Ricardo and comparative advantage

David Ricardo is probably most famous because of his introduction of the idea of comparative advantage into economics. Today comparative advantage is the standard reason given as to why countries gain from trade. But is Ricardo the author of the famous pages in his "Principles of Political Economy"?

In a footnote on page 132 of the fifth edition of his "Economic Theory in Retrospect" Mark Blaug writes

Ironically enough, it is now been shown that the famous pages on comparative advantage in the chapter on foreign trade were almost certainly written by James Mill. Moreover, Ricardo's own conception of foreign trade never effectively went beyond the idea of absolute advantage; in short, he does not deserve the credit he has been given for the theory of comparative advantage.

The basis for Blaug's claim is the paper, by William O. Thweatt, "James Mill and the Early Development of Comparative Advantage", History of Political Economy 8 (Summer 1976) 207-34.

A quick look at Douglas Irwin's book "Against the Trade: An Intellectual History of Free Trade" gives rise to another footnote, from page 91, which reads,

Thweatt's case is plausible because Mill worked closely with Ricardo on the Principles and commented extensively on drafts. Inconclusive evidence against his interpretation comes in a letter from Mill to Ricardo in which he states: "... that it may be good for a country to import commodities from a country where the production of those same commodities cost more, than it would cost at home: that a change in manufacturing sill in one country, produces a new distribution of the precious metals, are new propositions of the highest importance, and which you fully prove." See David Ricardo (1952, 7: 99). Futher, in his article on colonies Mill also credits Ricardo with the theory.

I had known that Mill explained the idea of comparative advantage better in his "Elements of Political Economy", published after Ricardo's "Principles", but not that he could have been the author of Ricardo's original discussion.

EconTalk this week

Eugene Fama of the University of Chicago talks with EconTalk host Russ Roberts about the evolution of finance, the efficient market hypothesis, the current crisis, the economics of stimulus, and the role of empirical work in finance and economics.

Food aid and civil war: is there a link?

It looks like the answer is yes. There is a new NBER working paper out on Aiding Conflict: The Impact of U.S. Food Aid on Civil War by Nathan Nunn and Nancy Qian.

The abstract reads:

This paper examines the effect of U.S. food aid on conflict in recipient countries. To establish a causal relationship, we exploit time variation in food aid caused by fluctuations in U.S. wheat production together with cross-sectional variation in a country's tendency to receive any food aid from the United States. Our estimates show that an increase in U.S. food aid increases the incidence, onset and duration of civil conflicts in recipient countries. Our results suggest that the effects are larger for smaller scale civil conflicts. No effect is found on interstate warfare.

If you are starving, you can't fight?

Great thinkers in economics?

Palgrave-Macmillan has a book series on "Great thinkers in economics". Titles in the series include Adam Smith, Alfred Marshall, Joseph A. Schumpeter and John Maynard Keynes, about which I would think no one could complain.

But the series also includes the likes of John Kenneth Galbraith, Michal Kalecki, Joan Robinson, Piero Sraffa, Gunnar Myrdal, Nicholas Kaldor, Dennis Robertson, Franco Modigliani and Roy Harrod.

First, are these really the greatest thinkers economics has to offer? What of, for example, Menger, Jevons, Walras, Marx, Mill - both James and J.S. - Ricardo, Malthus, Mises, Hayek, Arrow, Becker, Coase, Buchanan, Tullock or Milton Friedman?

Second, isn't there a somewhat obvious Keynesian, largely Post-Keynesian, bias to the books so far published?

The nature of the firm and its financing

The AFA presidential address by Raghuram Rajan is now out as an NBER working paper. The abstract reads:

The nature of the firm and its financing are closely interlinked. To produce significant net present value, an entrepreneur has to transform her enterprise into one that is differentiated from the ordinary. To achieve the control that will allow her to execute this strategy, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain rights over going-concern surplus. I argue that the availability of a vibrant stock market helps the entrepreneur commit to these two transformations in a way that a debt market would not. This helps explain why the nature of firms and the extent of innovation differ so much in different financing environments.

The idea that the entrepreneur has to be replaceable is important, without this a firm would die with its founder or would die if the founder tried to leave the firm. For a firm to have any chance of outlasting its founder, the human capital of the founder has to be made replaceable.

"The quality of new music has not fallen since Napster."

With issues around Megaupload being in the news, this summary, by Linda Gorman, of an NBER working paper - "Copyright Protection, Technological Change, and the Quality of New Products: Evidence from Recorded Music Since Napster" - from the latest NBER Digest makes the point that "The quality of new music has not fallen since Napster."

Napster was the first widely used program that allowed music lovers to share music by exchanging MP3 files, thereby allowing millions of people to enjoy music without paying for it. Recorded music revenues plunged, raising a concern that piracy would stem the flow of good new music. In Copyright Protection, Technological Change, and the Quality of New Products: Evidence from Recorded Music Since Napster (NBER Working Paper No. 17503), Joel Waldfogel explores the possibility that technological changes in the music industry "may have altered the balance between technology and copyright law for digital products." Despite music industry claims that digital piracy harms consumers by undercutting its revenues and reducing the amount of new music that it can bring to market, he constructs indexes of music quality based on critics' best-of lists, airplay, and sales that show no evidence of a decline in music quality since Napster.

Waldfogel's first index of music quality is based on critics' retrospective lists of the best music (for example, "best of the decade"). It encompasses 88 different rankings from the United States, England, Canada, and Ireland, and covers more than 16,000 musical works from 1960 to 2007. Statistically combining information from these sources results in an overall quality index that rises between 1960 and 1970, declines through the 1980s, rises again in the mid-1990s, declines in the latter half of the 1990s, and is stable for the period after 2000. Waldfogel concludes that although the index was falling prior to the appearance of Napster, it is stable after 2000 and thus shows no evidence of a decline in quality.

His second and third indexes are derived from data on radio airplay and sales of music. Music is aired on radio less, and sells less, as it gets older; but if a vintage is better, it will receive more sales or airplay after accounting for such depreciation. Using data on the frequency with which songs originally released as early as 1960 were aired on the radio from 2004 to 2008, Waldfogel constructs an airplay-based vintage quality index suggesting that music quality rose from 1960 to 1970, fell until at least 1985, and rose substantially after 1999. The analogous sales-based index is derived from Recording Industry Association of America Gold (sales greater than 500,000 copies) and Platinum (sales greater than one million copies) certifications. The sales-based index echoes the result of other indexes: it rises from 1960 to 1970, falls to the 1980s, and then rises sharply after 1999.

Based on the movements of these three indexes over time, Waldfogel concludes that "the quality of new music has not fallen since Napster." The post-Napster flow of product appears to be as strong as or stronger than it was before Napster, with independent labels accounting for a growing share of successful albums. Although it is impossible to determine whether creative output is as high as it would have been without Napster, the evidence does not suggest that innovations in digital technology, and associated changes in effective copyright protection, reduced the quality or quantity of new music.

So the effects of technological changes in the music industry may not be as the industry would have us believe.

Odd things you read

I've been reading parts of Roger Backhouse's book "The Ordinary Business of Life: A history of economics from the ancient world to the twenty-first century". From what I've read thus far the book is, by and large, a good read for the general reader with an interest in the history of economic thought. But every so often you come across something strange. For example at one point Backhouse writes,

Politically, the Austrians were conservatives [...].

How you can conclude that economists like Mises, Hayek or Rothbard were conservatives I'm not sure. Mises, for example, wrote a book on "Liberalism: The Classical Tradition" while Hayek wrote a very famous essay on "Why I'm Not a Conservative". All this seems very non-conservative to me.

Later Backhouse writes,

The term 'transaction costs' was first used by Marschak in 1950, but the idea has a long history.

Actually the term was used at least 10 years before Marschak. Tibor de Scitovszky in an article - A Study of Interest and Capital - published in the journal Economica in 1940 wrote,

One reason must be liquidity preference, another, perhaps equally important one, seems to be the high transaction costs (brokerage charges, stamp duties, commissions, etc.) on long-term securities. (Emphasis added.).

The idea of transaction costs or frictions was explained by John Hicks in 1935,

The most obvious sort of friction, and undoubtedly one of the most important, is the cost of transferring assets from one form to another

Backhouse also writes that

Transaction costs are the costs of transferring ownership from one person to another.

and

Coase pointed out that activities could be organized in two ways. One is through the market. The other is by management within the firm. Both methods involve transaction costs, but the costs are different.

If the costs are different then I would think one of them isn't a transaction cost. In fact I would interpret Coase as saying only the market costs are transactions costs. In his 1937 paper "The Nature of the Firm" Coase attributed the existence of the firm to the cost of using the price mechanism and Coase's point about about firms is that they suppress the price mechanism. Costs inside a firm are management costs or some such thing.

Related, if transaction costs are defined as the costs of transferring ownership - which seems reasonable - then how can costs within a firm be transaction costs? Ownership isn't transferred within a firm.

Views change with time, even in economics

In his classic book "A History of Economic Analysis" Joseph Schumpeter argued that there was one general equilibrium system and Walras had given it to us.

As far as pure theory is concerned, Walras is in my opinion the greatest of all economists. His system of economic equilibrium [...] is the only work by an economist that will stand comparison with the achievements of theoretical physics. Compared with it, most of the theoretical writings of the period - and beyond - [...] look like boats beside a liner, like inadequate attempts to catch some particular aspect of Walrasian truth.

Compare this with the view, I have noted before, of a later great of the history of economic thought, Mark Blaug,

We may conclude that GE theory as such is a cul-de-sac: it as has no empirical content and never will have empirical content. Moreover, even as research programme in social mathematics, it must be condemned as an almost total failure.

The high watermark for Walrasian general equilibrium was arguably Debreu's 1959 book "Theory of Value" but is Till Duppe right when he says of Debreu’s influence today that,

[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.

The question all this raises in my mind is, If Blaug and Duppe are right then does this explain why so much of post-1970 economics, e.g. contract theory, game theory, theory of the firm, industrial organisation etc, turned its back on general equilibrium theory and has worked within a partial equilibrium framework?

For the case of contract theory Bernard Salanie has argued,

The theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well-defined institutional settings.

What will the next great writer on the history of economic thought make of the 20th century giants of the field? As far as general equilibrium theory is concerned, Will he be a supporter of Schumpeter or Blaug?

EconTalk this week

David Rose of the University of Missouri, St. Louis and the author of The Moral Foundation of Economic Behavior talks with EconTalk host Russ Roberts about the book and the role morality plays in prosperity. Rose argues that morality plays a crucial role in prosperity and economic development. Knowing that the people you trade with have a principled aversion to exploiting opportunities for cheating in dealing with others allows economic actors to trust one another. That in turn allows for the widespread specialization and interaction through markets with strangers that creates prosperity. In this conversation, Rose explores the nature of the principles that work best to engender trust. The conversation closes with a discussion of the current trend in morality in America and the implications for trust and prosperity.

The DIY economy

The standard neoclassical (Arrow-Debreu) approach to general equilibrium has been criticised by many economists, for many reasons. Mark Blaug, for example, has written,

We may conclude that GE theory as such is a cul-de-sac: it as has no empirical content and never will have empirical content. Moreover, even as research programme in social mathematics, it must be condemned as an almost total failure.

When looking at the production side of the model a common criticism made is that the model has not reason for the existence of firm. As Foss, Lando and Thomsen summarise it:

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

Nicolai Foss uses a few less words to make this point when he notes

With perfect and costless contracting, it is hard to see room for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and wouldn't need the services of the intermediaries known as firms.

In other words the neoclassical model is DIY on steroids!!

Interestingly, in addition to the above comment on GE Mark Blaug notes that the fictional auctioneer famous from Walras's model of general equilibrium isn't in fact due to Walras.

[..] Walras never mentioned the concept of a fictional auctioneer announcing and changing prices until an equilibrium price is agreed upon - this is one of those historical myths that subsequent generations invented [..]

One wonders who invented the idea.

EconTalk this week

Nassim Taleb, author of Fooled By Randomness and The Black Swan, talks with EconTalk host Russ Roberts about antifragility, the concept behind Taleb's next book, a work in progress. Taleb talks about how we can cope with our ignorance and uncertainty in a complex world. Topics covered include health, finance, political systems, the Fed, your career, Seneca, shame, heroism, and a few more.

When is a contract incomplete?

Things you think about over a sunny weekend.

One way to think about the different types of contracts modelled in contract theory is to divide contract theory into three groups: complete contacts, comprehensive contracts and incomplete contracts. Complete contracts are those which are written in a zero transaction cost, Arrow-Debreu type, world. Such contracts can be made continent on all variables in all states of the world. They result in the first-best being achieved in all states of world. Comprehensive contracts are those written under conditions of asymmetric information, that is, in a world with moral hazard and/or adverse selection. Such contracts are "constrained optimal" in that they are optimal given the existence of the information asymmetry. Comprehensive contracts maximise the objective function of the agent subject to the informational constraint. Incomplete contracts do not maximise the objective function of the agent, they result in "money being left on the table", even taking into account any informational asymmetries. A standard incomplete contracts model will be a symmetric information model and thus neither moral hazard or adverse selection are driving the model's results. The issue for incomplete contracts is generally argued to be one of "non-verifiability" rather than asymmetric information. That is, the informational problem with incomplete contracts is between that contracting parties and the courts rather than between the contracting parties themselves, as in asymmetric information models.

In the law and economics literature it is argued that there are two forms of incompleteness: obligationally incomplete [OI] and informationally incomplete (or insufficiently state contingent) [II] contracts. A contract is obligationally incomplete if it does not fully describe the obligrations of each party in every state of the world. That is, the contract has a "gap" and thus will be silent on what should happen in any state of the world which falls within the "gap". The problem here is why should a contract be ever be obligationally incomplete since it should be possible to complete a contract with an obligration that applies to a broadly enough defined set of contingencies at a reasonable cost. A contract is informationally incomplete if it fails to describe an efficient set of obligations in each possible state of the world. As Oliver Hart puts it

[...] the contract might not specify what is to happen if the supplier's factory burns down, because this is not anticipated [OI]; or the contract might say that the supplier must always supply one widget, rather than a number of widgets that varies with the state of the world, because it is too costly to distinguish between different states of the world [II].

A problem here is that if a contract with an inefficient set of obligations specified is incomplete then why are asymmetric information contracts not incomplete?

Eric Maskin writes that

I will consider a contract to be “incomplete” if it is not as fully contingent on the state of the world” (the resolution of uncertainty about the future) as the parties to the contract might like it to be.

This seems to mean that asymmetric information contracts are incomplete. But in a footnote Maskin says

This definition is so broad that it covers many contracts in the literature that are not normally considered "incomplete", e.g., insurance contracts with adverse selection.

So moral hazard and adverse selection contracts are not, it seems, incomplete contracts. The issue is that asymmetric contracts are verifiable, the variable on which the incentive contract is written is assumed to be observable and verifiable so that the courts can fully enforce the contract. As noted above the standard assumption for incomplete contracts is that they are incomplete because some relevant variable is not verifiable, to the courts. Another way to look at this is that if performance of the terms of a contract would result in the gains from trade not being fully exploited, given the information that the contracting parties and the courts have available to them at the time performance takes place, then the contract is incomplete. Under the assumptions of complete or comprehensive contracting any gains from trade available are always exploited to the fullest extent possible.

But the assumption of non-verifiability has its own problems as Maskin and Tirole have pointed out. Maskin and Tirole argue that information which is observable to the contracting parties (symmetric information) can be made verifiable (to a third party) by the use of ingenious revelation mechanisms. The contracting parties write into their contract a game which when played gives the appropriate incentives for them to truthfully reveal their private information in equilibrium. This undermines the non-verifiability approach to incomplete contracts.

To deal with the Maskin and Tirole critique, Hart and Moore developed the 'reference point' approach to incomplete contracts. Very briefly the Hart and Moore reference point theory argues that when the parties meet at date 0 there is uncertainty about the state of the world. This uncertainty is resolved shortly before date 1. There is symmetric information throughout, but the state is not verifiable. A date 0 contract serves as a reference point for the contracting parties' feelings about entitlements at date 1. Specifically, neither party feels entitled to an outcome outside those permitted by the contract but within the contract there can be disagreement about the appropriate outcome. To simplify matters, it is supposed that each party feels entitled to their best possible outcome permitted by the contract. Of course, this means that usually at least one party will be disappointed or "aggrieved" by any particular outcome. Hart and Moore assume that no outcome from a transaction is perfectly contractible even at date 1. In particular, they assume that each party has the discretion to provide "perfunctory" performance rather than "consummate" performance. Performing at the lower perfunctory level rather than the higher consummate level is referred to as shading and it is assumed that shading cannot be penalised by a court. A court can, however, enforce the perfunctory level of performance. When a party is aggrieved he shades, by an amount theta times his level of aggrievement where 0< theta <=1. Consummate performance does not cost significantly more than perfunctory performance to whomever is providing the good or service, and a party will provide consummate performance if he feels "well treated" but not otherwise. Shading hurts the other party and causes a deadweight loss. The important point here is that the reference point approach does not suffer from the Maskin and Tirole critique but get around it by introducing a number of ad hoc behavioural assumptions, e.g. aggrievement and shading.

After all of this we find that M'hand Fares argues that the difference between complete and incomplete contracts is not verifiability at all but the ability to commit to not renegotiating the initial contract.

In the controversy on the theoretical foundations of the property rights approach, Hart and Moore [...] and Maskin and Tirole [...] point out that a key distinction between complete and incomplete contracting is the ability of risk neutral parties to commit not to renegotiate the initial contract. The renegotiation design issue in contract solutions to the hold-up problem restates this view in a more general fashion as a contrast between (i) a world where contract can determine the entire relationship between the parties and (ii) a world where contract can only influence an existing underlying game between them, that is, the renegotiation game. This implies that the capacity of a contract to influence this game defines its 'incompleteness' or 'degree of incompleteness' [...]: the more a contract is able to design the renegotiation game, the less it is incomplete.

So in the end we are left with Jean Tirole's point that,

[f]or all its importance, there is unfortunately no clear definition of "incomplete contracting" in the literature. While one recognizes one when one sees it, incomplete contracts are not members of a well-circumscribed family; at this stage an incomplete contract is rather defined as an ad hoc restriction on the set of feasible contracts in a given model. The concept of "ad hoc restriction" is of course subjective: to give it some content, we will [...] take the standard approach to contract theory as the benchmark. The methodology developed in the last thirty years to treat moral hazard, adverse selection, and implementation problems provides a well-defined delineation of the set of feasible outcomes by incentive constraints. Incomplete contracting then relates to a focus on a subset of feasible outcomes through the imposition of restrictions on the set of allowable contracts.

Thus I'm left asking, When is a contract incomplete?

Peter Boettke on Austrian Economics

Professor Pete Boettke of George Mason University was recently interviewed by "The Browser" on Austrian Economics.

A take home message:

Analytically, the biggest difference between the Austrians and their mainstream brethren is a focus on processes of adjustment and changing conditions, as opposed to static or equilibrium states of affairs. In a supply and demand curve, a standard economist would focus on the price and quantity vector that would clear the market. The Austrians want to talk about all the exchanges and activity that take place that results in that vector being discovered and the market being cleared.

Imagine if refrigeration wasn’t an option and you had some fish to sell. You start selling them at $10 a fish, and this many people buy the fish. After a while it slows down and you still have some fish remaining. As the day wears on you’re trying to get rid of the fish because they’re going to spoil. So you adjust your price down, you sell it at $8 a fish, or $6 a fish or $5 a fish. Eventually the market clears and all the fish find a buyer. In standard economics, we talk about the price and quantity vector that would clear that market, and the formal techniques of economics – a series of simultaneous equations – would get us to that vector. The Austrians don’t disagree with that price and quantity vector. But they want to talk about all the activity, a lot of which is what we call entrepreneurship – people adjusting the price, arbitrage opportunities and so on. Eventually you get to that vector, but your focus isn’t on the vector, it’s on all the stuff that goes on before it’s discovered.

EconTalk his week

Dean Baker of the Center for Economic Policy and Research talks with EconTalk host Russ Roberts about the financial crisis. Baker sees the crisis as part of a broader set of phenomena--rising inequality and declining unionization. Baker is highly critical on both economic and political grounds of the policy attempts to stimulate the economy as well as the governance structure of the Federal Reserve. The conversation closes with a discussion of potential innovations to lower the budgetary cost of health care.

Partical privatisation good, full privatisation better

Given that the current government wants to partially privatise several SOEs the question to ask is, What effect will this have on firm performance? Some insight into this question is offered by a recent paper in the Scottish Journal of Political Economy (Volume 59, Issue 1, pages 1–27, February 2012). The paper "What Drives the Operating Performance of Privatised Firms?" by Laura Cabeza García and Silvia Gómez Ansón argues that the greater the amount of privatisation the better the performance of the firm. Not an entirely surprising result as the full force of market discipline can only be applied if the firm is fully in private hands but it is something for the government to keep in mind. It would suggest that any performance improvements due to the government's privatisation plans will be modest.

The abstract reads,

Using a panel data analysis of Spanish privatised firms, we study how different factors influence the operating performance of divested companies. The results show that it is not privatisation per se but other factors that matter. After controlling for possible sample selection bias related to government timing of divestments, we find that the greater the relinquishment of State control and the smaller the percentage of ownership held by managers and/or employees, the better the firms’ post-privatisation performance. Moreover, privatisations that are accompanied by liberalisation programmes and occur during buoyant economic cycles turn out to be more successful. (Emphasis added.)

EconTalk this week

Scott Sumner of Bentley University and the blog The Money Illusion talks with EconTalk host Russ Roberts about the state of monetary policy, the actions of the Federal Reserve over the past two years and the state of the economy. Sumner argues that monetary policy has been too tight and helped create the crisis. He disputes the relevance of the so-called liquidity trap and argues that aggressive monetary policy is both possible and desirable. The conversation closes with a discussion of what we have learned and failed to learn during the crisis.

Happy birthday Ronald Coase

Coase was born at 3:25 p.m. on December 29th, 1910 in a house in Willesden, a suburb of London so he now a young and sprightly 101!

Coase received the 1991 Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel

“for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy”

In its press release on Coase’s Nobel award, The Royal Swedish Academy of Sciences makes mention of only two papers: "The Nature of the Firm" and "The Problem of Social Cost". It is largely on these two contributions to the theory of the firm and the theory of externalities that Coase’s rightful claim to be the greatest economist of the 20th century is based.

Incentives matter: marketing file

Thanks to Tim Worstall for this wonderful example of a bad marketing promotion and the rational response to it.

To introduce you to a little bit of English English. To “do a Hoover” is not exactly everyday language, even here, but it will be understood by those discussing retail promotions. It means doing something sufficiently silly that it ends up enraging your customers, costs you a lot of money and in general is entirely counter-productive. You may have started off trying to sell more goods and thus making more profit but that’s not quite the way it turns out.

It comes from what the UK subsidiary of Hoover did back in 1992. In order to sell more of those machines that suck the dirt out of your carpet (a “spangler” we might say) the company decided that anyone who bought more than £100 worth of the company’s goods would be entitled to two free roundtrip air tickets.

Seeing that sales did go up they decided to expand the offer, to two roundtrip tickets to the US. Which is where the roof really started falling in. For instead of simply accelerating future purchases, moving them from the future to today (this was a time of severe recession in the UK so that could have been a decent tactic), or transferring sales from competitors to Hoover, what was actually happening was that people who wanted to visit the US bought a sucking machine.

In fact, the classifieds sections of local papers across the country began to fill up with new, unused but very cheap Hoovers. For what the promoters of the scheme seemed to have missed was that the value of two roundtrip tickets (from memory, at the time, perhaps £300 to £400) was rather larger than the amount they were asking people to spend with the company.

So, rational beings that people are, people were buying the Hoover as a cheap way of getting the tickets. Chaos obviously ensued, it became very difficult to actually cash in on the offer (they had not limited it to the first 1,000, or 10,000) and Hoover was desperately running around trying to book cheap flights from the airlines. Who, of course, knowing that they had them over a barrel, were not playing ball.

In the end this cost the company £50 million (yes, even in our funny money, quite a significant sum) the people responsible were fired and Hoover US sold off the UK company to some Italians. The court cases were still rumbling on years later.

EconTalk this week

Alex Tabarrok of George Mason University talks with EconTalk host Russ Roberts about his new book, Launching the Innovation Renaissance. Tabarrok argues that innovation in the United States is being held back by patent law, the legal system, and immigration policies. He then suggests how these might be improved to create a better climate for innovation that would lead to higher productivity and a higher standard of living.

Productivity does matter

From Mark Perry at the Carpe Diem blog:

According to new data just released by the United Nations, China surpassed the United States in 2010 to become the world's No. 1 manufacturing nation, ending America's dominance as the world's largest manufacturer since the late 1800s (see chart above of the top five manufacturing countries). China's manufacturing output in 2010 of $19.222 trillion and 18.89% share of world manufacturing output of $10,176 trillion,was slightly ahead of America's manufacturing output of $1.855 trillion and 18.24% share of global manufacturing production.

But note:

China's manufacturing workforce is estimated to be around 100 million and could be as high as 120 million, compared to America's manufacturing employment of about 11.5 million. Therefore, China is producing roughly the same manufacturing output as the U.S. but Chinese worker productivity is so low it needs 9-10 workers for every one American factory worker.

So China's workforce is huge and not very productive, but cheap.

Even though China is now the world largest manufacturer, its GDP per capita of only $2,800 (data here from the USDA) is just now reaching a level of output per person that the U.S. achieved back in 1878, 133 years ago.

Put simply having low productivity results in low income per capita. Paul Krugman makes the point when he writes,

Economic history offers no example of a country that experienced long-term productivity growth without a roughly equal rise in real wages. In the 1950s, when European productivity was typically less than half of U.S. productivity, so were European wages; today average compensation measured in dollars is about the same. As Japan climbed the productivity ladder over the past 30 years, its wages also rose, from 10% to 110% of the U.S. level. South Korea's wages have also risen dramatically over time. ("Does Third World growth hurt First World Prosperity?" Harvard Business Review 72 n4, July-August 1994: 113-21.)

Thus in the battle to improve wages and the standard of living, China (and New Zealand) must improve its productivity.

EconTalk this week

Dan Klein of George Mason University talks with EconTalk host Russ Roberts about the ideas in Klein's new book, Knowledge and Coordination. Klein argues that allegory is a powerful way to think about outcomes of emergent order. He goes deeply into the concept of the invisible hand and creates a novel way to evaluate processes that not under any one's control. Klein then suggests novel ways of evaluating economic outcomes outside of the traditional metrics and techniques. Along the way, Klein emphasizes the role of uncertainty and imperfection in the entrepreneurial process.

How big is the North Korean army? Evidence from missing population

In a recent column at VoxEU.org Ho Il Moon notes that little is known about North Korea's economy as official statistics are scant. But North Korea cannot be ignored, especially when it comes to the size of its army. This column suggests that the true number is hidden between the lines of the census. It provides an estimate based on missing population, that is, the difference between the whole population and the number of registered citizens. Moon writes

Since the country established its armed forces in 1963, North Korea has never published any number on military personnel. One estimate from The Military Balance is formally used by the Japanese government. It suggests North Korea's military personnel are around 1,020,000 in the ground forces, 60,000 in the navy, and 11,000 in the air force. However, no clear explanation is provided as to how these figures were obtained.

But North Korea may have accidentally published its number of military personnel. It implemented two population censuses – one in 1993 and one in 2008. As the censuses were supported by the UN Population Fund and South Korea's Foundation for Inter-Korean Cooperation, North Korea was obliged to report the data.

A close examination of the numbers reveals an anomaly. The population overall is greater than the sum of the populations by administrative district. The discrepancy in the 1993 census is of 691,027 persons, while in the 2008 census, it is of 702,373 persons. This means that roughly 700,000 people are not registered in administrative districts.

The reason for this discrepancy lies in North Korea's citizen registration system. According to the Citizen Registration Law, not all citizens are registered. Article 13 stipulates that the citizen ID, ie the citizen registration, is to be returned to the public security office where the citizen resides if she enlists in the Korean People's Army or Korean People's Guard, or a public- or national-security institution, or if her citizenship ceases because of death or mental illness. This implies that the 700,000 discrepancy consists in part of those enlisted in the army.

Looking at the demographic characteristics of these 700,000 persons, it is highly likely that a majority of them are in the Korean People's Army. Figure 1 shows the sex ratio by age taken from the 1993 data by administrative region. At the time of birth, there are slightly more boys than girls (the ratio is around 1.05). Because men have a higher mortality than women the older they get, the ratio declines from around age 30. However, as can be clearly seen in the figure, there is a sharp dent between ages 16 and 26. This coincides exactly with the end of compulsory-education, when some join the armed forces, and is entirely due to a decline in the number of men, which make up the numerator of the ratio. As the majority of the armed forces are young men, it is likely that most of the unregistered 700,000 persons are members of the armed forces.

At best, this number of 700,000 persons forms the upper bound for estimates of the number of North Korean military personnel.

Figure 1. Sex ratio by age (1993 census)

Another big question to do with North Korea is, How many famine victims were there? Moon writes on this question,

Another area in which available data are extremely scant is the number of victims of famine. Numbers circulated indicating that “several million people” had died from starvation. Although there were numerous sources for such claims, the first to provide a statistical underpinning is South Korea's Korean Buddhist Sharing Movement. The latter repeatedly interviewed food refugees in China's border regions and tried to estimate the scale of the famine. These estimates suggest that in the roughly three years from the floods in 1995 until late 1997, about 3.5 million people had died from starvation (KBSM 1998). But these estimates are extrapolations reconstructed from demographic information given by refugees from the region with the highest mortality rate and the most prone to famine. Hence, these numbers are unconvincing.

Taking a very different approach, I estimate the number of famine-related deaths based on ‘excess mortality,’ ie the difference between the mortality rate at normal times and that at the time of the famine. My estimates, which have been published by South Korea’s government, suggest that 336,000 persons died of famine from 1995 to 2000.

So that's, roughly, the population of Christchurch killed in the space of 5 years. And we thought earthquakes were bad.

EconTalk this week

Mike Munger of Duke University talks with EconTalk host Russ Roberts about profit. What is profit's role in allocating resources? How should we feel about the people who earn profits or who take them in ways that may not be earned? How easy is it to discover profitable opportunities? Munger examines these questions through a series of stories, real and fictional, to illuminate the sometimes puzzling nature of profit.

Great new paper

Well actually it's not that great or that new, it's a revision of a previous paper, but it is here.

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

Some days you just get lucky!!!

And this is one of those days.

Tossing your toys

From Greg Mankiw:

1. John summarizes a recent Hoover conference on restoring robust economic growth.
2. Paul is annoyed at John.
3. John is annoyed at Paul.

On what basis is Krugman getting upset at a summary of papers given at a conference he didn't attend?

Mario Rizzo says It is Hayek versus Keynes

From ThinkMarkets comes this from Mario Rizzo,

And yet the recent obsession Krugman has with Hayek (and lately the obsession DeLong has with Mises) means that some nerve has been touched. Of course, it might simply be that Krugman needs material for his blogs and columns.

However, I think the real issue is this. Hayek’s approach attacks, root-and-branch, the macroeconomic way of thinking. It is not simply a challenge to a particular theory of the determinants of mass unemployment, inflation, business cycles and the like. Hayek is not accepting the rules of the game or the parameters of the sub-discipline of modern macroeconomics. Hayek does not want to argue that the government expenditure multiplier is 0.5 instead of 2.0, for example. He does not want to discuss just how much fiscal stimulus should be undertaken and what form it should assume.

In short, he does not want to focus on aggregate spending and aggregate consequences. Hayek’s approach says: Let us pierce the veil of aggregates and look at the distortive effects on relative prices and relative output produced by boom-time credit expansions. Let us look at the distortive effects that booms leave us as we work our way through a recession. Let us concentrate on sustainable lines of expenditure both during the boom and during the road out from the bust.

Suffice it to say this greatly erodes the intellectual capital of a field of economics – although one not noted for its successes.

There is much that economic aggregates don't tell us.

EconTalk for two weeks

Tyler Cowen of George Mason University talks with EconTalk host Russ Roberts about the European crisis. Cowen argues that Greece is likely to default either in fact or in spirit but that the key question is which nations might follow--whether Italy and Spain can find a road to economic health and honoring past debts. Cowen gives his best guess as to what is likely to happen to the euro and the European Union and the implications for the rest of the world. He explores some less likely scenarios as well. He is pessimistic about Greece and the short-run prospects for preserving the status quo, but he is optimistic in the long-run about the European Union though it may have a different structure down the road.

Simon Johnson of MIT and the author (with James Kwak) of 13 Bankers talks with EconTalk host Russ Roberts about the origins of the financial crisis and how the next one might be prevented. Invoking the work of George Stigler, Johnson argues that the financial sector has captured the regulatory process and the result is that regulation and government intervention have been steered more by the interests of the financial sector than to the benefit of the general public. Johnson argues for capping the size of banks in order to reduce the danger of systemic risk and the too-big-to-fail excuse for bailing out banks. Johnson also discusses the role of the Fed in subsidizing risk-taking and leverage in the financial sector.

Explaining charter school effectiveness

Charter Schools are in the news right now with much uninformed comment is being made by those on all sides of the debate, so here's some actual research on Charter Schools.

In December 2011 edition of The NBER Digest Linda Gorman summaries a recent NBER Working Paper, "Explaining Charter School Effectiveness" by Joshua D. Angrist, Parag A. Pathak, and Christopher R. Walters.

"Over-subscribed urban charter schools that admit students by lottery have produced the largest improvement in student achievement."

Comparisons of those who did and did not win charter school admissions lotteries in Massachusetts suggest that urban charter schools boost student achievement. In Explaining Charter School Effectiveness (NBER Working Paper No. 17332), Joshua Angrist, Parag Pathak, and Christopher Walters find that student demographics are related to the extent of this improvement: urban charter schools are most effective for non-whites and low-baseline achievers. They also find that while over-subscribed urban charter schools that admit students by lottery have produced the largest improvement in student achievement, non-urban charter schools are uniformly ineffective in raising measured achievement.

This research uses data on students who attended any of 32 Massachusetts charter schools at any time between the 2001-2 and 2009-10 school years. The authors match school records with test scores and administrative data, including demographic variables such as race, gender, and poverty status, as well as information on school policies, teaching staff, and hours spent in school. Overall their results show that middle school charter lottery winners outscored lottery losers somewhat in English and more significantly in math. High school lottery winners outscored lottery losers about equally in English and math.

Massachusetts' urban charter school students are drawn from a population in which middle school students generally score below the average on state-wide math and English tests. The authors estimate that one year in an urban lottery charter middle school boosts scores dramatically, by 0.34 standard deviations in math and 0.14 standard deviations in English. In contrast, non-urban charter schools appear to degrade performance. Although, as the authors note, "most non-urban students do reasonably well in any case," the causal effect of a year of non-urban charter attendance is a substantial reduction in achievement in all levels and subjects, on the order of 0.16 standard deviations in middle school with almost a quarter of a standard deviation decline in high school math.

The researchers conclude that the relative effectiveness of urban lottery charter schools can be explained by over-subscribed schools' embrace of the No Excuses approach to education.

The second best

When looking at many of the discussions of claims of some form of market failure and how governments can fix things, I wonder if this is one area where partial equilibrium modelling can leads us astray. While the use of taxes or subsidies may, in theory, correct a failure in a single market the question has to be asked, What effect does this have in general? It is here that the theory of second best can ruin the day of our would be market failure fixes.

It is well known that the attainment of a Paretian optimum requires the simultaneous fulfillment of all the optimum conditions. The general theorem for the second best optimum states that if there is introduced into a general equilibrium system a constraint which prevents the attainment of one of the Paretian conditions, the other Paretian conditions, although still attainable, are, in general, no longer desirable. In other words, given that one of the Paretian optimum conditions cannot be fulfilled, then an optimum situation can be achieved only by departing from all the other Paretian conditions. The optimum situation finally attained may be termed a second best optimum because it is achieved subject to a constraint which, by definition, prevents the attainment of a Paretian optimum.

From this theorem there follows the important negative corollary that there is no a priori way to judge as between various situations in which some of the Paretian optimum conditions are fulfilled while others are not. Specifically, it is not true that a situation in which more, but not all, of the optimum conditions are fulfilled is necessarily, or is even likely to be, superior to a situation in which fewer are fulfilled. It follows, therefore, that in a situation in which there exist many constraints which prevent the fulfillment of the Parteian optimum conditions, the removal of any one constraint may affect welfare or efficiency either by raising it, by lowering it, or by leaving it unchanged. (R. G. Lipsey and Kelvin Lancaster, The General Theory of Second Best, The Review of Economic Studies, Vol. 24, No. 1 (1956 - 1957): 11-2)

So even if the use of a tax or subsidy may appear to have removed some market failure in a single market it may cause more trouble that it is worth in a general equilibrium setting.

Interesting blog bits

Mark Blaug

1. Frederic Sautet on Mark Blaug (1927-2011), fellow traveller of Austrian economics
2. Tyler Cowen on Very sad news, Mark Blaug passes away, 1927-2011
3. Eric Schliesser on Weekly Philo economics: Mark Blaug (1927-2011)
4. Gavin Kennedy on Mark Blaug and the Invisible Hand
5. Eric Crampton on Blaug
6. Steve Kates on Mark Blaug

Andrew Skinner

1. Eric Schliesser on Weekly Philo economics: Mark Blaug (1927-2011) & Andrew Skinner (1935-2011)
2. Gavin Kennedy on Andrew Skinner; doyen among Smithian Scholars, 1935-2011

Blaug on Smith

Given the recent deaths of both Mark Blaug and Andrew Skinner I was reminded of this comment by Blaug on Adam Smith and the "invisible hand",

"[ ... ] Smith's faith in the benefits of 'the invisible hand' has absolutely nothing whatever to do with allocative efficiency in circumstances where competition is perfect a la Walras and Pareto; the effort in modern textbooks to enlist Adam Smith in support of what is now known as the 'fundamental theorems of welfare economics' is a historical travesty of major proportions. For one thing, Smith's conception of competition was, as we have seen, a process conception, not an end-state conception. For another society, a decentralised competitive price system was held to be desirable because of its dynamic effects in widening the scope of the market and extending the advantages of the division of labour - in short, because it was a powerful engine for promoting the accumulation of capital and the growth of income."

Blaug, Mark 1996. Economic Theory in Retrospect. 5th edn. 60-1. Cambridge: Cambridge University Press.

In today's terms, in some ways, I would see Smith as more "Austrian" than "neoclassical".

Andrew Skinner, 1935-2011

Eric Crampton has noted the passing of Mark Blaug. It now turns out that we must also note the passing of another great historian of economics, the Adam Smith scholar, Andrew Skinner. From the Adam Smith’s Lost Legacy blog comes this tribute to Skinner:

Eric Schliesser, a fine scholar who is much appreciated for his knowledge of 18th-century leading figures of the Scottish Enlightenment, has written a tribute to Andrew Skinner, whose death was reported today:

“This has been a terrible week for the history of economics: two of its giants, Andrew Skinner and Mark Blaug, died a few days apart. Skinner was the Daniel Jack Professor of Political Economy from 1985 to 1994 and Adam Smith Professor of Political Economy from 1994 until 2000 at University of Glasgow. Skinner is best known for his superb editing of the 2-volumes of the The Wealth of Nations in The Glasgow Edition of the Works and Correspondence of Adam Smith (1976).

He was also the author of a very fine collection of essays on Adam Smith, A System of Social Science: Papers Relating to Adam Smith. (He also edited several volumes of scholarly papers on Adam Smith.) He should have been better known for his very helpful (1966) edition of Sir James Steuart (1767) An Inquiry into the Principles of Political Economy. (The edition does contain some cuts, so let the buyer be aware.) Steuart was a subtle reader of Hume's political economy, and was deliberately ignored by Adam Smith; it mattered a lot to Skinner to ensure that Steuart was not forgotten.

I did not have much interaction with Skinner. But one is worth recounting. At the start of 2000, I sent him a draft of my main methodological/interpretive chapter on Smith's Wealth of Nations of my dissertation-then-in-progress. (We had never met.) Skinner was a natural choice because he was the leading scholar of the connections between Adam Smith's economics and Smith's Kuhnian theory of science. A few months went by, and just before his official retirement from the university he sent me his (kind) reflections on my chapter. Then I did not realize how rare such generosity is. He concluded his letter with a remark that I quote: "I met [Thomas] Kuhn in 1975 in Princeton when he told me, as I recall, that he was unaware of [Adam Smith's "The History of] ASTRONOMY" - if true, intriguing in that both Kuhn and Smith cite Copernicus' introduction as a classic example of the crisis state?"

Mega-events “crowding out effect”

One reason economist frequently cite when arguing that the economic impact of mega-events like the rugby world cup or the Olympics is lower than advertised is the “crowding out effect.” According to the UK’s Guardian newspaper,

The Really Useful Group, Andrew Lloyd Webber’s production company, is reportedly considering closing West End shows including The Phantom of the Opera and The Wizard of Oz, with tourist bookings predicted to slide in July and August.

The European Tour Operations Association (ETOA) has announced that its members are facing a 95% decrease on London bookings for the period, while the managing director of Encore Tickets, John Wales, said the company was bracing itself for “sales from tourists to be at least 40 per cent down on last year”.

While it will be true that London will have more that its fair share of Olympics tourists next summer, it has to be remembered that London is normally overrun with all sorts of other tourists in the summer including those who go to musicals. Sports fans, rugby or Olympic, don't always add to the tourist base, rather they simply displace other visitors leading to lower than expected increases in net tourism.

The case against a financial transactions tax

There is a new web publication from the IEA on The case against a financial transactions tax by Tim Worstall. The main points made in the article are:

• There is strong economic evidence that the proposed Financial Transactions Tax (FTT) would not increase the amount of tax revenue collected by governments. In fact it would reduce total tax revenue by shrinking the economy.
• Workers and consumers in general - not the banks - would carry the main economic burden of the FTT. Wages would be lower because the tax would increase the cost of capital, thereby reducing growth in productivity.
• Returns on pension funds and other savings would also be lower, in part because the FTT would increase the costs of buying and selling shares as well as reducing their values.
• The FTT would not have prevented the financial crisis, nor would it have avoided current sovereign debt problems. The tax would shrink those parts of the financial markets which did not contribute to the recent crisis but would not make much difference to the factors that caused the crash.
• The FTT would not reduce volatility; it would increase it. Market movements will come in larger steps if speculation is discouraged. It is preferable to have deep and liquid markets so that changes are incremental and smooth.

The Green Party supports such a tax if all countries were to implement one, while the Maori Party and Hone Harawira are also in favour. May be they should read the essay.

EconTalk this week

Gary Taubes, author of Good Calories, Bad Calories, talks to EconTalk host Russ Roberts about what we know about the relationship between diet and disease. Taubes argues that for decades, doctors, the medical establishment, and government agencies encouraged Americans to reduce fat in their diet and increase carbohydrates in order to reduce heart disease. Taubes argues that the evidence for the connection between fat in the diet and heart disease was weak yet the consensus in favor of low-fat diets remained strong. Casual evidence (such as low heart disease rates among populations with little fat in their diet) ignores the possibilities that other factors such as low sugar consumption may explain the relationship. Underlying the conversation is a theme that causation can be difficult to establish in complex systems such as the human body and the economy.

Oh dear ... the Standard on privatisation

Ben Clark writing at the Standard says

There are so many arguments against asset sales:

The fact that even Bill English thinks that they may raise less than $5 billion – when last year’s deficit was $18 billion – shows how quickly the money raised will disappear, leaving us without the income stream or the cash.

As I have noted before, I don't know how many times, the amount of money raised by privatisation isn't the issue. Let the debate about privatisation be in terms of efficiency, not price. Also note that an income stream along way in the future is worth a close approximation zero in present value terms so even if you do "lose it" you don't lose much. But assuming a competitive method of sale, the price received by the government for a asset will equal the present value of the revenue stream. In addition you don't lose all the stream anyway since tax is paid on the profits made by the new owners of the asset and we gain by making more efficient use of resources given that on average over time private firms out perform public ones. Also a competitive sale process it will capture some of these likely efficiency gains.

The fact that the only “Mums and Dads” able to afford to buy shares of assets we already own will be the top 1 or 2% – ensuring another National transfer of wealth from all of us to the richest in the country.

As to the idea that "we already own" these assets, we don't. The taxpayers or the "public" do not own government assets in any meaningful sense of the word "ownership". All of the attributes of ownership, such as control, the right to determine what use is made of it and under what conditions, is determined by the government or the bureaucracy in control of the asset in question.

The important point here is that without control you don't have ownership. As Oliver Wendell Holmes Jr. put it,

But what are the rights of ownership? They are substantially the same as those incident to possession. Within the limits prescribed by policy, the owner is allowed to exercise his natural powers over the subject-matter uninterfered with, and is more or less protected in excluding other people from such interference. The owner is allowed to exclude all, and is accountable to no one. (The Common Law, p193, (1963 edn.))

Clearly the "public" does not have the rights Holmes refers to. The government (or its bureaucracy) has these rights. Following Grossman and Hart ("The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration", 'Journal of Political Economy', 94:691-719) economist's tend to define the owner of an asset as the one who has residual rights of control over the asset; that is, whoever can determine what is done with the asset: how it is used, by whom it is used, when they can use it etc - note that ownership is not defined in terms of income rights. Under "public" ownership it isn't the "public" who has the control rights, its the government. The "public" can not determine what use is made of a "public" asset, rather its use is determined by the politicians and managers in command of it. As Madsen Pirie has noted

The term 'public ownership' is a misnomer. The state sector may have the name of the public filled in on the dotted line, but the public do not own it in any meaningful sense of the word. All of the attributes of ownership, such as control, the right to determine what use is made of it and under what conditions, is determined by the bureaucracy in command of it. Far from being owned by the public, it is owned in effect by the people who administer it. The public actually has more influence, via its choices and purchasing decisions, on private sector businesses than it can ever have over state industries and services. In those cases its influence is diffuse and diluted through the political process.

Just think of any of the SOEs in New Zealand, what control does the "public" have over them? Control rests with either the government or the bureaucracy or the firm's managers. The taxpayers have the least say of anyone in their running.

If you are worried about the amount of money raised, as Clark is in the first point above, selling to all "Mum and Dads" is a bad idea as this will result in a lower price being received. A sale of shares in general will result in underpricing.

The fact that those uber-wealthy “Mums and Dads” will inevitably sell off their shares for a quick buck to foreign owners, as they did with Contact Energy, meaning a much worse balance of payments as those profits head offshore – growing other countries’ economies, not ours.

A good bit of xenophobia. Also note the selling of the shares will have no effect on the balance of payments given that the BoP is always zero by construction. Also note that if profits are heading overseas this means that good and services must have already been produced here in New Zealand to give rise to the profits in the first place. This production of goods and services means our economy has grown.

The fact that those foreign owners will have no motive to protect and improve our vitally important electricity supply, only to rake as much wealth out of us as they can.

As I have noted before an SOE, New Zealand owned firm and a foreign owned firm will all act in the some way, i.e. maximise profits, so the performance of firm does not depend on the nationality of the owner. Is this just more capital xenophobia from the Standard?

A justification for partial asset sales

A justification in the view of Seamus Hogan over at Offsetting Behaviour at least. Hogan writes,

At the same time, however, vertical integration makes the retail market less contestable. If competition between retailers is not as intense as we would like, it is difficult for a new entrant to come into the market, as it would be highly exposed being a buyer and not a seller on the wholesale market, particularly in periods when low rainfall or transmission constraints gave a seller some temporary monopoly power.

One would have to say that any such market power arguments have to be trade-off against efficiency and relationship-specific investment arguments as pointed out by Oliver Williamson et al many years ago. And why can't you deal with such problems via a long-term contract?

Now imagine, however, that a new entrant in the retail market could simultaneously buy shares in the company that was the dominant generator in the region the entrant wanted to sell in. This would be a risk management strategy that would enable it to price to the retail market based on normal wholesale prices, knowing that losses in the event of a high wholesale price would be offset by the return on its shareholdings.

I can't help but think this is a better argument for the sale of 100% of the shares in an SOE.

More on asset sales

Over at Kiwiblog it is argued that

“Mixed ownership” will improve the SOEs performance:

This one can be debated for ever. My view is simple. If you look globally, on average private sector companies significantly out-perform state owned companies. Now let’s us be very clear about this. This does not mean every single private sector company does better than every single state owned company. Of course not. It doesn’t mean that no private sector company never fails and it doesn’t mean that all state owned companies fail. It also doesn’t mean that private sector companies out-perform public sector companies every minute of every day.

The first thing to note here is that the literature that shows that on average private firms out-perform SOEs is dominated by private firms which are controlled by their private shareholders and thus are not mixed ownership firms as the government means to set them up. That is, the private owners have at least 51% of the firm's shares. As to the evidence on the subject the following comes from the summary of chapter 4, ‘Empirical Evidence on Privatization’s Effectiveness in Nontransition Economies’, from William L. Megginson’s book The Financial Economics of Privatization, New York: Oxford University Press, 2005,

The 87 studies from nontransition economies discussed in this chapter offer at least limited support for the proposition that privatization is associated with improvements in the operating and financial performance of divested firms. Most of these studies offer strong support for this proposition, and only a handful document outright performance declines after privatization. Almost all studies that examine post-privatization changes in output, efficiency, profitability, capital investment spending, and leverage document significant increases in the first four measures and significant declines in leverage.

Secondly when you look at the performance of mixed ownership firms 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].' So fully private firms out-perform mixed ownership firms.

The basic problem is that partial government ownership politicises the firm. Full privatisation is the better option.

Why big firms die

There is an arresting moment in Walter Isaacson's biography of Steve Jobs in which Jobs speaks at length about his philosophy of business. He's at the end of his life and is summing things up. His mission, he says, was plain: to "build an enduring company where people were motivated to make great products." Then he turned to the rise and fall of various businesses. He has a theory about "why decline happens" at great companies: "The company does a great job, innovates and becomes a monopoly or close to it in some field, and then the quality of the product becomes less important. The company starts valuing the great salesman, because they're the ones who can move the needle on revenues." So salesmen are put in charge, and product engineers and designers feel demoted: Their efforts are no longer at the white-hot center of the company's daily life. They "turn off." IBM and Xerox, Jobs said, faltered in precisely this way. The salesmen who led the companies were smart and eloquent, but "they didn't know anything about the product." In the end this can doom a great company, because what consumers want is good products.

That is from Peggy Noonan in the Wall Street Journal.

Is there a political version of this? Can political parties govern only for so long when led by a "salesman" who can sell an image but can't deliver a quality product - jobs, growth, small deficit etc? Will this ultimately be a problem for National?

More Goffonomics

From Kiwiblog today we learn:

On The Nation today:

Duncan So looking at the asset sales, if you were to get into government and not sell those assets, how would you control power prices? Because that has been a major issue over the last ten years, and National one of their big attacks in office has been that under your leadership, when I say leadership I talk about the Labour government, power prices went up 70-80% over ten years. What will you do? What reassurance can you give to voters that you’ll control power prices.

Phil [Goff] Oh the power prices are gonna fluctuate depending on how much extra you build in terms of generation. No but what you can assure them is this. That you don’t have an outside foreign investor coming in, wanting a really big return on their investment, because you know, and you know from Contact Energy that this happened, that your power prices will go up if you privatise. Contact Energy was charging 500 bucks a year more for an average family of four, than any of the SOEs.

Now I take it from what Phil Goff says about foreign investors that when they take over a company they want a really big returns on their investment. But even if they do want such a return how can they get it? Does Phil think that just because they want a big return they can somehow force people to pay a high enough price to give them this return? And if they can create any revenues they need to get the return they want why not go for an infinite return?! I mean if you can get any return you want then infinity sounds good. Phil seems to miss the point that customers can change suppliers if they think prices from one particular suppler are too high and even if they couldn't investors can't get any return they want since the maximum willingness to pay is bounded by the height of the demand curve.

Also if foreign investors can want, and get ,these high returns why can't New Zealand investors want and get the same returns? The price of power does not depend on the nationality of the owner of the power company. I assume that New Zealand firms can maximise profit just as well as foreign companies.

In addition the SOE Act requires that the SOE is as successful as a non-state owned firm:

Principal objective to be successful business
(1) The principal objective of every State enterprise shall be to operate as a successful business and, to this end, to be—
(a) as profitable and efficient as comparable businesses that are not owned by the Crown;

So if foreign owners can get these really big returns then the SOE has to act in such a way as to get them as well.

So the SOE, an New Zealand owned private firm and a foreign owned private firm will all charge the same prices for power as they are all trying to maximise profits. Thus prices will not rise if SOEs are privatised.

Now if these evil, bad "foreign investors" really can increase the profits and return paid by the power companies then this will be because they are more efficient in using the resources of the companies. But in this case we want them to be the owners as we want our resources utilised in the most efficient manner possible.

So ignoring capital xenophobia, foreign ownership looks good.

Viner on Smith on government

The standards of honesty and competence of the governments of his day with which Smith was acquainted were unbelievably low, moreover, not only in comparison with what they are today in England, Germany, and the Scandinavian countries, but apparently even in comparison with earlier periods in English political history. Smith had encountered few instances in which government was rendering intelligent and efficient service to the public welfare outside of the fields of protection and justice. The English government of his day was in the hands of an aristocratic clique, the place-jobbing, corrupt, cynical, and classbiased flower of the British gentry, who clung to the traditional mercantilism not so much because of a strong faith that it met the problems of a growing trade struggling to burst its fetters, but because they did not know anything else to do. Even when Smith was prepared to admit that the system of natural liberty would not serve the public welfare with optimum effectiveness, he did not feel driven necessarily to the conclusion that government intervention was preferable to laissez faire. The evils of unrestrained selfishness might be better than the evils of incompetent and corrupt government. (Jacob Viner, "Adam Smith and Laissez Faire", Journal of Political Economy, Vol. 35, No. 2 (Apr., 1927), pp. 198-232.)

How much have things really changed since Smith's time?

Interesting blog bits

1. Joanne Nova on Naomi Klein’s crippling problem with numbers

   Naomi Klein was the wrong person to send to a heavy-weight science conference — in “Capitalism vs Climate” she notices hundreds of details, but they’re all the wrong ones. Naomi can tell you the colour of the speakers hair, what row they sat in, and the expression on their face — it adds such an authentic flavor to the words, but she’s blind to the details that count. She can explain the atmosphere of the room, but not the atmosphere of the Earth. One of these things matters, and Klein has picked the wrong one. Her long attack on the Heartland ICCC conference this year is all color and style, and nothing of consequence — the lights are on and no brain is home. Unpack the loquacious pencraft and we wallow in innumerate arguments that confuse cause and effect, peppered with petulant name-calling. She can throw stones, but she can’t count past “one”.

2. Hans-Werner Sinn on The threat to use the printing press

   The first major crisis in the era of independent central banks is severely testing that independence – nowhere more so than the Eurozone. This column argues that the ECB is monetising the sovereign debt – a view widely held in Germany. It argues that the ECB is the Eurozone’s economic government with the power to enforce comprehensive rescue measures, up to and including a fiscal transfer union.

3. Joel Waldfogel asks Is the Sky Falling? The quality of new recorded music since Napster

   Napster – the first peer-to-peer file sharing service – changed the music industry forever. Many people now download music without paying, often illegally. This column looks at the effect on the music industry, in particular what it means for the quality of new recorded music.

4. Bruno S Frey and Lasse Steiner on Selecting World Heritage sites: A new proposal

   There are nearly 1,000 UNESCO World Heritage sites. These sites benefit hugely from tourism, so suspicions of fixing the judges’ verdicts are rife. This column suggests a novel way to get rid of the politicisation: random selection.

5. Gary Becker asks Has Structural Unemployment Become Important in the United States?

   The persistently high unemployment rate in the United States during the Great Recession has led to claims that much of American unemployment is “structural”. According to this view, the demand for workers by companies is insufficient to employ all unemployed workers because there is a mismatch between the skills possessed by many American workers and the skills required by companies. The structural advocates believe the skills demanded by companies tend to exceed or otherwise be different from the skills possessed by many unemployed workers. As a result, so goes the argument, these unemployed workers cannot find jobs and remain unemployed for a long time.

6. John Mackey says To Increase Jobs, Increase Economic Freedom

   Business is not a zero-sum game struggling over a fixed pie. Instead it grows and makes the total pie larger, creating value for all of its major stakeholders, including employees and communities.

7. Eric Crampton on Post-Kyoto

   Extending the date for various industries' entry into the New Zealand Emissions Trading System costs the public purse only to the extent that the government is required to buy carbon credits on the international market to make up for any failure to reach aggregate pollution reduction targets.

8. Peter Klein on Shakespeare and Epistemology

   We university types love The Bard — we’ve got bookstores hither and yon, pizza joints, you name it. Not surprisingly, Shakespearean scholars are up in arms at Roland Emmerich’s film Anonymous, which they view as silly entertainment at best, disreputable Oliver Stone style revisionism at worst.

9. Art Carden on Absolut Insanity? Underage Drinkers Don't Need Vodka-Soaked Tampons

   This much is certain: people like to get high. Indeed, people have probably been experimenting with mood-altering substances since the beginning of time. Attempts to control these impulses with prohibitions and regulations have either backfired completely or created “cures” that are probably worse than the disease.

The foundations of economic models

How important are foundations to what economists do? Take, for example, the way economists think about competition. Milton Friedman has written,

Of course, competition is an ideal type, like a Euclidean line or point. No one has ever seen a Euclidean line – which has zero width and depth – yet we all find it useful to regard many a Euclidean volume – such as a surveyor’s string – as a Euclidean line. Similarly, there is no such thing as “pure” competition. Every producer has some effect, however tiny, on the price of the product he produces. The important issue for understanding and for policy is whether this effect is significant or can properly be neglected, as a surveyor can neglect the thickness of what he calls a “line”. The answer must, of course, depend on the problem.

In other words there is a trade-off between the usefulness of our models and the foundations of those models. Jean Tirole has made this point with regard to incomplete contracts models.

A methodological divide may have developed in our profession in recent years between those who advocate pragmatism and build simple models to capture aspects of rea;ity, and others who wonder about the foundations and robustness of these models [...]

Personally I’m more in the build simple models that help us understand the issues we are dealing with camp rather than worry about getting all the foundation exactly right before using models. To take Tirole’s example of incomplete contracts models. We know that there are issues with the standard, property rights, story told about why contracts are incomplete. The reliance of the property rights approach to the firm on a theory of incomplete contracts that assumes unforeseen or indescribable states of the world as a way of generating incompleteness has lead to a number of criticisms, the most significant of which is the Maskin and Tirole (1999) critique. Maskin and Tirole argue that information which is observable to the contracting parties can be made verifiable (to a third party) by the use of ingenious revelation mechanisms. The contracting parties write into their contract a game which when played gives the appropriate incentives for them to truthfully reveal their private information in equilibrium. This undermines the non-verifiability approach to incomplete contracts.

But such issues have not prevented the property rights approach from becoming a workhorse in the theory of the firm literature or from being applied in many other areas such as the analysis of firms’ internal organisation; firms’ financial decisions; the costs and benefits of privatisation; and the organization of international trade between inter- and intra-firm trade.

So the question remains, Does this lack of proper foundations for some economic modela really matter? Or is getting answers to important questions, regardless of foundations of the model, enough?

Incentives matter: education file

Incentives matter even for university professors. From a new paper in Economic Letters on Piece rates for professors

Using panel data, we demonstrate a 50% increase in research productivity following a dramatic increase in the piece rate paid for articles by a major Chinese University. The increased productivity comes exclusively from those who were already research active.

Of course one wonders how much of this extra output is actually worth having. Are they producing a whole lot of extra articles at the AER standard or a whole lot at the NZEP standard?

No advantage

A successful business needs a competitive advantage. A successful country is no different.

Or at least this is what "Pure Advantage" want us to believe. As I said earlier, A country is not a company and should not be run like one. I wrote,

As Paul Krugman (yes even he is right about some things!) said A Country Is Not a Company. To see why consider, for example, the basic point that companies compete with each other but New Zealand doesn't compete with other countries. Thinking that countries compete is a just one false analogy that comes from thinking that countries are like companies when they're not. The point is that Coke and Pepsi, for example, do compete, one gains at the others expense, but New Zealand and Australia, for example, don't, their loss is not our gain. International trade is not a zero-sum game. To see this, note that while Coke may wish to put Pepsi out of business, so that Coke can increase their sales and prices and therefore profits, New Zealand would not gain if we put Australia "out of business".

Why? Well in the Coke/Pepsi case, Coke gain a lot, in terms of sales and profits, from not having Pepsi to compete with and lose little since Pepsi doesn't buy much, if anything, from Coke. Or Coke from Pepsi. This is not true of the New Zealand/Australia example. We may gain some sells if Australia stopped producing, but we would lose much more. Australia is our biggest export market and if they "went out of business", they would stop importing, and that would hurt us a lot. Also they are suppliers of much of our useful imports and that would stop too, which would hurt us even more.

So New Zealand does not need a "competitive advantage", it needs, and has, a comparative advantage. We do not compete with other countries like Coke and Pepsi compete with each other, other countries are your friends, they buy our stuff and sell us their stuff. What we need to do is look for the most efficient way of trading with these countries, that is, workout our comparative advantage.

Bill Kaye-Blake writes with regard to a Pure Advantage press release,

The language of this media release is atrocious. The sloppy thinking, the non-sequiturs, the begging the question. The leaders of the group are supposed to be scientists, and this is what they produce? I don’t have time or energy for a Fisking, so I’ll leave it at that.

While rauparaha at TVHE sees

[...] the dangers of management thinking in economics.

So economist-bloggers seem to see no advantage in Pure Advantage. But then again I'm guessing economists are not their target audience. The government and taxpayers money looks a more likely target.As Bill Kaye-Blake points it,

What’s the solution? More money for science! And not just any science — the science that particularly interests the scientists behind the organisation.

Or rent seeking as some would call it.

Weitzman talk

Remember Professor Martin Weitzman is presenting here at Canterbury tomorrow afternoon, on the economics of climate change.

RSVP now if you haven't already!

Talk: 4:30 - 5:30pm, Law 108, Law Building

EconTalk this week

Roy Baumeister of Florida State University and the author of Is There Anything Good About Men talks with EconTalk host Russ Roberts about the differences between men and women in cultural and economic areas. Baumeister argues that men aren't superior to women nor are women superior to men. Rather there are some things men are better at while women excel at a different set of tasks and that these tradeoffs are a product of evolution and cultural pressure. He argues that evolutionary pressure has created different distributions of talent for men and women in a wide variety of areas. He argues that other differences in outcomes are not due to innate ability differences but rather come from different tastes or preferences.

Religious competition

A new NBER working paper looks at Substitution and Stigma: Evidence on Religious Competition from the Catholic Sex-Abuse Scandal.

This paper considers substituting one charitable activity for another in the context of religious practice. I examine the impact of the Catholic Church sex-abuse scandal on both Catholic and non-Catholic religiosity. I find that the scandal led to a 2-million-member fall in the Catholic population that was compensated by an increase in non-Catholic participation and by an increase in non-affiliation. Back-of-the-envelope calculations suggest the scandal generated over 3 billion dollars in donations to non-Catholic faiths. Those substituting out of Catholicism frequently chose highly dissimilar alternatives; for example, Baptist churches gained significantly from the scandal while the Episcopal Church did not. These results challenge several theories of religious participation and suggest that regulatory policies or other shocks specific to one religious group could have important spillover effects on other religious groups.

So different religious denominations are substitutes for one another. That is an interesting result and not one I would have expected. I would have thought there would be "lock-in" when it comes to religion. But when the "price" of being Catholic, in terms of dealing with scandals, goes up the demand for other religious denominations goes up. How people substitute is also interesting, they seem to go for denominations which are very unlike the Catholic Church. I would have expected, if there was to be substitution, that it would be to similar denominations.

You have to be careful about how you word things

Yes but its the amount of debt that they would leave that many people are worried about.

(HT: Homepaddock)