Is China’s economic future a rosy one?

So asks Gary Becker. He writes,

Starting with the opening of agriculture to private incentives in the late 1970s, China has experienced faster and more prolonged economic growth than any other country. In a mere three decades China has moved from a very poor nation to a middle-income level country, a development that pulled hundreds of millions of Chinese out of poverty. China’s aggregate GDP is now second in the world only to that of the US. While its per capita income is still much smaller than that of America’s, many are predicting that even China’s per capita GDP will surpass that of the US in a few decades.

But as Becker points out, good economic growth today doesn't always mean good growth tomorrow. At different times the Soviet Union and Japan had faster growth than any country in the West but they didn't manage to become the world's economic superpower. We know what happened to the Soviet Union and Japan's rapid growth stopped abruptly during the early 1990s, and Japan has largely stagnated economically for the past two decades.

A major problem for China is its efforts to maintain growth may be political rather than economic. Economic growth will come at the price of political power. As people become wealthier, they have more to lose to the grabbing hand of government. People will want, and will demand, protection from the state and this means the Communist Party in China will lose power. Limits on the arbitrary power of the state are needed if growth is to continue at the rate it is now. The incentives are wrong for growth if people are not sure they will keep the rewards of their efforts. Even in the West we see an example of this problem in the effects of Regime Uncertainty. People don't invest when they fear the loss of any return to their investment.

A related problem is that the party will also have to give up its economic power. As an example of this problem look at the SOEs in China. As Becker notes

The China 2030 report argues that the SOEs must operate more like commercial companies, but that is not easy since officials from the Communist Party usually have high positions in these enterprises, and many of the larger SOEs are closely related to the Communist Party and the military. The ideal solution would be to privatize most SOEs, but that does not seem likely in the near future. This is partly because government officials would lose power if SOEs were privatized, and partly because the government fears that privatized companies would greatly cut employment and increase social unrest.Unfortunately for China, it would not be possible to close rapidly the per capita income gap with rich countries as long as a large fraction of manufacturing output in China is produced in over-manned and inefficient state enterprises.

So for growth to continue at anything near its current rate, at some point, the Communist Party in China will have to give up some, if not all, of its political and economic power. And its unlikely they will be too keen on that.

EconTalk this week

David Weinberger of MIT and author of Too Big to Know, talks with EconTalk host Russ Roberts about the ideas in the book--how knowledge and data and our understanding of the world around us are being changed by the internet. Weinberger discusses knowledge and how it is attained have changed over time, particularly with the advent of the internet. He argues the internet has dispersed the power of authority and expertise. And he discusses whether the internet is making us smarter or stupider, and the costs and benefits of being able to tailor information to one's own interests and biases.

Education and economic development: evidence from the industrial revolution

In this short audio from VoxEU.org Sascha Becker of the University of Warwick talks to Romesh Vaitilingam about his research on the important role that formal education played in facilitating industrialisation in nineteenth century Prussia. They also discuss the relationship between education and fertility, and historical evidence in support of ‘unified growth theory’.

Boundedly rational dynamic programming

A new NBER Working paper on Boundedly Rational Dynamic Programming: Some Preliminary Results by Xavier Gabaix

The abstract reads

A key open question in economics is the practical, portable modeling of bounded rationality. In this short note, I report ongoing progress that is more fully developed elsewhere. I present some results from a new model in which the decision-maker builds a simplified representation of the world. The model allows to model boundedly rational dynamic programming in a parsimonious and quite tractable way. I illustrate the approach via a boundedly rational version of the consumption-saving life cycle problem. The consumer can pay attention to the variables such as the interest rate and his income, or replace them, in his mental model, by their average values. Endogenously, the consumer pays little attention to interest rate but pays keen attention to his income. One consequence of this is that Euler equations will be biased, and the intertemporal elasticity of substitution will be biased toward 0, in a manner that is quantitatively important.

Now who says economists don't do super-cool stuff!!

A relationship between income and freedom

There is a new working paper by Derek Stimel out on The Short-Run Relationship between Income and Freedom: Evidence from 128 Countries. The abstract reads:

The relationship between income, economic freedom, and political freedom is often examined over the long-run but recently, there is increased interest in the short-run. From a review of the literature, I develop possible short-run relationships between a country’s income per capita, economic freedom, political rights, and civil liberties while taking into consideration broad institutional differences across countries. The empirical strategy is to estimate a structural panel vector autoregression where each equation is estimated using the dynamic panel general method of moments procedure of Arellano and Bover (1995). I then estimate impulse responses for the full sample of 128 countries between 1994-2009 as well as key sub-samples. From this relatively a theoretical approach, results indicate that improvements in economic freedom benefit more developed countries relative to less developed countries, as do improvements in income per capita. Improvements in political rights improve economic freedom in highly developed countries and low developed countries but improve income the most in countries with medium development. Improvements in civil liberties have somewhat the opposite effect as political rights. Implications of these results are discussed with an eye toward their practical relevance for business as well as policymakers.

Daron Acemoglu and James Robinson now have a blog

This is good news. You can find the blog here. The blog is related to their forthcoming book Why Nations Fail.

(HT: Marginal Revolution)

Economics is what exactly?

Reading the Prologue to Roger Backhouse's book "The Ordinary Business of Life: A History of Economics from the Ancient World to the Twenty-First Century" (a very readable book even for non-economists) I found a number of definitions of economics.

Backhouse offers us

• Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. (From Lionel Robbins)
  
• The study of mankind in the ordinary business of life. (From Alfred Marshall. Guess where the title of the book comes from!)
• Economics deals with the production, distribution and consumption of wealth. (I guess that would capture much of classical economics.)
• How production is organised to in order to satisfy human wants. (Surely economics is more than this. What of public choice for example?)
• The logic of choice. (But what about production?)
• The study of markets. (But what about all non-market institutions, like firms or clubs or farms or ....)

I'm not sure any of these really work for me.

Later Backhouse writes

Is is possible, for example, to have societies in which money does not exit [...], in which production is not undertaken by firms, or in which transactions are undertaken without markets.

I'm willing to accept this, apart from the no markets bit. I can't think of an example of a society without markets and I can't help thinking if there is such an example it would be a very poor, very small and very limited kind of society. As the division of labour is limited by the extent of the market, no markets means that the division of labour would be, basically, non-existent. This alone would make for a very poor society.

Management practices

A quick Look at the paper "Recent Advances in the Empirics of Organizational Economics" by Nicholas Bloom, Raffaella Sadun and John Van Reenen, Annual Review of Economics (2010) 2: 105–37, shows up a few interesting results with regard to management practices and decentralisation of firms. In particular the paper suggest that (a) Competition seems to foster improved management and decentralisation; (b) larger firms, skill-intensive plants, and foreign multinationals appear better managed and are more decentralised; (c) firms that are both family owned and managed appear to have worse management and are more centralised; and (d) firms facing an environment of lighter labour market regulations and more human capital specialise relatively more in people management. Decentralisation here means the degree to which lower levels of the hierarchy have power relative to upper levels of the hierarchy (e.g., a higher degree of autonomy of junior managers from senior managers, a higher degree of autonomy of shopfloor workers from management)

The point about foreign firms being better managed is one that more than a few politicians, and others, in New Zealand would do well to take on board. Also the importance of competition to management practices needs to be kept in mind. This is just one advantage of increasing competition via a well implemented program of deregulation.

The paper also argues that there is evidence for complementarities between information and communication technology, decentralisation, and management, but the relationship is complex, and identification of the productivity effects of organisational practices remains to be fully investigated. But it does raise a possible reason for New Zealand's poor productivity performance. How well have we integrated ICTs into our businesses?

EconTalk this week

Adam Davidson of NPR's Planet Money talks with EconTalk host Russ Roberts about manufacturing. Based on an article Davidson wrote for The Atlantic, the conversation looks at the past, present, and future of manufacturing. Davidson visited an after-market auto parts factory in Greenville, South Carolina and talked with employees there as well as with executives at corporate headquarters. What is the future of factory work in America? Why are some manufacturing jobs in America while others are in China or elsewhere? The conversation looks at these questions as well as how well or poorly the U.S. education system prepares students for the world of work.

Just for fun: theory of the firm 12

A recent, but still relatively unknown, contribution to the theory of the firm which can be seen as outside, if related to, the mainstream of the economic approach to the theory of the firm is Daniel F. Spulber, "The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations", Cambridge: Cambridge University Press, 2009. If we think of the mainstream theory of the firm as being concerned with three basic issues to do with the existence, boundaries and internal organisation of the firm then Spulber's book is somewhat outside of the mainstream but the issues it deals with are related closely enough to those of the mainstream to justify a brief overview. (For criticisms of the Spulber approach to the firm from inside the mainstream see Hart (2011).) In addition Spulber offers insights into a number of important issues missing from the mainstream and thus lays the groundwork for future research in both the theory of the firm and industrial organisation more generally. Spulber "[ ... ] seeks to explain (1) why firms exist, (2) how firms are established, and (3) what firms contribute to the economy" (Spulber 2009: ix). These issues are clearly related to those of the mainstream but they are not the same. In particular the mainstream does not have a theory of the entrepreneur or market creation. Spulber's book in an attempt to create a general approach to microeconomics in which entrepreneurs, firms, markets, and organizations are all endogenous.

To start Spulber defines a firm "[ ... ] to be a transaction institution whose objectives differ from those of its owners. This separation is the key difference between the firm and direct exchange between consumers". (Spulber 2009: 63). Note that under this definition organizations such as clubs, basic partnerships, many family firms, worker cooperatives, non-for-profit organisations and public enterprises are not firms. The basic reason being that the objectives of these types of organizations cannot be separated from those of their owners. The separation of objectives between owners and firms also justifies the profit maximisation objective. Consumers who are the owners of the firm, obtain income via the firm's profits and thus want profit maximisation so they can maximise their consumption (utility).

Spulber has three additional players in his story: consumers, organisations and markets. Consumers are individuals who consume the goods and services generated within the economy. Organisations are transaction institutions whose objectives cannot be separated from those of their owners. Markets are transaction mechanisms that bring buyers and sellers together.

For Spulber the entrepreneur is important because it is their efforts that leads to the creation of firms. A combination of market opportunities interacting with the individual's preferences, endowments and other such characteristics leads the consumer to take on the role of entrepreneur. The individual is an entrepreneur for the time it takes to establish the firm. Assuming that the firm is successfully established, the entrepreneur's role changes to that of an owner of the firm. Ownership is valuable insofar as it provides returns to the (former) entrepreneur. This change from entrepreneur to owner is in Spulber's terms, `the fundamental shift'. (Spulber 2009: 152). The point is that before the change from entrepreneur to owner, the objectives of the organisation cannot be separated from those of the (then) entrepreneur. After the fundamental shift has occurred, the entrepreneur is now the owner and the firm's objectives are separate from those of the owner, which means a firm has been established.

Other organisations can be formed that allow consumers to take advantage of joint production. Such advantages include economies of scale, public goods, common property resources and externalities. Unlike the firm, the objectives of the organisation reflect the consumption objectives of the members of the organisation. A problem with an organisation is that it can experience inefficiencies due to free riding. Firms overcome such problems by separating the objectives of the organisation from the consumption objectives of its owners and thus inducing profit maximisation. Profit maximisation may not achieve full efficiency due to problems such as allocative inefficiencies that result from market power. Thus the comparison between a firm and an organisation depends on the trade-off between profit maximisation and free riding. When the number of consumers is small, free riding problems tend to be small and thus an organisation may be more efficient than the firm.

Given we have firms, firms can create markets. Firms can act as intermediaries and in doing so they increase the gains from trade and reduce transactions costs when consumers are separated by time, distance and uncertainty. Firms create markets by providing centralised mechanisms for matching consumers, in their roles as buyer and sellers, in a more efficient manner than decentralised exchange can achieve. Market making firms are required to buy and sell at any moment meaning that buyers and sellers avoid the costs involved with trading delays and the risk of being unable to find a trading partner. In the world of financial markets, market-making firms provide liquidity by being ready to buy and sell financial assets. Addition transaction efficiencies are bought about by market-making firms being able to consolidate trades which allows traders to reduce the costs involved with having to find multiple trading partners or with having mismatched trades. Firm can also avoid the problems inherent with complex bartering arrangements by simplifying the trading process vis the use of posted prices. Supply and demand can be equated in a market by firms adjust their buying and selling behaviour thereby reducing potential losses due to market imbalances. Thus market creation is endogenous.

Spulber offers insights into a number of issues that the mainstream theory of the firm does not deal with well, if at all. The discussion of issues such as the role of the entrepreneur and the creation of markets are important issues that lie outside of the mainstream of the theory of the firms, at least as far as the mainstream is conceived of here. Such issues do however raise questions for the future of the theory of the firm and industrial organisation.

• Hart, Oliver D. (2011). `Thinking about the Firm: A Review of Daniel Spulber's The Theory of the Firm', "Journal of Economic Literature", 49(1) March: 101-13.

To GE or not GE

That is the question. While looking on the web for material for a paper I'm working on, "The Past and Present of the Theory of the Firm", I came across a number of discussions on the evils or the non-evils of general equilibrium theory. Some people argue McKenzie, Arrow and Debreu et al are the great satans who are out to destroy economics - if not the world. Others believe GE theory is the greatest achievement in the history of economics. This interested me because I end my paper with the following observation (a couple of footnotes have been removed)

A final point about the models of the firm discussed in this essay is that they highlight a general issue to do with post-1970 microeconomics, that is, the movement away from the use of general equilibrium (GE) models. All the models considered above are partial equilibrium models, but in this regard the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation etc, has largely turned its back, presumably temporarily, on GE theory and has worked almost exclusively within a partial equilibrium framework. This illustrates the point made at the beginning of the paper that there is a close relationship between the economic mainstream and the theory of the firm; when the mainstream forgoes general equilibrium, so does the theory of the firm.

For the case of contract theory, a field closely related to that of the theory of the firm, Salanie (2005: 2) has argued,

``[t]he 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".

As was noted in Section 4.1 the post-1970s literature on the firm can be classified into two general groups based on which of two of the standard assumptions of GE theory, namely symmetric information and complete contracts, is violated when modelling the firm. This requirement to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms, or other important economic institutions. As Bernard Salanie notes,

``[ ... ] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models". (Salanie 2005: 1).

This would suggest that creating GE models that can account for information asymmetries, contractual incompleteness, strategic interaction and the existence of institutions is needed if GE theory is to be able to deal with the issues - including those related to the firm - that microeconomists wish to tackle.

Now what I'm wondering is, Is the problem with GE a problem with the idea of general equilibrium as such or a problem with the Arrow-Debreu approach to GE? I can't help thinking that the world is GE and thus to handle the "real world" we need general equilibrium models. But the way we model GE leaves much to be desired. The current generation of GE models don't deal well with things like information asymmetries, contractual incompleteness, strategic interaction and economic institutions. Thus do we need at new GE which doesn't just try to model the extreme decentralisation of the perfectly competitive framework? Not that it is obvious what such a form of GE would look like. How much, if any, of the current approach to GE can be saved? Or is the Arrow-Debreu framework the right way to go? Or should we just stay with partial equilibrium models and not worry about interactions between markets?

Things you ponder on a Thursday afternoon.

Its ok to hate Valentine's Day

Let me repeat my posting from a few years back, it still applies.

The Times has a list, "20 reasons it's okay to hate Valentine's Day". Number 14 is

It's such a rip-off. With flowers, dinner and cabs, you’re looking at a hundred quid minimum. Wouldn’t she just prefer the cash instead?

This has to be true, as any economist will tell you. Just giving her the cash must be Pareto improving. With the cash she can either go out and buy what you would have bought, so she and you are no worse off, or she can buy what she really wants, and you would not have bought, so you will both be better off.

So next year, just give her the money guys.

EconTalk this week

David Owen of the New Yorker and author of The Conundrum talks with EconTalk host Russ Roberts about the ideas in his book. Owen argues that innovation and energy innovation have increased energy use rather than reduced it and similarly, other seemingly green changes do little to help the reduce humanity's carbon footprint or are actually counter-productive. Only large reductions in consumption are likely to matter and that prescription is unappealing to most people. Owen points out that New York City, ironically perhaps, is one of the greenest places to live because of the efficiencies of density. The conversation concludes with a discussion of how to best approach global warming given these seeming realities.

The past and present of the theory of the firm

There is a new paper available at SSRN that looks at The Past and Present of the Theory of the Firm.

The abstract reads,

In this survey we give a short overview of the way in which the theory of the firm has been formulated within the 'mainstream' of economics, both past and present. As to a break point between the periods, 1970 is a convenient, if not entirely accurate, dividing line. The major difference between the theories of the past and the present, as they are conceived of here, is that the focus, in terms of the questions asked in the theory, of the post-1970 literature is markedly different from that of the earlier (neoclassical) mainstream theory. The questions the theory seeks to answer have changed from being about how the firm acts in the market, how it prices its outputs or how it combines its inputs, to questions about the firm's existence, boundaries and internal organization. That is, there has been a movement away from the theory of the firm being seen as developing a component of price theory, namely issues to do with firm behavior, to the theory being concerned with the firm as a subject in its own right.

More MED mercantilism?

From Groping towards Bethlehem we learn that

[...] MED in its Briefing to the Incoming Minister pointed out that the high exchange rate means we are all a little bit richer? Don’t be silly. ‘Cause, see, it’s all about the exports. The opening sentence:

The Government’s aim of building a stronger economy will require a substantial increase in the share of exports in the economy.

The question I would ask of MED is, But why does building a stronger economy require an increase in the share of exports? In simple terms, doesn't building a stronger economy just mean producing more - and thus increasing our real wealth - and who we sell our output to doesn't matter?

I mean if we produce a widget here in Canterbury, does MED really mean that selling that widget to someone in Auckland doesn't help our economy, since it wouldn't increase the share of exports, but selling it to someone in Sydney does, since it does increase the share of exports in the economy?!!

EconTalk this week

William Black of the University of Missouri-Kansas City and author of The Best Way to Rob a Bank Is to Own One, talks with EconTalk host Russ Roberts about financial fraud, starting with the Savings and Loan debacle up through the current financial crisis. Black explains how bank executives can use fraudulent loans to inflate the size of their bank in order to justify large compensation packages. He argues that "liar loans" were a major part of the crisis and that policy changes made it easy to generate such loans without criminal repercussions.

Shleifer on the transition from communism

At VoxEU.org Andrei Shleifer tells us about the Seven things I learned about transition from communism. These seven things being:

First, in all countries in Eastern Europe and the former Soviet Union, economic activity shrunk at the beginning of transition, in some very sharply. In many countries, economic decline started earlier, but still continued. In Russia, the steepness and the length of the decline (almost a decade) was a big surprise. Countries with the biggest trade shocks (such as Poland and Czechoslovakia) experienced the mildest declines. To be sure, the true declines were considerably milder than what was officially recorded – unofficial economies expanded, communist countries exaggerated their GDPs, defence cuts, and so on – but this does not take away from the basic fact that declines occurred and were surprising. These declines contradicted at least the simple economic theory that a move to free prices should immediately improve resource allocation. The main lesson of this experience is for reformers not to count on an immediate return to growth. Economic transformation takes time.

Second, the decline was not permanent. Following these declines, recovery and rapid growth occurred nearly everywhere. Over 20 years, living standards in most transition countries have increased substantially for most people, although the official GDP numbers show much milder improvements and are inconsistent with just about any direct measure of the quality of life (again raising questions about communist GDP calculations). As predicted, capitalism worked and living standards improved enormously. One must say, however, that for a time things looked glum. So lesson learned: have faith – capitalism really does work.

Third, the declines in output nowhere led to populist revolts – as many economists had feared. Surely reform governments were thrown out in some countries, but not by populists. Instead of populism, politics in many countries came to be dominated by new economic elites, the so-called oligarchs, who combined wealth with substantial political influence. From the perspective of 1992, this came as a huge surprise. Ironically, in some countries in Eastern Europe populism appeared 20 years after transition started, after huge improvements in living standards were absolutely obvious. Indeed, people in all transition countries were unhappy with transition: they were unhappy even in countries with rapidly improving quality of life (and this itself is another surprise and major puzzle – something for future reformers to keep in mind). But the lesson is clear: a reformer should fear not populism but capture of politics by the new elites.

Fourth, economists and reformers overstated both their ability to sequence reforms, and the importance of particular tactical choices, eg, in privatisation. In retrospect, many of the theories that animated the discussion of reform – whether institutions should be built first, whether companies should be prepared for privatisation by the government, whether voucher privatisation or mutual fund privatisation is better, whether case by case privatisations might work – look quaint. Reformers nearly everywhere, including in Russia, had a vastly overstated sense of control. Politics and competence frequently intervened and dictated to a large extent most of the tactical choices. Still, most countries, despite different choices, ended up with largely similar outcomes (notable and sad exceptions are Belarus, Uzbekistan, and Turkmenistan). In various forms, all had privatisation and macroeconomic stabilisation as well as legal and institutional reform to support a market economy. Lesson learned: do not over-plan the move to markets, but, more importantly, do not delay in the hope of having a tidier reform later.

Fifth, economists have greatly exaggerated the benefits of incentives by themselves, without changes in people. Economic theory of socialism has put way too much weight on incentives, and way too little on human capital. Winners in the communist system turned out not to be so good in a market economy. Transition to markets is accomplished by new people, not by old people with better incentives. I realised this and wrote about it in the mid-1990s, but the lesson both in firms and in politics in profound: you cannot teach an old dog new tricks, even with incentives.

Sixth, it is important not to overestimate the long-run consequences of macroeconomic crises and even debt defaults. Russia experienced a major crisis in 1997–98, which some extremely knowledgeable observers said would set it back by 20 years, yet it began growing rapidly in 1999–2000. Similar stories apply elsewhere, from East Asia to Argentina. Debt restructurings do not necessarily make permanent scars. This experience bears a profound lesson for reformers, who are always intimidated by the international financial community: do not panic about crises; they blow over fast.

Seventh, it is much easier to forecast economic than political evolution. Although nearly all transition countries have eventually converged to some form of capitalism, there has been a broader range of political experiences, from full democracies, to primitive dictatorships, to just about everything in between. There appears a strong geographic pattern in this, with countries further West, especially those involved with the European Union, becoming clearly democratic, and countries further East remaining generally more authoritarian. For countries in the middle, including Russia and Ukraine, the political paths over the 20 years have wiggled around. Lesson learned: middle-income countries eventually slouch toward democracy, but not nearly in as direct or consistent a way as they move toward capitalism.

Ricardo and comparative advantage 2

Thanks to an email from Jorge Morales Meoqui I have been alerted to his recent paper in the journal History of Political Economy on "Comparative Advantage and the Labor Theory of Value". The abstract reads,

With the famous numerical example of chapter 7 of the Principles (1817) David Ricardo intended to illustrate first and foremost the new proposition that his labor theory of value does not regulate the price of international transactions when the factors of production are immobile between countries. Unfortunately, later scholars have often omitted this proposition when referring to Ricardo's numerical example. Instead, they have highlighted only the comparative-advantage proposition, although Ricardo considered it as a corollary of the omitted proposition and therefore inextricably linked to it. This inexplicable omission has led to an incomplete understanding of the logical construction of Ricardo's numerical example, as well as to the misinterpretation of the four numbers as unitary labor costs. With an accurate understanding of Ricardo's numerical example and the logical relationship between the two propositions it meant to prove, it is relatively easy to refute the main objections that have been raised against the very same numerical example in the past. Moreover, it reaffirms the sustained relevance of Ricardo's two propositions as important insights for understanding the current process of economic globalization.

Jorge also has a working paper "On the distribution of authorship-merits for the comparative-advantage proposition". The abstract reads,

Due to a better understanding of the logical interrelationships between the comparative- advantage proposition, the classical rule of specialization and the proposition regarding the non- appliance of the labor theory of value in international exchanges in Ricardo’s famous numerical example in the Principles, it is now possible to arrive to a definite conclusion regarding the longstanding academic debate about the true author of the comparative-advantage proposition. Torrens is not entitled to the same amount of merit as David Ricardo with regard to the comparative-advantage proposition since he fell short of formulating a full prove of it prior to the publication of Ricardo’s Principles. In the 1815 example of English cloth being traded for Polish corn, Torrens missed to apply the classical rule of specialization for Poland. For the featured international exchange to take place, though, there has to be gains from trade for both trading partners. More importantly, Torrens also failed to recognize the crucial role of Ricardo’s insight regarding the non-appliance of the law of value in international exchanges in proving the comparative-advantage proposition. Therefore, the bulk of the authorship-merit for this proposition rightly belongs to Ricardo.

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.