managers. In particular, risk-averse managers are matched with firms that offer low-powered contracts. We also show that empirical findings linking governance, incentives, and performance that are typically observed in isolation, can instead be interpreted within a simple unified matching framework.

Such results make sense. If markets for managers are in anyway efficient then the matching of managers to firms is to be expected.

EconTalk this week

Robert Townsend of MIT and the Consortium on Financial Systems and Poverty talks with EconTalk host Russ Roberts about development and the role of financial institutions in growth. Drawing on his research, particularly his surveys of households in Thailand, Townsend argues that both informal networks and arrangements and formal financial institutions play important roles in dealing with risk. Along the way, he discusses the role of microfinance in poor countries and the potential for better financial arrangements to lead to higher growth and the accumulation of wealth.

Migration and the welfare state

In this audio from VoxEU.org Assaf Razin of Cornell University and Tel Aviv University talks to Romesh Vaitilingam about his book, ‘Migration and the Welfare State: Political-Economic Policy Formation’, which explores implications of the observation that open immigration cannot co-exist with a strong safety net, and policies to resolve intra- and intergenerational conflicts over immigration policies and the generosity of the welfare state.

Competition is the consumer's friend

Mark Perry at the Carpe Diem blog gives this nice example of a simple truth, that competition aids the consumer:

This was probably inevitable. Faced with all of the competition from Bolt Bus, Mega Bus, Chinatown Bus, DC2NY, Vamoose, etc. for cheap bus fares between cities like Washington, D.C. and NYC, the long-time industry leader Greyhound had to match the "predatory" fares and "cutthroat competition" of its new, upstart rivals.

As the graphic above shows, Greyhound is now offering $15 fares between DC and NYC on the Uncommon Transport website, which is less than 50% of the "standard fare" of $35 listed on Greyhound's regular website for DC to NYC. And for a route of approximately the same distance - DC to Charleston, WV (250 miles) - but without the intense competition of the 225-mile DC-NYC route, the one-way Greyhound fare is $109.

The lesson to be taken from this is that competition - even "cutthroat" competition - is the consumer's best friend, and often the best regulator of a market. This latter point often seems to be overlooked in policy circles. Introducing competition regulates a market better than any regulator can.

Problems with measuring the "knowledge economy"

The previous posting on More on the productivity paradox highlighted the problem of the measurement of the modern, new or "knowledge economy". Much time and effort is expended by many national and international organisations in an attempt to measure the economy or economies of the world. While the measuring of the ‘standard’ economy is funny enough, when we move to the measurement of the ‘knowledge economy’ measurement goes from the mildly humorous to the outright hilarious. Most attempts to measure, or even define, the information or knowledge economy border on the farcical: the movie version should be called, "Mr Bean(counter) Measures the Economy".

There are substantial challenges to be overcome in any attempt to measure the knowledge economy. These are at both the theoretical and the method level. A more consistent set of definitions are required as are more robust measures that are derived from theory rather than from whatever data is currently or conveniently available. In order to identify the size and composition of the knowledge based economy one inevitably faces the issue of quantifying its extent and composition. Economists and national statistical organisations are naturally drawn to the workhorse of the ‘System of National Accounts’ as a source of such data. Introduced during World War II as a measure of wartime production capacity, the change in (real) Gross Domestic Product (GDP) has become widely used as a measure of economic growth. However, GDP has significant difficulties in interpretation and usage (especially as a measure of wellbeing) which has led to the development of both ‘satellite accounts’ - additions to the original system to handle issues such as the ‘tourism sector’; ‘transitional economies’ and the ‘not-for-profit sector’ - and alternative measures, for example, the Human Development Indicator and Gross National Happiness. GDP is simply a gross tally of products and services bought and sold, with no distinctions between transactions that add to wellbeing, and those that diminish it. It assumes that every monetary transaction adds to wellbeing, by definition. Organisations like the Australian Bureau of Statistics and the OECD have adopted certain implicit/explicit definitions, typically of the Information Economy-type, and mapped these ideas into a strong emphasis on impacts and consequences of ICTs. The website (http://www.oecd.org/sti/information-economy) for the OECD’s Information Economy Unit states that it:

“[...] examines the economic and social implications of the development, diffusion and use of ICTs, the Internet and e-business. It analyses ICT policy frameworks shaping economic growth productivity, employment and business performance. In particular, the Working Party on the Information Economy (WPIE) focuses on digital content, ICT diffusion to business, global value chains, ICT-enabled off shoring, ICT skills and employment and the publication of the OECD Information Technology Outlook.”

Furthermore, the OECD’s Working Party on Indicators for the Information Society has

“[...] agreed on a number of standards for measuring ICT. They cover the definition of industries producing ICT goods and services (the “ICT sector”), a classification for ICT goods, the definitions of electronic commerce and Internet transactions, and model questionnaires and methodologies for measuring ICT use and e-commerce by businesses, households and individuals. All the standards have been brought together in the 2005 publication, Guide to Measuring the Information Society [ . . . ]” (http://www.oecd.org/document/22/0,3343,en_2649_201185_34508886_1_1_1_1,00.html).

The whole emphasis is on ICTs. For example, the OECD’s “Guide to Measuring the Information Society” has chapter headings that show that their major concern is with ICTs. Chapter 2 covers ICT products; Chapter 3 deals with ICT infrastructure; Chapter 4 concerns ICT supply; Chapter 5 looks at ICT demand by businesses; while Chapter 6 covers ICT demand by households and individuals.

As will be shown below several authors have discussed the requirements for, and problems with, the measurement of the knowledge/information economy. As noted above most of the data on which the measures of the knowledge economy are based comes from the national accounts of the various countries involved. This does raise the question as to whether or not the said accounts are suitably designed for this purpose. There are a number of authors who suggest that in fact the national accounts are not the appropriate vehicle for this task. Peter Howitt argues that:

“[...] the theoretical foundation on which national income accounting is based is one in which knowledge is fixed and common, where only prices and quantities of commodities need to be measured. Likewise, we have no generally accepted empirical measures of such key theoretical concepts as the stock of technological knowledge, human capital, the resource cost of knowledge acquisition, the rate of innovation or the rate of obsolescence of old knowledge.” (Howitt 1996: 10).

Howitt goes on to make the case that because we can not measure correctly the input to and the output of, the creation and use of knowledge, our traditional measure of GDP and productivity give a misleading picture of the state of the economy. Howitt further claims that the failure to develop a separate investment account for knowledge, in much the same manner as we do for physical capital, results in much of the economy’s output being missed by the national income accounts.

In Carter (1996) six problems in measuring the knowledge economy are identified:

1. The properties of knowledge itself make measuring it difficult,
2. Qualitative changes in conventional goods: the knowledge component of a good or service can change making it difficult to evaluate their ‘levels of output’ over time,
3. Changing boundaries of producing units: for firms within a knowledge economy, the boundaries between firms and markets are becoming harder to distinguish,
4. Changing externalities and the externalities of change: spillovers are increasingly important in an knowledge economy
5. Distinguishing ‘meta-investments’ from the current account: some investments are general purpose investments in the sense that they allow all employees to be more efficient
6. Creative destruction and the ‘useful life’ of capital: knowledge can become obsolete very quickly and as it does so the value of the old stock drops to zero.

Carter argues that these issues result in it being problematic to measure knowledge at the level of the individual firm. This results in it being difficult to measure knowledge at the national level as well since the individual firms’ accounts are the basis for the aggregate statistics and thus any inaccuracies in the firms’ accounts will compromise the national accounts.

Haltiwanger and Jarmin (2000) examine the data requirements for the better measurement of the information economy. They point out that changes are needed in the statistical accounts which countries use if we are to deal with the information/knowledge economy. They begin by noting that improved measurement of many “traditional” items in the national accounts is crucial if we are to understand fully Information Technology’s (IT’s) impact on the economy. It is only by relating changes in traditional measures such as productivity and wages to the quality and use of IT that a comprehensive assessment of IT’s economic impact can be made. For them, three main areas related to the information economy require attention:

The investigation of the impact of IT on key indicators of aggregate activity, such as productivity and living standards,

1. The impact of IT on labour markets and income distribution and
2. The impact of IT on firm and on industry structures.

Haltiwanger and Jarmin outline five areas where good data are needed:

1. Measures of the IT infrastructure,
2. Measures of e-commerce,
3. Measures of firm and industry organisation,
4. Demographic and labour market characteristics of individuals using IT, and
5. Price behaviour.

In Moulton (2000) the question is asked as to what improvements we can make to the measurement of the information economy. In Moulton’s view additional effort is needed on price indices and better concepts and measures of output are needed for financial and insurance services and other “hard-to-measure” services. Just as serious are the problems of measuring changes in real output and prices of the industries that intensively use computer services. In some cases output, even if defined, is not directly priced and sold but takes the form of implicit services which at best have to be indirectly measured and valued. How to do so is not obvious. In the information economy, additional problems arise. The provision of information is a service which in some situations is provided at little or no cost via media such as the web. Thus on the web there may be less of a connection between information provision and business sales. The dividing line between goods and services becomes fuzzier in the case of e-commerce. When Internet prices differ from those of brick-and-mortar stores do we need different price indices for the different outlets? Also the information economy may affect the growth of Business-to-Consumer sales, new business formation and in cross-border trade. Standard government surveys may not fully capture these phenomena. Meanwhile the availability of IT hardware and software results in the variety and nature of products being provided changing rapidly. Moulton also argues that the measures of the capital stock used need to be strengthened, especially for high-tech equipment. He notes that one issue with measuring the effects of IT on the economy is that IT enters the production process often in the form of capital equipment. Much of the data entering inventory and cost calculations are rather meagre and needs to be expanded to improve capital stock estimates. Yet another issue with the capital stock measure is that a number of the components of capital are not completely captured by current methods, an obvious example being intellectual property. Also research and development and other intellectual property should be treated as capital investment though they currently are not. In addition to all this Moulton argues that the increased importance of electronic commerce means that the economic surveys used to capture its effects need to be expanded and updated.

In Peter Howitt’s view there are four main measurement problems for the knowledge economy:

1. The “knowledge-input problem”. That is, the resources devoted to the creation of knowledge are underestimated by standard measures.
2. The “knowledge-investment problem”. The output of knowledge resulting from formal and informal R&D activities is typically not measured.
3. The “quality improvement problem”. Quality improvements go unmeasured.
4. The “obsolescence problem”. No account is taken of the depreciation of the stock of knowledge (and physical capital) due to the creation of new knowledge.

To deal with these problems Howitt makes a call for better data. But it’s not clear that better data alone is the answer, to both Howitt’s problems and the other issues outlined here. Without a better theory of what the “knowledge economy” is and the use of this theory to guide changes to the whole national accounting framework, it is far from obvious that much improvement can be expected in the current situation.

One simple, theoretical, question is, To which industry or industries and/or sector or sectors of the economy can we tie knowledge/information production? When considering this question several problems arise. One is that the “technology” of information creation, transmission and communication pervades all human activities so cannot fit easily into the national accounts categories. It is language, art, shared thought, and so on. It is not just production of a given quantifiable commodity. Another issue is that because ICT exists along several different quantitative and qualitative dimensions production can not be added up. In addition if much of the knowledge in society is tacit, known only to individuals, then it may not be possible to measure in any meaningful way. Also if knowledge is embedded in an organisation via organisational routines then again it may not be measurable. Organisational routines may allow the knowledge of individual agents to be efficiently aggregated, much like markets aggregate information, even though no one person has a detailed understanding of the entire operation. In this sense, the organisation “possesses” knowledge which may not exist at the level of the individual member of the organisation. Indeed if, as Hayek can be interpreted as saying, much of the individual knowledge used by the organisation is tacit, it may not even be possible for one person to obtain the knowledge embodied in a large corporation.

As noted above Carter (1996) emphasises that it is problematic to measure knowledge at the national level in part because it is difficult to measure knowledge at the level of the individual firm. Part of the reason for this is that none of the orthodox theories of the firm offer us a theory of the “knowledge firm” which is needed to to guide our measurement.

Thus many of the measurement problems of the "knowledge economy" are rooted in the fact that we don't have a good theory of the "knowledge economy" or the "knowledge firm". Without such theories calls for better data are wasted, they miss the point. "Better" data collection alone is not going to improve the measurement of the "knowledge economy".

More on the productivity paradox

Annie Lowrey has an article in Stale in which she asks, Why hasn't the Internet helped the American economy grow as much as economists thought it would? And answer is, may be it has but we just don't know how to measure it.

Maybe it is not the growth that is deficient. Maybe it is the yardstick that is deficient. MIT professor Erik Brynjolfsson explains the idea using the example of the music industry. "Because you and I stopped buying CDs, the music industry has shrunk, according to revenues and GDP. But we're not listening to less music. There's more music consumed than before." The improved choice and variety and availability of music must be worth something to us—even if it is not easy to put into numbers. "On paper, the way GDP is calculated, the music industry is disappearing, but in reality it's not disappearing. It is disappearing in revenue. It is not disappearing in terms of what you should care about, which is music."

As more of our lives are lived online, he wonders whether this might become a bigger problem. "If everybody focuses on the part of the economy that produces dollars, they would be increasingly missing what people actually consume and enjoy. The disconnect becomes bigger and bigger."

But providing an alternative measure of what we produce or consume based on the value people derive from Wikipedia or Pandora proves an extraordinary challenge—indeed, no economist has ever really done it. Brynjolfsson says it is possible, perhaps, by adding up various "consumer surpluses," measures of how much consumers would be willing to pay for a given good or service, versus how much they do pay. (You might pony up $10 for a CD, but why would you if it is free?) That might give a rough sense of the dollar value of what the Internet tends to provide for nothing—and give us an alternative sense of the value of our technologies to us, if not their ability to produce growth or revenue for us.

In short, we are trying to use 20th century measurement technology to measure a 21st century economy. And that just isn't going to work. As Don Boudreaux put it,

what has stagnated isn’t the economy but, rather, economists’ and statisticians’ capacity to measure economic activity and its contribution to human well-being.

Milton Friedman on Donahue

In this 1979 video, Milton Friedman is interviewed by talk-show host Phil Donahue. The discusion centres on the nature of greed and the virtues of capitalism.

Cheap at twice the price

Earlier I noted the anniversary of the publication of Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations. In the comments to the posting Wayne H points us to this page from Christies where they sold a first edition of the book for a mere US$122,500!

Or you could just read it online for nothing.

Demand curves slope downwards

From writer Joe Konrath,

Eighteen days ago, I dropped the price of my ebook, The List, from $2.99 to 99 cents on Amazon. I was selling 40 copies a day prior to that.

Currently, The List is #37 in the Top 100 Bestsellers on the Kindle. It's selling 620 copies a day on Amazon.

An anniversary I missed

Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations was published on 9th March 1776. It is this book, it is normally claimed, that started economics.

Computers and productivity

As noted in a previous post, Chris Trotter wrongly attributes New Zealand's post-reform increases in MFP growth to the concurrent adoption of information technologies by business in New Zealand:

Have you given any thought to the fact that the period of rapid MFP growth depicted in the graph coincides with the widespread adoption of the personal computer in New Zealand workplaces; the opening up of the Internet from 1992 onwards; and the rapid take-up of the mobile phone as an essential tool of business?

While Chris's timing is wrong he does inadvertently raise the interesting issue of what is the relationship between information technologies and productivity growth. Here the U.S. is an interesting case study.

Alcaly (2003: 20) says,

Whatever else we might wish it where, a new economy is one that has changed significantly through the adoption of innovative new technologies and business practices, leading to a meaningful and sustainable increase in the rate of productivity growth.

Robert Solow famously quipped in a 1987 review of the book “Manufacturing Matters: The Myth of the Post-Industrial Economy” that: “[y]ou can see the computer everywhere but in the productivity statistics.” A remark that has given rise to what is often called the “Solow productivity paradox”. We have computers but where are the productivity gins? Post-1995 the effects of computers finally showed up in the U.S. productivity statistics. In the post mid-90s period paradox seemed resolved. Computers did finally show up in the productivity stats.

It [productivity growth in the United States] finally began to pick up after 1995, rising over the next five years at a rate of more than 2.5 percent a year, almost twice as fast as its pace between 1973 and 1995 and within striking distance of the rates achieved during the golden age of 1948-1973. The surge during the last half of the 1990s raised the average growth rates of productivity and living standards for the entire decade to roughly 2 percent a year, about the same as for the century as a whole. (Alcaly 2003: 37-8)

The average rates of productivity growth in the U.S. for the period 1948-73 was 2.9 percent, for 1974-1995 it was 1.4 percent and 1996 to the third quarter of 2002 it was 2.6 percent. Coyle (2001: 27) explains that “[ . . . ] the improvement [in U.S. productivity growth in the late 1990s] came mainly from greater use of information technology and greater efficiency in its production. Average U.S. growth climbed from 2.75 percent in 1991-95 to 4.82 percent in 1996-99. Of this two-point improvement, 0.5 point come from growth in the input of information-technology capital, 0.9 from other capital and labor input, and 0.6 from increased growth in total factor productivity. The contribution to growth from this measure of technical progress shot up from 0.48 percent a year in the early 1990s to 1.16 percent in the second half of the decade.” So around two-thirds of the mid-to-late-90s acceleration in productivity growth was due to investment in computers, software, networks infrastructure etc along with efficiency gains in the production of computer equipment and semiconductors. By 1996 the new economy had finally arrived. For the U.S. at least.

The productivity surge was not worldwide. As Robert Gordon notes Europe, for example, did not follow the U.S. in having a post 1995 productivity increase, “[ . . . ] since 1995 Europe has experienced a productivity growth slowdown while the United States has experienced a marked acceleration. As a result, just in the past eight years, Europe has already lost about one-fifth of its previous 1950-95 gain in output per hour relative to the United States. Starting from 71 percent of the U. S. level of productivity in 1870, Europe fell back to 44 percent in 1950, caught up to 94 percent in 1995, and has now fallen back to 85 percent.” (Gordon 2007: 176).

But wherever the acceptance of the new economy went scepticism about the causes of the productivity increases was soon to follow. Robert Gordon is one who argues that by themselves computers could not match the effects of the innovations of the past which involved a cluster of new technologies being developed contemporaneously. As an example he points to the combination of innovations which occurred over the period 1860-1900 and resulted in developments such as electricity, air and motor transport, radio and movies and indoor plumbing.

As to the reasons for the apparently small effects and slow appearance of the new economy, in the aggregate data, Coyle (2007: 60-1) offers three observations,

There are several responses to the argument that computers have not been very important for growth. One is that measuring the impact of steam or electricity in exactly the same way as the impact of computers is measured (using the growth accounting described above), you find that steam and electricity look pretty small too: a “small” percentage point difference in growth rates is the statistical footprint of a large economic and social change (Crafts 2004). [ . . . ] A second is that any radical innovation takes a long time to have measurable aggregate impact because people take many years to adjust: perhaps new infrastructure must be built, new skills learned, workplaces reorganized (David 1991). Indeed, many people have an incentive to resist innovations. As Niccol`o Machiavelli put it in The Prince, “Innovation makes enemies of all those who prospered under the old regime, and only lukewarm support is forthcoming from those who would prosper under the new.” And, lastly, although popular attention has focused on computers, there is a cluster of new technologies today, including biotechnology, new materials, and nanotechnology. Their combined impact on our well-being is likely to be just as profound as the cluster of technologies introduced around the start of the twentieth century.

Interestingly, unlike the macro-level data we have just been looking at, micro-level data provides little evidence in support of Solow’s productivity paradox. Pilat (2004a: 11) explains “[s]tudies with firm-level data often find the strongest evidence for economic impacts of ICT.” Recent research on the productivity paradox based on firm-level data suggests that ICT use is beneficial to firm performance and productivity, even for industries and countries where there is no evidence at the more aggregate levels. This result holds for all countries in which micro-level studies have been carried out. For example, Hempell, Van Leeuwen and Van Der Wiel (2004) found that ICT capital deepening increased labour productivity in services firms in Germany and the Netherlands. A close correlation between labour productivity and ICT use was found for Swiss firms by Arvanitis (2004). Maliranta and Rouvinen (2004) looked at ICT use in Finland and concluded there are productivity-enhancing effects associated with ICTs. Baldwin, Sabourin and Smith (2004) found that greater use of ICTs was associated with higher labour productivity growth in the nineties for Canada. Clayton et al (2004) analysed U.K. data and found a positive effect on labour productivity and multi-factor productiviy associated with the exploration of computer networks for trading. U.S. data was used by Atrostic and Nguyen (2002) to demonstrate that average labour productivity was higher in plants with computer networks with labour productivity being around 5 percent higher for such plants.

But the evidence also suggests that turning investment in ICT into higher productivity is not a forgone conclusion - something policymakers in New Zealand should keep in mind - and that to do so requires complementary investments and changes in areas such as human capital, organisational change and innovation. Countries which better support a process of creative destruction, with successful firm growing and failing firm disappearing, are better able to seize the advantages of ICTs.

Pilat (2004b: 56-8) argues there are six reasons why we find a productivity paradox in the aggregate data but do not see it in the micro-level data:

“[f]irst, aggregation across firms and industries, as well as the effects of other economic changes, may disguise the impacts of ICT in sectoral and aggregate analysis. This is also because the impacts of ICT depend on other factors and policy changes, which may differ across industries. The size of the aggregate effects over time depends on the rate of development of ICT, their diffusion, lags, complementary changes, adjustment costs and the productivity-enhancing potential of ICT in different industries (Gretton et al., 2004). Disentangling such factors at the aggregate or industry level is not straightforward.

Second, the firm-level benefits of ICT in many OECD countries may not yet be large enough to translate into better outcomes at the aggregate level. The firm-level benefits may be larger in the United States (and possible also in Australia) than in other OECD countries, and thus show up more clearly in aggregate and sectoral evidence. For example, Haltiwanger et al. (2003) suggest that the impacts of ICT are smaller in Germany than in the United States. Given the more extensive diffusion of ICT in the United States, and its early start, this interpretation should not be surprising. This is particularly the case if it takes time before the benefits from ICT become apparent, e.g. because of high costs of adjustment to the new technology. Moreover, the conditions under which ICT is beneficial to firm performance, such as having sufficient scope for organisational change or process innovation, might be more firmly established in the United States than in many other OECD countries. Small firm-level benefits in most OECD countries might thus lead to relatively small productivity benefits at the aggregate level.

Third, firms that are successful in implementing ICT may be better able to gain market share and grow in a competitive market such as the United States than in less competitive markets. This would contribute to greater overall impacts of ICT in the United States. For example, some of pick-up in US productivity growth over the second half of the 1990s can be attributed to the growth in market share of Wal-Mart, a company that replaced many less efficient retailers, partly owing to its effective use of ICT throughout the value chain. If the most efficient firms in Europe find it difficult to expand and gain market share, even if they do benefit from ICT, the overall impacts on productivity might be more limited than in the United States.

Fourth, measurement may play a role. The impacts of ICT may be insufficiently picked up in macroeconomic and sectoral data outside the United States, due to differences in the measurement of output. For example, the United States is one of the few countries that have changed the measurement of banking output to reflect the convenience of automated teller machines. Since services sectors are the main users of ICT, inadequate measurement of service output might be a considerable problem.

Fifth, countries outside the United States may not yet have benefited from spill-over effects that could create a wedge between the impacts observed for individual firms and those at the macroeconomic level. The discussion above has already suggested that the impacts of ICT may be larger than the direct returns flowing to firms using ICT. For example, ICT may lower transaction costs, that can improve the functioning of markets (by improving the matching process), and make new markets possible. Another effect that can create a gap between firm-level returns and aggregate returns is ICTs impact on knowledge creation and innovation. ICT enables more data and information to be processed at a higher speed and can thus increase the productivity of the process of knowledge creation. A greater use of ICT may thus gradually improve the functioning of the economy. Such spill-over effects may already have shown up in the aggregate statistics in the United States, but not yet in other countries.

Finally, the state of competition may also play a role in the size of spill-over effects. In a large and highly competitive market, such as the United States, firms using ICT may not be the largest beneficiaries of investment in ICT. Consumers may extract a large part of the benefits, in the form of lower prices, better quality, improved convenience, and so on. In other cases, firms that are upstream or downstream in the value chain from the firms using ICT might benefit from greater efficiency in other parts of the value chain. In countries with a low level of competition, firms might be able to extract a greater part of the returns, and spill-over effects might thus be more limited.

So Chris Trotter raises an important question about the relationship between information technologies and productivity growth, even if he doesn't have an answer. The answer largely depends on what data you are looking at. We see Solow's productivity paradox in the macro-level data but the micro-level data provides little evidence in support of the paradox.

Chris Trotter on technological innovation and productivity growth

In a posting, Reply to Chris Trotter, at his blog Roger Kerr quotes Chris Trotter as saying,

An interesting graph, Roger.

As you quite rightly state, MFP measures the influence of innovation and technological improvements on the productivity of our business enterprises.

Have you given any thought to the fact that the period of rapid MFP growth depicted in the graph coincides with the widespread adoption of the personal computer in New Zealand workplaces; the opening up of the Internet from 1992 onwards; and the rapid take-up of the mobile phone as an essential tool of business?

All of these technological changes were responsible for substantial productivity gains, but none of them are attributable to the neoliberal economic reforms introduced by Roger Douglas and Ruth Richardson.

Robert Solow famously quipped in a 1987 review of the book “Manufacturing Matters: The Myth of the Post-Industrial Economy” that: “[y]ou can see the computer everywhere but in the productivity statistics.” A remark that has given rise to what is often called the “Solow productivity paradox”. It wasn't until post-1995 that the effects of computers finally showed up in the U.S. productivity statistics. The point here is that productivity gains can be hard to find and even when found there is a long lag between the technological innovation and the productivity increases showing up. Computers started to play an increasing role for business in the U.S. in the 1970s but it was not until the mid-1990s that productivity increases showed up in the data. A delay of some 20-25 years. So the idea that "rapid MFP growth [...] coincides with the widespread adoption of the personal computer in New Zealand workplaces; the opening up of the Internet from 1992 onwards; and the rapid take-up of the mobile phone as an essential tool of business" is implausible simply on a timing bases. Technological innovation and the MFP growth simply do not coincide as Trotter argues.

Demsetz on Coase and Pigou

At Cafe Hayek Don Boudreaux points us to a new paper by Harold Demsetz on The Problem of Social Cost: What Problem? A Critique of the Reasoning of A.C. Pigou and R.H. Coase. The paper is in the Review of Law & Economics, Vol. 7 (2011), Issue 1.

Boudreaux argues that the key part (pp. 4-5; emphasis added) is:

[A.C.] Pigou’s other examples are of the same sort. They depict conditions that seem quite removed from how we would describe a decentralized, private-ownership economic system (populated by rational persons). A private person (or the Dept. of Recreation) constructs a park but does not control its use by others; the park is over-crowded as a result. But it must be that the owner of the property takes pleasure from the overcrowding or that he neglects his own interest. In the first case there is no inefficiency, since the pleasure he derives from large crowds must be taken into account; in the second case, this person cannot be a resident of the model being examined by Smith or neoclassical economists. A third type of example involves what we now call an agency problem. An owner of land rents the land to an occupant. Pigou asserts that the occupant will not take proper care of the land because he cannot be monitored closely by the owner of the land. Hence, Pigou calls for legislation to reduce the severity of misuse of property. But there is no reason to suppose the State can monitor the renter more effectively than can the land’s owner. It must be then, if the owner is rational, that the cost of monitoring the tenant’s behavior exceeds the added value that doing so would bring to the owner’s property. Hence, there is no inefficiency. All Pigou’s examples that I have examined suffer from this type of failure: they assume faulty behavior or a non-private organizational arrangement (State ownership or the complete absence of ownership) that is precluded by the neoclassical model. Special attention should be given to the last example discussed above, the land-owner/land-renter example, for the assumed positive cost of monitoring comes very close to costs that Coase would classify as transaction costs or as being necessary to a price system.

In response to the inefficiencies that he sees, Pigou turns to the State to levy taxes or confer subsidies that result in equality between private and social cost. His manner of doing this idealizes the State, which somehow knows the facts and is able to employ them at less cost than could private parties. He writes of idealized State-directed solutions to the problems that, as illustrated above, are likely to have been caused by the State itself. A Nirvana State is a dangerous tool, for it diverts attention from the real underlying problem. Why is ownership lacking or why is an owner not tending to his self-interest? In The Economics of Welfare and the doctrine that it spawned, the State is but a magic wand that Pigou waves with no effort to make private and social cost equal – the same State that, through its mismanagement, has caused many of the inequalities between private and social cost that Pigou discusses.

Notwithstanding the weaknesses in Pigou’s demonstration, his view commanded attention from economists and succeeded in replacing or becoming an appendage to the neoclassical model. Then, in 1960, came Coase’s ‘ The Problem of Social Cost.’ Coase noted, as had Knight, that Pigou’s examples were offered without rationalizing their emergence from or within a private ownership, decentralized, competitive economy. Coase then goes on to modify the conditions that describe the decentralized, private-ownership economic system. Since perfect decentralization assumes that all persons know all prices that are relevant to their decisions, the model implicitly assumes that the cost of acquiring knowledge about various opportunities for employing resources is zero. Coase identifies this implicit assumption as a presumption that the price system is free to all to use, and he argues effectively for rejecting this assumption and replacing it with one that recognizes that resources are needed to create and maintain a price system. (Following contemporary discussion, I henceforth denote the cost of creating and maintaining the price system as the cost of transacting.) I concur with Coase in his claim that the perfect decentralization model treats the price system as if it were free. Where Pigou simply conjures unowned resources and failures of contracts, Coase essentially proposes a modified model of a decentralized, private-ownership economic system in which positive transaction cost is embedded. However, had Coase remembered Knight’s work, he might have found an equally good or, in my judgment, a better way to enrich the neoclassical model. The model assumes that private ownership attaches to all resources and that rights of ownership are fully respected. In effect, in addition to a free price system, it assumes a free private ownership system. And we know this cannot be the case. Rather than rely on positive transaction cost, Coase could have insisted on positive cost of ownership, or on both.

Reference points and the theory of the firm

A new working paper on 'Reference Points' and the Theory of the Firm: A Introduction is available below. The abstract reads:

There is a small but growing literature on the theory of the firm based around the “reference point” theory of (incomplete) contracts formulated in Hart and Moore (2008). The reference point approach has been applied to the theory of the firm in Hart (2008, 2009), Hart and Moore (2007) and Hart and Holmstrom (2010). This survey reviews each of these papers in turn. It then discusses the relationship between the reference point approach to the firm, the transaction cost approach and the property rights approach. Here it is argued that the reference point approach is a step back towards ex post inefficiencies, away from reliance on ex ante inefficiencies.

Its a work in progress so comments are welcome.




Reference Points and the Theory of the
Firm

Seasteading

There is a great new article in latest issue of The Freeman (March 2011, Volume: 61, Issue: 2) entitled Seasteading: Striking at the Root of Bad Government by Patri Friedman and Brad Taylor. Brad in a UC grad in pols, although his masters thesis was co-supervised by Eric Crampon, so he has some redeeming features!!! Brad is also is a research associate at The Seasteading Institute. He blogs on seasteading and competitive government at Let a Thousand Nations Bloom and is writing a book on seasteading with Patri Friedman and Daniel Holt.

Friedman and Taylor open their article by saying,

Libertarians have done a wonderful job of pointing out the inefficiency and cruelty of government and identifying some of the causes. We know that current policies are bad; we know that such policies are the inevitable outcome of unrestrained democracy; and we even have some ideas about what would work better. The most fundamental problem with government and the most promising form of activism have been largely ignored, though. If we want liberty in our lifetimes, we need to think more carefully about why we have bad government and how best to improve things.

To think about this question, we need to avoid being either too romantic or too cynical about governance. While readers of this publication are at no risk of being romantic about government, there is a chance of excessive cynicism. Government currently works very poorly, but this doesn’t need to be so. Competition would force providers of governance to offer high-quality rules and public services at a reasonable price, unleashing institutional innovation and making the world a much better place.

So far, most libertarians have been hacking at branches, while a few come tantalizingly close to striking at the root. We’re going to try to convince you that the root at which we should be striking is a tangled mess of barriers to entry and costs of switching in the governance market. The ax we should be using is the technology to settle the ocean.

Having people being able to move between governments has many advantages. For start it increases competition between goverments:

As it happens, the ocean has another important benefit. Water makes it easy to shift large objects around cheaply. This is what allowed the global shipping industry to prosper, and it could also help make government more competitive. We normally think of buildings as being tied to land, and this has serious implications for competition. Government can do a lot of harm before it becomes worthwhile for someone to move away. The fluidity of the ocean, in contrast, allows people to vote with their house by sailing to a neighboring jurisdiction. If a seasteading government announces an unpopular policy, it could find that it rules over nothing but empty waves. This would allow bad governments to die without bloodshed and force governors to think about what people really want.

Friedman and Taylor end by saying,

While the challenges and uncertainties in settling the ocean are large, there are only a few core problems and none are insurmountable. To make seasteading a reality we need to take a pragmatic, incremental, and business-focused approach. Rather than creating a multibillion-dollar vessel straight away without any clear way to finance it, we encourage seasteading entrepreneurs to think carefully about the business case for particular industries for which seasteading has a comparative advantage. Many industries are overregulated, and a seastead off the coast of a major U.S. city offering medical treatments not yet approved by the FDA, for example, would be a very lucrative proposition.

We know it is possible to live on the ocean; we know there are ways to make money there, and our mission is to drive down the costs of seasteading to transform the ocean from potential frontier into real frontier and eventually into just another option with some serious advantages. This will lead to experimentation and innovation in governance and force existing States to improve or wither away for a lack of residents. The challenges are large but the potential payoffs are much, much larger. By transforming the political problem of bad governance into a hard but achievable technological problem, which humans have a knack for solving, we make success possible.

Now go read the stuff between the beginning and the end, its well worthwhile.

EconTalk this week

Freeman Dyson of the Institute for Advanced Study in Princeton talks with EconTalk host Russ Roberts about science, his career, and the future. Dyson argues for the importance of what he calls heresy--challenging the scientific dogmas of the day. Dyson argues that our knowledge of climate science is incomplete and that too many scientists treat it as if it were totally understood. He reflects on his childhood and earlier work, particularly in the area of space travel. And he says that biology is the science today with the most exciting developments.

Privatisation myths need to be busted

Or so says Roger Kerr. In a piece in the Dominion Post today Kerr discusses 8 myths to do with privatisation.

Myth#1 In a supportive article in the Dominion Post of February 23, Terry McLaughlin, chief executive of the New Zealand Institute of Chartered Accountants, wrote, “privately owned businesses consistently outperform publicly owned businesses.”

This is clearly not the case: some private firms fail and some publicly owned ones perform well, at least for a time.

The correct statement, supported by much economic research, is that, on average and over time, privately owned businesses outperform publicly owned ones. [...]

For evidence on this point see here.

Myth #2 Privatisation is ideological. To the contrary, it is pragmatic: it (generally) works. When the Thatcher government embarked on privatisation in the 1980s, some regarded it as a leap of faith. It was not a popular policy to advance but was supported when the benefits became clear. As a British minister said, “facts overtook the debate.” [...]

Myth #3 Privatisation is needed to reduce debt. This is a secondary argument: privatisation is really just a transfer of ownership. The policy is desirable regardless of New Zealand’s (public or private) debt position. I’d be happy to see the government simply give away shares in state-owned enterprises to their true (but disenfranchised) owners, taxpayers.

I have discussed parts of this Myth here and here.

Myth #4 The government should own SOEs because it has a lower cost of (debt) capital. This is one of the oldest of economic fallacies, recycled recently by British academic David Wood on a visit to New Zealand sponsored by the PSA. If it were true, the government should take over most businesses in the economy! But it isn’t – the economic risk and cost of a project, and hence its cost of capital, is unaffected by the source of funds. Government borrowing is (largely) risk-free only because the government can force taxpayers to fund losses.

Eric Crampton has considered this Myth before.

Myth#5 SOEs were sold too cheaply. In fact almost all privatisations in New Zealand were conducted through an open and competitive sales process with anyone in the world able to bid. The price obtained was therefore the best available. The price paid for Telecom ($4,250 million in 1990) was widely seen as high and a positive surprise to the market. Fletcher Challenge clearly paid too much in retrospect for the Forestry Corporation but hindsight is an irrelevant standard from an investment perspective.

Myth #6 Privatisation leads to more foreign control over New Zealand. Not so: it may lead to a level of foreign control of the privatised company (which is inevitable and desirable for large listed companies: domestic institutions must have diversified portfolios) but not to more overall foreign ownership of New Zealand assets. When a foreigner buys New Zealand assets they must exchange them for an equivalent New Zealand claim on foreign assets. The net claims on New Zealand from the rest of the world are unchanged.

Ironically, many of the people who regard the privatisation of Tranz Rail as a failure also wrongly make this complaint. But in the case of Tranz Rail overseas investors did not achieve returns that covered their cost of capital – the likely result was a reduction in net claims on New Zealand.

Myth #7 The government loses financially from privatisation because it forgoes dividends. This is nonsense: the sale price reflects all future expected dividends paid up front. In addition, the government will capture in the sale price some of the likely efficiency gains resulting from
privatisation.

Myth #8 Air New Zealand is a good model for the government’s partial privatisation approach. Air New Zealand is innovative and it is performing well operationally. However, it has not been meeting its cost of capital (by perhaps as much as half in the last financial year), meaning that potential national income has been sacrificed (New Zealanders are poorer than otherwise). Treasury numbers indicate Air New Zealand’s value (market capitalisation) more than halved between 2007 and 2010. A private firm that fails to meet its cost of capital (like Fletcher Challenge in the 1990s) ultimately has to cut costs, end loss-making activities or restructure, but there are weaker pressures on Air New Zealand.

Kerr ends his article by saying

The government will need to do better if it is to sustain its case for partial privatisation.

On why I'm not a great fan of partial privatisation see here.

Kerr is right in saying that myths about privatisation need to busted, and does a good job in doing so. I have discussed many aspects of privatisation before including a number of these Myths. See here for a complete list of postings.

Protectionists are to economics what astrologers are to astrophysics

How can you not love the title. It is, of course, due to Don Boudreaux at the Cafe Hayek blog. Boudreaux has written to website Economy in Crisis and makes a point similar to my previous posting Imports Good; Exports Bad. Boudreaux just says it better.

Setting up a straw man for the slaughter, Dustin Ensinger asserts that “Proponents of unfettered free trade have long claimed that lowering trade barriers will allow America to export more and more goods, eventually leading to trade surpluses and economic prosperity” (“Exports Won’t Solve America’s Many Trade Woes,” March 6).

Wrong.

Proponents of unfettered free trade have long claimed that lowering trade barriers will allow America to import more and more goods, eventually leading to greater economic prosperity. Period.

Proponents of unfettered free trade – at least those who understand economics – don’t give a damn about trade ‘deficits’ or ‘surpluses.’ They agree with Adam Smith that “Nothing, however, can be more absurd than this whole doctrine of the balance of trade.”

One of the most strange, and dangerous, ideas on trade is the idea that exporting is good as it -somehow- leads to trade surpluses and thus economic prosperity. Of course it doesn't. Importing expands our consumption possibilities and this increases our prosperity.

The economics of the sports stadium again

With AMI stadium here in Christchurch now in need of a large amount of repair work it is a good time to think about the economics of such a stadium. It looks like the ratepayer/taxpayer will be on the hook for very large bill so lets ask, Is the stadium worth it?

Sports economist Phil Miller at the Market Power blog helps with the answer:

Fortunately, the Atlanta Journal Constitution presents an article in which sports economists discuss some hard data.

A new open-air stadium downtown for the Atlanta Falcons would be of enormous benefit — to the Atlanta Falcons. Neither local taxpayers nor the region’s economy is likely to accrue much advantage from a new arena built on public land, in part with public money, experts told The Atlanta Journal-Constitution last week.

“Economists have studied the economic impact of stadiums to death, and the clear consensus is that there is no positive impact,” said author and sports economist J.C. Bradbury of Kennesaw State University. “Economists don’t agree on a lot, but right wing, left wing, they all agree on that.” (Emphasis added)

So is the stadium worth it? No.

The decline of economic theory: I think not

Bryan Caplan at EconLog wishes to celebrate The Decline of Economic Theory,

When I started my Ph.D. in Princeton, pure economic theory was king. Economists with stellar math skills were high in status and high in demand, even if their knowledge of the real world was... slight.

In the following eighteen years, however, something big seems to have changed.

As one who takes the strange, it would seem, view that theory still has a lot going for it I would argue that what has happened is that the type of theory has changed over those 18 years. Gone are the days of just doing general equilibrium theory of the Arrow and Debreu type. As Till Duppe writes,

[f]rom the point of view of today Debreu's influence on the body of economics could be called zero, in that general equilibrium theory (GET) is the economics of yesterday. (Duppe 2010: 2-3).

Today theory is more likely to be partial equilibrium theory in the form of things like, for example, auction theory, game theory, market design theory or contract theory. All of these are making a contribution to our "knowledge of the real world", despite what Caplan seems to think.

And I'm not the only one who sees positive signs for theory. Jeff Ely at the Cheap Talk blog sees at least four positive signs:

1. Theorists have been recruiting targets for high-profile private sector jobs. Michael Schwarz and Preston McAfee at Yahoo!, Susan Athey at Microsoft for example. In addition the research departments in these places are full of theorists-on-leave.
2. Despite some overall weakness, theory is and always has been well represented at the top of the junior market. This year Alex Wolitzky, as pure a theorist as there is, is the clear superstar of the market. Here is the list of invitees to the Review of Economics Studies Tour from previous years. This is generally considered to be an all-star team of new PhDs in each year. Two theorists out of seven per year on average. (No theorist last year though.)
3. In recent years, two new theory journals, Theoretical Economics and American Economic Journal: Microeconomics, have been adopted by the leading Academic Societies in economics. These journals are already going strong.
4. Market design is an essentially brand new field and one of the most important contributions of economics in recent years. It is dominated by theorists.

That said, I do see very few economists, in this country at least, who take theory seriously as they should. Most economists look to me to be of the 'I run a million regressions and picked the one that confirmed my prejudices' type.

Oh well, it's back to the THEORY of the firm for me I guess.

• Duppe, Till (2010). ‘Debreu's apologies for mathematical economics after 1983’, Erasmus Journal for Philosophy and Economics, 3(1) Spring: 1-32.

Reasons to be bullish about Spain

In this audio from VoxEU.org Albert Marcet of the London School of Economics explains to Viv Davies why predictions of potential Spanish sovereign default are misguided. Marcet presents his views on Spain’s fiscal sustainability, its unemployment and housing problems, the autonomous regions and the recapitalisation of the cajas. He also discusses debt and fiscal coordination in the eurozone and comments on his new role as scientific chair of the Euro Area Business Cycle Network (EABCN).

Can we say "rent seeking"

From an article in the New Zealand Herald:

Kevin Hix, owner of Auckland's QF Tavern, told a committee considering the Alcohol Reform Bill yesterday that the two big supermarket chains had an extraordinary amount of power over the breweries. [...]

"They are cutting the margins to the point where it's very difficult for the breweries to move.[...]

Mr Hix was one of many people in the liquor industry at yesterday's hearing who supported the bill's measures to stem the proliferation of alcohol outlets since the industry was liberalised in 1989.[...]

But Mr Hix said the real problem was the spread of liquor sales in shops and corner grocers that had led to price-cutting.

"I don't know how supermarket operators can sleep at night."[...]

"Now you can buy a Steinlager in a supermarket for $2. In my bars it's $8 to $8.50.[...]

The bill, the first major reform of the industry since 1989, would give local councils powers to control the numbers and locations of liquor outlets. It would make all bars close by 4am and would ban advertising of price discounts of more than 25 per cent below the "normal" price of an alcoholic product.

But Murray Spearman, manager of the Portage and Waitakere licensing trusts in West Auckland, said the bill failed to define the "normal" price and did not go far enough.

"We suggest the best method is a ban on alcohol product price advertising," he said.

I have seen some self-serving, anti-competitive b-s in my time but this really does take the cake beer. Bars may be having a hard time due to competition from other outlets, but so what, that's what competition is all about. This submission to the committee considering the Alcohol Reform Bill is nothing more than a call for the government to guarantee cartel profits to existing bars.

(HT: TVHE)