Micro foundations of public sector management 2 (updated)

Update: Added discussion of the Holmstrom and Milgrom paper.

This is my second post on the Treasury working paper "Contemporary Microeconomic Foundations for the Structure and Management of the Public Sector" by Lewis Evans, Graeme Guthrie and Neil Quigley.

In chapter 3 the authors focus on the "incomplete contracts" or "property rights" approach to theory of the firm.

In section 3.2 Evans, Guthrie and Quigley write,

"Transaction-cost explanations for contractual incompleteness are unsatisfactory, because there is more incompleteness than can be accounted for by transaction costs (specifically, because there are many elements where contracting is not possible rather than just more costly than the alternative). Examples include situations where information is symmetric, but key contractible elements are not verifiable by either party. Even when transaction costs are zero, incomplete contracts may arise because parties cannot observe relevant economic variables, cannot verify those variables to a legal standard of proof, or prefer not to disclose information about themselves that would be required for a complete contract."

Now this I don't get. Aren't all cases of incompleteness driven by some form of transaction cost? If we think of transactions costs as the costs of market transactions then in a zero transaction costs world contract would be complete since such contracts would be cost-less to write. Coase has written,

"The solution to the puzzles that I took with me to America [Why are there firms?] was, as it turned out, very simple. All that was needed was to recognize that there were costs of carrying out market transactions and to incorporate them into the analysis, something which economists had failed to do. A firm had therefore a role to play in the economic system if it were possible for transactions to be organized within the firm at less cost than would be incurred if the same transactions were carried out through the market. The limit to the size of the firm would be set when the scope of its operations had expanded to the point at which the costs of organizing additional transactions within the firm exceeded the costs of carrying out the same transactions through the market or in another firm."

The idea that when

"information is symmetric, but key contractible elements are not verifiable by either party"

we get incomplete contracts seems odd. If information is known to the contracting parties, what does it not being verifiable to the parties mean? If the information is not verifiable to a third party, e.g. a court, then a contract can be incomplete, but this is a different thing from information being non-verifiable to the contracting parties. If information is symmetric in that it is unknown to all contracting parties, will a contract be incomplete? The answer to this depends on whether or not the information is verifiable to a third party. If it is then the contracting parties can contract on it by just getting the third party to verify the information. If the information is not verifiable to the third party then a contract will be incomplete. But the reason for the incompleteness is not because the information is unknown to the contracting parties but rather because it is non-verifiable to the third party.

The idea that,

"Even when transaction costs are zero, incomplete contracts may arise because parties cannot observe relevant economic variables, cannot verify those variables to a legal standard of proof, or prefer not to disclose information about themselves that would be required for a complete contract"

also seems odd. I'm not sure what they mean when they say that information is non-observable to the contracting parties. If this means a moral hazard/adverse selection type framework then contract are comprehensive and not incomplete. As Hart explains it,

"Although the optimal contract in a standard principal-agent model will not be first-best (since it cannot be conditioned directly on variables like effort that are observed by only one party), it will be 'comprehensive' in the sense that it will specify all parties' obligations in all future states of the world, to the fullest extent possible. As a result, there will never be a need for the parties to revise or renegotiate the contract as the future unfolds. The reason is that, if the parties ever changed or added a contract clause, this change or addition could have been anticipated and built into the original contract."

and

"One would also not expect to see any legal disputes in a comprehensive contracting world. The reason is that, since a comprehensive contract specifies everybody's obligations in every eventuality, the courts should simply enforce the contract as it stands in the event of a dispute."

Clearly such a contract is not incomplete. If Evans, Guthrie and Quigley mean that neither of the contracting parties can observe the variable then we are in case discussed above in; which the important point is the verifiability of the variable to a third party. If the contracting parties,

"cannot verify those variables to a legal standard of proof"

then contracts could be incomplete. Non verifiability of information to a third party such as a court is the standard argument as to why contracts are complete. But this argument can be countered by the Maskin and Tirole 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.

If some of the contracting parties,

"prefer not to disclose information about themselves that would be required for a complete contract"

then its hard to see that we are in a zero transaction costs world. Isn't not providing information the same as saying the costs of contracting on that information are infinite? This looks like a very large transaction cost!

Under section 3.3 Evans, Guthrie and Quigley write,

"The starting point for this approach to the theory of the firm is the incompleteness of contracts. Since humans are boundedly rational, not all issues of relevance to a contract can be anticipated at the time of writing the contract."

But Oliver Hart argues,

"In the last few years, a literature has developed on the theory of incomplete contracts, and on applications of this theory to the understanding of organizations, such as firms. In this paper, I will argue that, while transaction costs of various sorts are a crucial ingredient of this literature, bounded rationality in the sense that agents have limited cognitive, computational or comprehension skills is not."

Given that Evans, Guthrie and Quigley argue that incompleteness is important for contracts there is one question that they need to answer. As it is possible for the contracting parties to fill any gaps in their contract as they go along, Why is contractual incompleteness important? The reason is that renegotiation itself imposes costs. These cost can be both ex post, incurred at the time of renegotiation, or ex ante, incurred in anticipation of renegotiation.

In section 3.4 the point is made that,

"The incomplete contracting perspective embodied in this example represents a sharp break with the earlier transaction cost-based literature on the firm. Whereas incomplete contracts imply that inefficiencies arise because it was hard to foresee and contract about the uncertain future, earlier literature tended to take a “complete contracts” perspective in which imperfections arise as a result of moral hazard and asymmetric information."

I would read the "earlier literature" comment to refer to the transaction cost literature. But incomplete contracts are a central feature of the transaction cost approach. As Hart and Moore (2007) explain

"Transaction cost economics (see, e.g., Oliver Williamson (1975, 1985), Benjamin Klein et al. (1978)) argues that firms are important when contracts are incomplete, and parties make large relationshipspecific investments."

Section 3.5 of the paper looks at the link between transaction costs, incentive-based theories and incomplete contracts. When discussing incentive-based theories of the firm Evans, Guthrie and Quigley write,

Incentive-based theories of the firm have their foundation in the analysis of the incentive problem between a principal and an agent. This approach assumes that there are many tasks and many instruments associated with the agency problems in a firm, and asset ownership is merely one of the instruments. Papers in this paradigm consider two ways to structure the agency problem: (i) where the agent does not own the asset (is an employee) and therefore has incentives provided by being paid on measured performance, and (ii) where the agent does own the asset (is an independent contractor) and receives both a payment based on measured performance and the value of the asset after production occurs.

This approach to the theory of the firm has in effect focused on the claimed distinction between the low-powered incentives associated with employment, and the high-powered incentives associated with contracting. Employees require low-powered incentives because they are not distracted by the contractor’s incentives to increase the value of the assets used for production. More generally, joint optimisation over asset ownership and contract parameters determines whether to conduct activity within the firm or outside.

The incentive-system theory of the firm is therefore related to the incomplete contracts literature, both in its use of ownership as an instrument and in its ability to provide a unified account of the costs and benefits of integration.

Incentive theory is normally thought of as a comprehensive contracts based theory and much of the literature is of this form. Think of moral hazard models. Incentive theory of this type is probably best understood as a extension of the neoclassical theory of the firm that inquiries into the incentive conflicts that may hinder the firm from reaching its production possibility frontier. But not all incentive theory is of this kind. While its not exactly clear what set of papers is being referred to above. I assume that papers like Bengt Holmstrom and Paul Milgrom’s 1994 paper, "The Firm as an Incentive System" fall into this group.

Holmstrom and Milgrom here stress the importance of viewing the firm as "a system", specifically as a coherent set of complementary contractual arrangements which mitigate incentive conflicts. In their opinion, it is misleading to focus on any one single aspect of the coherent whole: the firm is characterized by the employee not owning the assets, by the employee being subject to a low-powered incentive scheme, and by the employee being subject to the authority of the employer. These “incentive instruments” are complementary: For example, in the presence of measurement costs, it is important that a person who does not own the assets which he uses is not subject to high-powered incentives, since he then is likely to care too little for the assets. Likewise, low-powered incentives make it important for the employer to be able to exercise authority over the use of the employee’s time, since the employee will lack the proper incentive to be productive. Due to this complementarity it is logical that independent contracting has the exact opposite constellation of instruments from the employment relationship.

The choice between the two different incentive systems depends importantly on the extent to which every dimension of a person’s contribution can be measured. When an important dimension is unmeasurable, it might be counterproductive to remunerate the person through a high-powered incentive scheme since the person is likely to allocate too little attention on the unmeasurable activity. Thus, according to Milgrom and Holmstrom lack of measurability is an important variable determining the size of the firm [...]. (Foss 2000)

An important point to note about this paper is that it is not only a principal-agent theory but also an incomplete-contracting theory. So the relationship between the two theories can be a very close one, the theories are not just related but can be usefully merged.

In the past I have argued that transaction cost and property rights theories are "orthogonal" to each other. In a discussion of the differences between the Grossman-Hart-Moore (GHM) theory of the firm and the transaction-cost approach, Williamson (2000, pp. 605–606) argues that the most important difference between them is that GHM introduce inefficiencies at the ex ante investment stage while the transaction-cost approach emphasises that ex post haggling and maladaptation drive inefficiencies. There are no ex post inefficiencies in GHM due to their assumption of common knowledge and ex post costless bargaining. Gibbons (2010, p. 283) explains it this way:

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

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

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

One point worth making is that the reference point approach (not much discussed in the Evans, Guthrie and Quigley paper) to the firm that has grown in very recent times out of the property rights approach can be seen as a move away from the ex ante GHM approach and back towards transaction cost thinking in so much as contracting is not perfectly contractible ex post.

Chapter 4 of the Evans, Guthrie and Quigley paper is on Real Options and Investment.

Cato Unbound

The September 2012 issue of Cato Unbound is on the Theory and Practice in the Austrian School.

Ludwig von Mises's Human Action is still the key summation of the Austrian school of economics. In it, Mises describes certain conclusions, those of praxeology, as having a special epistemological status: They are deductive conclusions that are not subject to falsification. In plain language, they cannot fail to be true: While the findings of history may always be subject to revision—if new evidence is discovered, say, or if old evidence is found to be unreliable—the conclusions of praxeology will always be valid.

This move has brought critics of Austrian economics to cry foul. Such critics are apt to see the Austrian school as a group of almost cartesian rationalists, deducing economic theorems that, while perhaps interesting in their own right, can by definition have no purchase in the real world of economic policy and the study of human events.

Professor Steven Horwitz begs to differ. In his lead essay he argues that logical deduction has a strictly limited role to play in economics, and that Austrian economists are indeed making important empirical contributions to the field. Further, he argues that the Austrian school stands to teach mainstream economics a good deal about how to conduct empirical observations and interpret them properly. To discuss with Horwitz, we have invited three other distinguished economists, each of whom has been influenced by the Austrian school — while ultimately settling elsewhere methodologically: Bryan Caplan, George A. Selgin, and Antony Davies.

Micro foundations of public sector management 1

The Treasury has a recent working paper out on Contemporary Microeconomic Foundations for the Structure and Management of the Public Sector by Lewis Evans, Graeme Guthrie and Neil Quigley. All three authors are at Victoria University of Wellington. The abstract reads:

The new public management of the 1980s was based in part on a range of important new insights about the role of transaction and agency costs arising from contractual incompleteness in defining the boundaries of the firm and the governance relationships within it. In this paper, we consider the literature of the last 25 years which extends our understanding of allocations of ownership rights and the boundaries of the firm as responses to contractual incompleteness. From this perspective, ownership represents an allocation of control rights to those with the potential to make the most important (value-enhancing) relationship-specific investments. We provide an outline of this modern approach to contractual incompleteness, illustrate its application to a range of issues in public and private ownership, investment, governance and decision-making, and provide suggestions about the impact that this approach might have on the scope, structure and management of the public sector in the 21st century.

I have done a quick read of the first three chapters of the paper. They do managed to get the references to the chapters of the paper wrong in the Introduction. When they refer to Chapter 2 they mean Chapter 3 and when they refer to Chapter 3 they mean Chapter 4 and so on.

In Chapter 2 they review the microeconomic foundations of the state-sector reform in New Zealand after 1984. The chapter looks at the economic theories that were important in the formulation and implementation of New Zealand's public management framework after 1984. The major influences from economics were the new institutional economics, principal-agent theory, transaction costs and information economics. At one point Evans, Guthrie and Quigley write,

Since the issue was first raised by Ronald Coase in the 1930s, academic economists have developed increasingly sophisticated theories of why firms exist, why some economic activity is organised within the market and some is organised within firms, and how the efficient boundaries of firms are determined.

Some economists would date the start of the modern theory of the firm from Knight (1921) rather than Coase (1937). Demsetz (1988: 244) goes so far as to state,

"[ ... ] it can be said without hesitation that Knight launched the modern theory of the firm in 1921".

I do sometimes wonder just how sophisticated even the modern theories of the firm really are. As Oliver Hart has written,

"[a]n outsider to the field of economics would probably take it for granted that economists have a highly developed theory of the firm. After all, firms are the engines of growth of modern capitalistic economies, and so economists must surely have fairly sophisticated views of how they behave. In fact, little could be further from the truth. Most formal models of the firm are extremely rudimentary, capable only of portraying hypothetical firms that bear little relation to the complex organizations we see in the world. Furthermore, theories that attempt to incorporate real world features of corporations, partnerships and the like often lack precision and rigor, and have therefore failed, by and large, to be accepted by the theoretical mainstream". (Hart 1989: 1757).

In 2008 Hart said of the 1989 quote

"[t]he language of 1989 is strong, and I'd probably tone it down a bit now. There's been a lot of work in the last twenty years, and some progress. However, we are still not at the point where we have good models of the internal organization of large firms".

In section 2.3 Evans, Guthrie and Quigley write,

"The Treasury (1987:37-39) set out a transaction-cost and incentive-based theory of the limitations of state ownership. It motivated the benefits of private ownership by drawing attention to the agency problems associated with information acquisition and performance management under state ownership given the complex objectives of state entities and the absence of market monitoring and competition."

The problem with the complete contracts approach to ownership was not shown until the late 1980s when the ownership neutrality theorems started to appear. These theorems give conditions, in particular complete contracts, under which private or public ownership of productive assets is irrelevant for the allocation of resources. As Hart (2003) sums it up,

"One of the insights of the recent literature on the firm is that, if the only imperfections are those arising from moral hazard or asymmetric information, organisational form - including ownership and firm boundaries - does not matter: an owner has no special power or rights since everything is specified in an initial contract (at least among the things that can ever be specified). In contrast, ownership does matter when contracts are incomplete: the owner of an asset or firm can then make all decisions concerning the asset or firm that are not included in an initial contract (the owner has 'residual control rights')."

In section 2.4 Evans, Guthrie and Quigley outline what they see as some of the unresolved issues with public management,

• The boundaries between the state and the private sector, including:
  • the case for public investment where the private sector is unwilling to invest, and
  • the allocation of ownership and service delivery between the private and public sectors.
• The place of competition in the public sector and, in particular:
  
  • the role of competition in promoting greater efficiency in the delivery of services and the management of assets within the public sector, and between the public and private sectors, and
  • the balance between competitive discovery of efficient solutions to operational and organisational problems, and single national approaches to investment and public-sector infrastructure.
• 
  The need for stronger individual and organisational incentives for performance, and more effective mechanisms for the measurement and monitoring of that performance. Gill and Hitchener (2010:498) argue that while the vertical structures of accountability created under the Public Finance Act and the State Sector Act were designed to allow greater scrutiny of performance of ministers, chief executives and their departments or agencies, in practice there is relatively little use of performance information by central agencies, other than as a measure of bottom-line performance when things go wrong, and that this has tended to reinforce rather than mitigate the “well known bureaucratic pathologies of public organisations, in particular risk-averse, rule-driven behaviour.”
• The effectiveness of the governance and management of the public sector as a whole, including the role of advisory and governance boards, the central monitoring agencies, and the challenge of producing more effective mechanisms for solving problems and developing innovative new approaches to policy where policy issues span the mandates of multiple teams and multiple government organisations. Scott et al (2010) point out that there have been consistent concerns about the ability of the public sector to deliver quality and innovative policy advice on the big issues that are of relevance to multiple departments and entities.

The rest of the paper looks at the recent academic literature to search for answers to these problems.

More on chapter 3 of the paper later.

Waldegrave and mixed strategies

In my online History of Game Theory I have an entry dated 1713 on the first use of a mixed strategy,

In a letter dated 13 November 1713 James Waldegrave provided the first, known, minimax mixed strategy solution to a two-person game. Waldegrave wrote the letter, about a two-person version of the card game le Her, to Pierre-Remond de Montmort who in turn wrote to Nicolas Bernoulli, including in his letter a discussion of the Waldegrave solution. Waldegrave's solution is a minimax mixed strategy equilibrium, but he made no extension of his result to other games, and expressed concern that a mixed strategy "does not seem to be in the usual rules of play" of games of chance.

The reference I gave for the belief that James was the author of the letter was to a work by Professor Harold Kuhn,

On Waldegrave see Kuhn, H. W. (1968), Preface to Waldegrave's Comments: Excerpt from Montmort's Letter to Nicholas Bernoulli, pp. 3-6 in Precursors in Mathematical Economics: An Anthology (Series of Reprints of Scarce Works on Political Economy, 19) (W. J. Baumol and S. M. Goldfeld, eds.), London: London School of Economics and Political Science and Waldegrave's Comments: Excerpt from Montmort's Letter to Nicholas Bernoulli, pp. 7-9 in Precursors in Mathematical Economics: An Anthology (Series of Reprints of Scarce Works on Political Economy, 19) (W. J. Baumol and S. M. Goldfeld, eds.), London: London School of Economics and Political Science, 1968.

But James was not the only Waldegrave who could have written the letter. Professor David Bellhouse published a paper in 2007 arguing that Charles, not James, Waldegrave was the author of the famous letter. Charles was an uncle to James.

This morning I received an email from Professor Kuhn alerting me to the fact that Professor Bellhouse has been continuing his research into which Waldegrave wrote the letter and now believes that it was neither James nor Charles but Charles's brother Francis. In light of this I have amended my history to show Francis as the likely author of the letter.

Professor Bellhouse is working on a new paper about Montmort, Bernoulli and Waldegrave. I look forward to seeing this in print so we can get the whole story.

Justifications for foreign aid

From the Economist

Where poor people live, it turns out, makes a big difference to justifications for foreign aid. Research by Andy Sumner of the University of Sussex’s Institute of Development Studies has found that four-fifths of those living on $2 a day or less live in middle-income countries (such as China and India). Most of these countries can afford to help poor people themselves—and usually do. India, for instance, as provides subsidised food for the poor through the Public Distribution System and temporary work for anyone who asks for it through a rural employment guarantee act. Of course, this fact says nothing about justifications for aid in general. The Indians may be spending their money wisely, they may not. But it does undercut one obvious justification for foreign aid, since if national governments can afford to send the needed help, what do foreigners have to offer?

My first question about this would be, What about Africa? What percentage of the really poor are in Africa? Many of the African government may be too dysfunctional to provide aid to their own people, here foreign aid could help.

Blogging on stadiums

Thanks to Close Up the economics of stadiums is back in the news. I'm not sure what planet Gerry Brownlee is on when it comes to economics but his defence of a Christchurch stadium wasn't great. He didn't have any answers to the points raised against stadiums in the Close Up video.

Sam Richardson from the Fair Play and Forward Passes blogs starred in the Close Up video but he has also blogged on the topic of stadiums a number of times: see his label Stadiums. Eric Crampton at the Offsetting Behaviour blog has also blogged on stadiums, see his label Stadiums. I have also blogged on the economics of stadiums, see my label Stadiums.

Bradley on Enron

Over at EconLib Robert L. Bradley Jr writes on Enron: The Perils of Interventionism. His conclusion is

Enron was essentially a political company, not a free-market one. Ken Lay's creation would be unknown to history were it not for the distorted incentives from the government side of the mixed economy.

For classical liberals, Enron is a case study in support of the separation of government and business. There is egregious rent-seeking, whereby the company worked to shape political intervention for economic advantage. There is bootleggers and Baptist politicking, whereby Enron teamed with nonprofit groups to win support for what was in the company's narrow self-interest.

There is the peril of half-slave, half-free. Partially deregulated markets (such as with electricity in California) created a devil's sand box for profit-making that otherwise would have been absent in a free-market order.

Although an Enron could not have been predicted, it is yet another example of the unintended consequences of interventionism in the field of energy, as well as from the politicized accounting and tax systems that governed all corporations.

And then there is the ultimate consequence from the dynamics of intervention. Historically, the failures of the mixed economy have been an excuse to further politicize the economy. Richard Epstein warned: "The greatest tragedy of the Enron debacle is not likely to be the consequences of the bankruptcy, but from the erroneous institutional reforms that will take hold if its causes are not well understood." The Sarbanes-Oxley Act (2002) and the Bipartisan Campaign Reform Act (2002), enacted with Enron in mind, proved him right.

Both the false narrative and the real story of Enron impart lessons for intellectuals and pundits alike. Sound theory makes complex history intelligible; bad theory blinds us to recognizing what is there for the taking. Enron fooled many people in its active life, and it continues to fool in death. A true understanding of "Exhibit A" deserves to enter into the mainstream of thought.

No the usual way the Enron story is presented.

EconTalk this week

Neil Barofsky, author of Bailout and the former Special Inspector General for the TARP program, talks with EconTalk host Russ Roberts about his book and the government bailouts by the Bush and Obama Administrations. Barofsky recounts what he learned about how Washington works and the incentives facing politicians and bureaucrats. His book and this interview are a workshop in public choice economics. Along the way he unravels some of the acronyms of the last few years including TARP, TALF, and HAMP. The conversation concludes with lessons learned by Barofsky and what might be done in the future to prevent the corruption and ineffectiveness of past bailouts.

Firms reorganise to grow

Lorenzo Caliendo, Ferdinando Monte and Esteban Rossi-Hansberg have a new column up at VoxEU.org on the subject Firms reorganise to grow (by hiring workers that know and earn less). The basic idea is that firms that reorganise production to grow account for almost 40% of the value added created in the manufacturing sector. They add layers of management, increase by 7% the average hours worked in the firm, and reduce the average wage at pre-existing layers of managers or workers by 11%.

The Caliendo, Monte and Rossi-Hansberg column presents new stylised facts about the way firms organise production and explains how recent advances in economic theory can help to understand these findings.

In recent research (Caliendo et al. 2012) we identify a number of robust empirical patterns on the organisation of firms as well as the changes in this organisation as firms grow. We find that:

• Firms that expand (or contract) significantly are exactly those involved in a reorganisation process;
• Firms that do not reorganise typically change very little.

One part of the literature on firms thinks of firms as hierarchies of knowledge. This idea of a division of knowledge within a firm was first recognised by Demsetz (1988) and formalised by Becker and Murphy (1992). What these works suggested was simply a new interpretation of the role of the firm. Given that there are limitations to what a worker can know, the competence that a firm has to possess to produce must be divided into manageable portions and allocated between the workers. The actions of the different groups of workers are then coordinated by the firm’s management. Thus workers who produce on the basis of knowledge they themselves do not possess, have their activities directed by someone who does possess (at least more of) the necessary knowledge. This gives a rationale for management. As there are asymmetries in information among workers, management is required to coordinate the activities of the different groups of employees. If the workers knew everything about the production process they could carry out production without coordination. In this way, direction is a substitute for education, that is, a substitute for the transfer of the knowledge itself.

Caliendo, Monte and Rossi-Hansberg make the point that it is useful to interpret the data  if we think of firms as hierarchies of knowledge.

• Production requires labour and knowledge.
• Knowledge is embedded in individuals and is costly to acquire.
• The organisational problem is then the result of the limited time of individuals.

This time constraint implies that it is not optimal to have only very knowledgeable employees, but to have many agents with basic knowledge and fewer experts that focus on exceptions. Subordinates save the time of knowledgeable expert by dealing with the simple problems. This is the essential role of organisations.

• Firms are hierarchical with a large base of workers, who know and are paid less, and with higher layers of management with more knowledgeable employees that earn more.

The next question worth asking is, Are firms different in their organisation? Caliendo, Monte and Rossi-Hansberg present new evidence on this point.

We use administrative data from the French manufacturing sector on the balance sheet of firms and the occupations of their workers from 2002 to 2007. To construct a picture of the organisation of firms our empirical analysis is guided by Caliendo and Rossi-Hansberg (2012). We can distinguish up to three layers of management (supervisors, senior staff and CEOs) above clerks and blue collars whom we refer to as production workers.

Firms do, in fact, differ in their organisation. On average firms have 1.5 layers of management above their production workers, many small firms have only production workers, and about as many large firms have all three of them (the maximum we can observe). Larger firms (i.e. firms that employ more workers and add more value) tend to have more layers of management. This fact makes perfect economic sense. If an artisan wants to produce more, he or she can of course hire other workers that perform exactly his or her tasks, but it is better just to hire apprentices, who know only the most common operations (and are therefore cheaper), and use his or her own time to deal with more infrequent matters. Organisations allow exactly this leveraging of the time of managers through the extensive use of a less able workforce. The data shows that firms are hierarchical, in the sense that higher layers of management tend to have fewer employees and pay them more than lower layers.

Now we get to the point of reorganising a firm. The question is, When do reorganisations occur?

Looking at all the firms with a given organisation type (i.e. with the same number of layers of management), we find that the larger the firm, the higher the likelihood that it will reorganise its production by adding one layer (symmetrically, the smaller firms are more likely to contract their production by dropping one). This fact also makes economic sense. Firms can respond to a given increase in the demand for their product with or without a reorganisation. In the latter case, they just expand their production base, i.e. they hire more workers. By doing so, however, a strain is put on the time of the managers above them, who now would have to deal with more people (and more problems). Hence, firms expanding this way must have more employees at each layer and must pay them more (in order for them to be more knowledgeable and ask less). Hence, the average wages at all layers must rise. Among all the firms with a given organisation, those which grow in this way are the small ones, since they employ fewer employees and so expanding the knowledge of all of them is cheaper. In contrast, if the firm is relatively large, it makes sense to add one layer of managers and reduce the knowledge of everyone below. In this case, firms grow by reorganising.

Another advantage of a more extensive division of labour was noted as far back as Charles Babbage. In his book “On the Economy of Machinery and Manufactures” Babbage observed that the greater the division of labour with workers knowing less about the overall production process reduced the less time required for learning any requisite skills. This results in a lessening of the period during which a new entrant to the workforce would be relatively unproductive and unremunerative. Because less knowledge and training was required to learn to undertake a single operation, as opposed to that required to undertake many different operations, a new employee would more quickly reach a situation where he generates a profit for his employer.

Caliendo, Monte and Rossi-Hansberg now ask, Why is growth through reorganisation different?

The data tells us that when firms reorganise, they have a larger number of employees than they used to in all layers, but the average wage at all pre-existing layers falls. Following the logic above this drop in average wages has a very clear economic rationale. The objective of the reorganisation is exactly to economise on the knowledge of all pre-existing layers. Apprentices are hired exactly because they know less than the master, and can deal with the most frequent and basic issues. So firms that expand by reorganising pay their workers less, because they prefer to employ less knowledgeable workers.

Caliendo, Monte and Rossi-Hansberg conclude that

While, in our data, only about 13% of the firms go through reorganisation episodes in a given year, these episodes account for almost 40% of the value added created in the manufacturing sector. These findings shed light on the process through which firms grow. Most of the existing literature documents a 'firm size – wage premium', whereas average wages are higher for larger firms; we show that this relation is just the result of the composition of many firms that grow little and raise wages, and a few firms that reorganise, grow a lot, pay the new top manager more, but reduce average wages in all pre-existing layers [...] Our analysis also explores the export behaviour of firms. Accessing a foreign market is a particularly important form of expansion for many firms, and we find that the same facts described above are reproduced for the subset of firms that grow and start exporting (or, of course, shrink and stop exporting). In particular, firms who start exporting are more likely to reorganise their activity than firms who keep operating only domestically, and new exporters who reorganise tend to reduce (rather than increase) average wages paid at all pre-existing layers.

The great ideas of the social sciences

At the ThinkMarkets blog Gene Callahan put forward a list of great ideas in social science:

* The state as the individual writ large (Plato)

* Man is a political/social animal (Aristotle)

* The city of God versus the city of man (Augustine)

* What is moral for the individual may not be for the ruler (Machiavelli)

* Invisible hand mechanisms (Hume, Smith, Ferguson)

* Class struggle (Marx, various liberal thinkers)

* The subconscious has a logic of its own (Freud)

* Malthusian population theory

* The labor theory of value (Ricardo, Marx)

* Marginalism (Menger, Jevons, Walras)

* Utilitarianism (Bentham, Mill, Mill)

* Contract theory of the state (Hobbes, Locke, Rousseau)

* Sapir-Worf hypothesis

* Socialist calculation problem (Mises, Hayek)

* The theory of comparative advantage (Mill, Ricardo)

* Game theory (von Neumann, Morgenstern, Schelling)

* Languages come in families (Jones, Young, Bopp)

* Theories of aggregate demand shortfall (Malthus, Sismondi, Keynes)

* History as an independent mode of thought (Dilthey, Croce, Collingwood, Oakeshott)

* Public choice theory (Buchanan, Tullock)

* Rational choice theory (who?)

* Equilibrium theorizing (who?)

I would add:

*Organisational theories explaining why a given organisational form gets used in a given situation (Coase)

Others?

Cutthroat v. cuddly capitalism

Why, ask Daron Acemoglu, James A. Robinson and Thierry Verdier, can't we all be more like Scandinavians? They have a new working paper out on the question Can't We All Be More Like Scandinavians? Asymmetric Growth and Institutions in an Interdependent World.

Acemoglu, Robinson and Verdier argue that many people perceive average welfare to be higher in Scandinavian societies than in the United States due to Scandinavian countries having more limited inequality and more comprehensive social welfare systems. This raises the question of Why doesn't the United States adopt Scandinavian-style institutions? Why isn't the U.S. more like the Scandinavians? More generally, in an interdependent world, would we expect all countries to adopt the same institutions? To provide theoretical answers to this question,  Acemoglu, Robinson and Verdier develop a simple model of economic growth in a world in which all countries benefit and potentially contribute to advances in the world technology frontier. A greater gap of incomes between successful and unsuccessful entrepreneurs (thus greater inequality) increases entrepreneurial effort and hence a country’s contribution to the world technology frontier. Under plausible assumptions, the world equilibrium is asymmetric: some countries will opt for a type of "cutthroat" capitalism that generates greater inequality and more innovation and will become the technology leaders, while others will free-ride on the cutthroat incentives of the leaders and choose a more cuddly form of capitalism. Paradoxically, Acemoglu, Robinson and Verdier are able to show that those with cuddly reward structures, though poorer, may have higher welfare than the cutthroat capitalists; but in the world equilibrium, it is not a best response for the cutthroat capitalists to switch to a more cuddly form of capitalism. They also show that domestic constraints from social democratic parties or unions may be beneficial for a country because they prevent cutthroat capitalism domestically, instead inducing other countries to play this role.

Stadiums and opportunity costs

John Spry, an economist with St. Thomas University in the Twin Cities, has written an opinion piece in the St. Paul Pioneer Press in which he takes issue with proposals to build a new stadium for the St. Paul Saints (an independent league baseball team) and to renovate the Target Center, the arena for the NBA’s Minnesota Timberwolves.

Spry make a number of points against these ideas, but one of the most important is

Finally, politicians erroneously claim that construction spending for these sports facilities will create jobs for Minnesotans. These claims ignore the basic economic concept of opportunity cost. Instead of building duplicative facilities, we could have either more productive public spending, such as improved courts or roads, or reduced taxes on private-sector investments.

Thinking about the opportunity cost of such proposals is important in any situation but it is doubly important for cities like Christchurch were there is so much that needs to be done.

(HT: The Sports Economist)

Interesting blog bits

1. Matt Nolan writes In defence of inflation targeting in NZ

   Why the RBNZ is a scapegoat for the failure of government

2. Steven Horwitz writes Ezra Klein Mistakes the Arsonist for a Firefighter

   In Friday’s Washington Post, Ezra Klein raises a number of criticisms of the gold standard using as his hook the call for a new Gold Commission that appears in a draft of the new Republican Party platform. Putting aside the question of party politics and what a new Commission might do, Klein’s arguments against the gold standard are not as strong as he thinks. I want to respond to three of them here, and in reverse order of importance.

3. John Cochrane on Gordon on Growth

   Bob Gordon is making a big splash with a new paper, Is US Growth Over?

4. Francisco Ceballos, Tatiana Didier and Sergio Schmukler on Different facets of financial globalisation

   A lot has been said about the pros and cons of financial globalisation. But what exactly is ‘financial globalisation’? This column argues that we can’t be clear about the pros and cons of financial globalisation unless we are clear on what it actually is.

5. Chris Dillow writes on Bad Incentives in Politics

   Why do politicians not solve social problems? One reason, of course, is that such problems are intractable. But there's another reason - politicians sometimes lack the incentive to do so because politicians need to keep their enemies alive just as parasites need to keep their hosts alive.

6. Russ Roberts on Competition

   In this conversation with Roger Noll, we talked about how much more purposive and less relaxed sports are for kids these days. There are travel teams. Coaching is much more intense and serious. Training and conditioning is much more intense and serious. All of it starts young. Roger and I chalked this up to the increased amount of money coursing through the sports pipeline. That money makes professional sports more competitive which in turn makes the stakes higher for college sports (which has its own cash pipeline) which in turn make high school and middle school more intense.

7. Donald J. Boudreaux on Inconceivable Complexity

   Nevertheless, too many people, including politicians, continue to believe that because they can observe a handful of bulky facts about the economy, they can thereby know enough to intervene into that economy in ways that will improve its operation. That belief, though, is hubris. It’s very much like believing that you’ll fly if you simply strap on a pair of wings and commence to flapping madly.

What is it about Labour and economics?

Another example of Labour getting basic economics wrong. Thanks to a message at the Homepaddock blog my attention to drawn to this comment on the upcoming partial sale of Mighty River Power:

Labour's state-owned assets spokesman, Clayton Cosgrove, seized on the result as evidence the company was in no fit state for sale.

"Mighty River's profits have almost halved. That will have a real impact on their share price if the Government rushes ahead with the sale. Listing a struggling company in a market like this is economics for dummies."

But the current level of profits of the company doesn't determine what people will pay for (part of) the company. The sale price will be determined by the expected future profits of the firm. Even if this years profits are down, what matters to investors are future profits. If investors think the future is likely to be good they will pay more for the firm no matter what the current level of profits are. Investors are forward looking, not backward looking as is the case with Clayton Cosgrove.

There are, I would argue, good reasons for not liking the partial sell-off of SOEs but Cosgrove's argument isn't among them.

Incentives matter: organ donation file

A new NBER working paper looks at the incentives for organ donation and bone-marrow donations. The paper, Removing Financial Barriers to Organ and Bone Marrow Donation: The Effect of Leave and Tax Legislation in the U.S., is by Nicola Lacetera, Mario Macis and Sarah S. Stith. The abstract reads,

In an attempt to alleviate the shortfall in organs and bone marrow available for transplants, many U.S. states passed legislation providing leave to organ and bone marrow donors and/or tax benefits for live and deceased organ and bone marrow donations and to employers of donors. We exploit cross-state variation in the timing and passage of such legislation to analyze its impact on organ donations by living and deceased persons, on measures of the quality of the organs transplanted, and on the number of bone marrow donations. We find that these provisions did not have a significant impact on the quantity of organs donated. The leave legislation, however, did have a positive impact on bone marrow donations. We also find some evidence of a positive impact on the quality of organ transplants, measured by post-transplant survival rates. Our results suggest that these types of legislation work for moderately invasive procedures such as bone marrow donation, but may be too low for organ donation, which is riskier and more burdensome to the donor.

So getting the incentives right matters for donation rates and what "right" means depends on what is being donated.

One instrument can't achieve two goals

From Don Brash

The Reserve Bank has got only one instrument, and that's monetary policy. You can't deliver two objectives with one instrument, and David Parker at least should have the brains to know that. Apparently not.

In short the RB can't control both inflation and the exchange rate.

The idea that some economic quantities can be classified as targets and others as instruments goes back to the 1950s and is due to the Dutch Nobel Prize winning economist Jan Tinbergen. He argued that targets are those macroeconomic variables the policy maker wishes to influence, whereas instruments are the variables that the policy maker can control directly. The important point that Tinbergen made, but David Parker has missed, is that achieving the desired values of a certain number of targets requires the policy maker to control an equal number of instruments.

Caplan v. Dickens on poverty and welfare (updated)

Bill Dickens and Bryan Caplan argue about poverty and welfare. Just read it all: start here then go here and then go here. The debate is obvious about the U.S. welfare system but but many of the issues carry over to New Zealand.

Update: Bryan responds to Bill's essay at Reply to Bill Dickens on Poverty: Part 1. David Henderson also has some Thoughts on Dickens.

EconTalk this week

Roger Noll of Stanford University talks with EconTalk host Russ Roberts about the economics of sports. Noll discusses the economic effects of stadium subsidies, the labour market for athletes, the business side of univeristy sports, competitive balance in sports leagues, safety in sports, performance-enhancing drugs, and how the role of sports in the lives of children has changed.

The interview begins with a discussion of the financial impact of sports stadiums. Noll makes the point that for a stadium to just break even it has to be used around 250-300 nights a year! This is something to keep in mind when you hear local councils arguing that their city should have a new sports stadium. Ask yourself, Will it be used 300 days a year?

The above comments refer to multiple-use stadiums. As for single use stadiums, rugby/cricket here in New Zealand, baseball/football in the U.S., Noll says,

Baseball and football stadiums, however--there aren't any that have been substantially subsidized where the local community has received anything remotely resembling a reasonable return on investment. They are financial black holes.

Preaching to the unconverted

The good news of the day is that there is now an economics blog on Sciblogs. It's called The Dismal Science and will pull posts from New Zealand economics blogs such as Fair Play and Forward Passes (Sam Richardson), Groping Towards Bethlehem (Bill Kaye-Blake), Offsetting Behaviour (Eric Crampton and Seamus Hogan) and The Visible Hand in Economics (Matt Nolan, James Zucollo and co-bloggers).

Eric Crampton explains there are still a few problems workings of the new blog:

We're still working out some back end issues to let me efficiently curate the different inbound feeds. When everything is working right, I'll see a morning dashboard with a list of new posts up at the source blogs that their authors deemed worthy, then schedule them for appearance at Dismal. I'd also like to be able to pull classic posts from our combined back archives when topics like capital gains taxes or stadiums become timely. Peter Griffin, the Editor at SciBlogs, is seeing what we can do to set up the system's back end.

But the problems will be sorted quickly, so keep an eye on The Dismal Science to add to your daily fix of economics blogging!

Growth and wages

I have made the point in the past that economic growth leads to wage growth. 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.)

Now James Otteson shows that Adam Smith was ahead of us on this issue, as he was on so many things.

It is not the actual greatness of national wealth, but its continual increase, which occasions a rise in the wages of labour. It is not, accordingly, in the richest countries, but in the most thriving, or in those which are growing rich the fastest, that the wages of labour are highest. [...] But though North America is not yet so rich as England, it is much more thriving, and advancing with much greater rapidity to the further acquisition of riches. ("An Inquiry into the Nature and Causes of the Wealth of Nations" I.viii.22-23)

De jure and de facto determinants of power

Is political power the result of the formal rules of the game or the result of more informal social conventions or both? Are the political rights of one group suppressed by legislation or by the use of extralegal forces, violence and intimidation. A new working paper (CEPR Discussion Paper No. 9064) from the Centre for Economic Policy Research looks at this question. The paper, De Jure and de Facto Determinants of Power: Evidence from Mississippi, is by Graziella Bertocchi and Arcangelo Dimico.

The paper evaluates the empirical relevance of de facto vs. de jure determinants of political power in the U.S. South (Mississippi) between the end of the nineteenth and the beginning of the twentieth century. The main message emerging from the paper is that on the one hand, there is clear evidence of an effect of legislation on political outcomes but on the other, the process of black disfranchisement starts well before the introduction of the new constitution and disfranchisement is stronger in counties where a black majority represents a threat to the de facto power of white elites. Moreover, the effect of the black share of voters becomes stronger after 1890, suggesting that the de jure barriers may have served the purpose of institutionalising a de facto condition of disfranchisement.

The abstract reads,

We evaluate the empirical relevance of de facto vs. de jure determinants of political power in the U.S. South between the end of the nineteenth and the beginning of the twentieth century. We apply a variety of estimation techniques to a previously unexploited dataset on voter registration by race covering the counties of Mississippi in 1896, shortly after the introduction of
the 1890 voting restrictions encoded in the state constitution. Our results indicate that de jure voting restrictions reduce black registration but that black disfranchisement starts well before 1890 and is more intense where a black majority represents a threat to the de facto power of white elites. Moreover, the effect of race becomes stronger after 1890 suggesting that the de jure barriers may have served the purpose of institutionalizing a de facto condition of disfranchisement.

Interesting blog bits

1. Carlo Altomonte, Tommaso Aquilante and Gianmarco I.P. Ottaviano on Triggering competitiveness: A 'decalogue' from new firm-level evidence
   

   Competitiveness is one of the most debated issues in policy circles. But, what triggers it? Capitalising on the first existing harmonised cross-country dataset measuring the entire range of international activities of firms in seven European countries, this column identifies the triggers of competitiveness. It argues that policymaking could be improved by firm-level evidence if there were less reluctance to the use of micro-founded indicators to inform policy decisions.

2. Eric Crampton on A symposium, of sorts

   The latest issue of the New Zealand Medical Journal features three papers on alcohol policy, including one from Matt Burgess, Brad Taylor and me, along with a commissioned editorial piece on the set. I have not yet had a chance to read the other two papers in the series but the editor of the journal kindly forwarded along a copy of the editorial piece late Thursday night.
   
   Doug Sellman, lead author on the editorial piece, says about what I expected he would say about our work on alcohol.

3. Alexander de Ville points out that the EU trade plans will increase protectionism and hinder development

   In June, the European Commission drew attention to the increase in protectionist tendencies worldwide. It claimed that over the previous eight months 123 new trade restrictions had been put in place, an acceleration of 25% compared with the previous period studied. However, the Commission’s own proposed trade reforms, published in January, were overlooked. These will push the EU itself towards further protectionism. They will 'hamper the global economy' and ‘hurt developing countries', according to a recent ODI study.

4. Ben Vollaard on How to cut prison numbers

   How to reduce incarceration rates without fuelling a crime boom? This column argues that by being more selective over whom to lock up and for how long, scarce public funds can be put to better use.

5. Art Carden asks Isn't it high time we legalize marijuana?

   On a couple of different occasions, I have used this space to call for an end to the economic, moral, and cultural disaster that is the drug war. American governments at all levels have been fighting the war on drugs for over four decades now, and it’s overwhelmingly clear that it’s time to cut our losses, admit that the whole thing was a mistake, and work toward restoring the lives that have been destroyed by the drug war.

6. Olivier Coibion and Yuriy Gorodnichenko say we should be Paying attention to inattention

   Economics and economists have taken a beating in the last few years. One practice on the receiving end of much criticism has been the use of models that assume rational expectations when individuals are well informed. This column proposes some tests of these assumptions and argues that 'imperfect information' models may succeed where others have failed.

Hype v. reality

As Sam Richardson and Eric Crampton have been interviewed for a Close Up segment, that will air early next week on TV One, on the economics of sports stadiums Sam has written a brief summary of why people should not be taken in by the hype around a stadium build. Sam writes,

Tangible economic impacts from sports facilities often fail to materialise for a variety of reasons. These include:

1. A substantial proportion of the crowds at stadiums are local rather than visitors. Some estimates I've seen in the literature suggest that it ranges from 80 to 95% of attendance being local.

1a. Spending by locals within a city on attending games is usually substituted from elsewhere within the local economy, for example, movie theatres, video rental stores, and other entertainment venues. A game merely redistributes spending rather than generates it.

2. Spending within a city often leaks outside the local area, as not all goods and services purchased by event attendees are produced locally, so a proportion of the spending has to go out of the local economy to pay for imported goods and services.

3. Government spending on stadiums, contrary to popular opinion, is not costless. That is, the funding has opportunity cost that must be considered. Money spent on a stadium could have been spent elsewhere in the local economy, and as such alternative activity is forgone. A benefit is only observed if the stadium activity more than outweighs the lost activity elsewhere.

4. Stadiums are almost always underutilised. Westpac Stadium in Wellington has around 45-50 event days per year. That is around one day per week. Game days are usually a hotbed of activity, but six of the seven days there is nothing going on. Surrounding development feels this too. Are businesses located nearby dependent on stadium activity going to survive with more off days than game days? It is unlikely.

5. Much of the projected activity that a new facility attracts comes from within the city at the expense of other facilities. Things such as conferences, conventions, trade shows, etc would by and large have been hosted elsewhere within the city at another venue. Thus we see another form of substitution in action here, which works towards reducing the overall realised impact of a new facility.

6. A replacement facility can not realistically be expected to do a lot more than a pre existing facility. Research in the US has suggested that there is a short term honeymoon effect of up to ten years where attendances spike due to the novelty of the new facility, but beyond this the experience has been that attendance returns to pre facility levels.

What about the intangible benefits? Surely they matter?

Relevant intangible benefits include consumer surplus that locals enjoy from attending games at the facility as well as the public good aspects. They are recognised as benefits but there are weaknesses in their ability to justify government funding. Firstly, consumer benefits are often captured to a greater or lesser degree by event organizers through ticket pricing structures - season tickets, family/adult/children, concessions, etc. It is in the organizers interest to capture as much of this as possible so as to maximize event profits. Secondly, it isn't just within the stadium that these benefits are appropriated. To watch your team elsewhere, you pay for it via Sky TV subscriptions. To read about your team you pay for it via newspapers, magazines, internet access, etc. A lot of benefits can be captured privately. Thirdly, one can argue that just about any activity or enterprise has some intangible benefits, but this doesn't mean we should subsidise every activity that generates intangibles!

The bottom line is that if tangible benefits don't materialise, the intangible benefits have to be substantial and international evidence suggests that while they aren't insignificant, they are nowhere near the size of subsidies given to build sports facilities and/or attract sports franchises.

People in Christchurch should think about these points very carefully and ask, Can spending $500 million on a new covered stadium really be justified? I can't help thinking the answer is no. I would also like to see the justification that CERA or the City Council or the government have for the idea of a new stadium.

Are bosses worth anything?

Do bosses matter? This is a question that Stephen Marglin famously answered in the negative. He argued that management doesn't affect productivity, just the share of output appropriated by managers. Now a new NBER working paper (No. 18317) looks at the question of  The Value of Bosses. The abstract of the paper, which is by Edward P. Lazear, Kathryn L. Shaw and Christopher T. Stanton, reads:

Do supervisors enhance productivity? Arguably, the most important relationship in the firm is between worker and supervisor. The supervisor may hire, fire, assign work, instruct, motivate and reward workers. Models of incentives and productivity build at least some subset of these functions in explicitly, but because of lack of data, little work exists that demonstrates the importance of bosses and the channels through which their productivity enhancing effects operate. As more data become available, it is possible to examine the effects of people and practices on productivity. Using a company-based data set on the productivity of technology-based services workers, supervisor effects are estimated and found to be large. Three findings stand out. First, the choice of boss matters. There is substantial variation in boss quality as measured by the effect on worker productivity. Replacing a boss who is in the lower 10% of boss quality with one who is in the upper 10% of boss quality increases a team’s total output by about the same amount as would adding one worker to a nine member team. Using a normalization, this implies that the average boss is about 1.75 times as productive as the average worker. Second, boss’s primary activity is teaching skills that persist. Third, efficient assignment allocates the better bosses to the better workers because good bosses increase the productivity of high quality workers by more than that of low quality workers.

So bosses matter and good bosses matter a lot. This may not be so surprising as this previous posting on work by Amanda Goodall that shows that the best research universities are lead by top researchers highlights.

The impact of right to carry laws

Right to carry laws have been discussed here before, see for example here and here. Now we have another  NBER working paper that that looks at right-to-carry (RTC) laws and concludes, we don't know what the effects are.

The paper is The Impact of Right to Carry Laws and the NRC Report: The Latest Lessons for the Empirical Evaluation of Law and Policy by Abhay Aneja, John J. Donohue III and Alexandria Zhang. The abstract reads:

For over a decade, there has been a spirited academic debate over the impact on crime of laws that grant citizens the presumptive right to carry concealed handguns in public - so-called right-to-carry (RTC)laws. In 2005, the National Research Council (NRC) offered a critical evaluation of the "More Guns, Less Crime" hypothesis using county-level crime data for the period 1977-2000. 17 of the 18 NRC panel members essentially concluded that the existing research was inadequate to conclude that RTC laws increased or decreased crime. One member of the panel, though, concluded that the NRC's panel data regressions supported the conclusion that RTC laws decreased murder.

We evaluate the NRC evidence, and improve and expand on the report's county data analysis by analyzing an additional six years of county data as well as state panel data for the period 1977-2006. We also present evidence using both a more plausible version of the Lott and Mustard specification, as well as our own preferred specification (which, unlike the Lott and Mustard model used in the NRC report, does control for rates of incarceration and police). While we have considerable sympathy with the NRC's majority view about the difficulty of drawing conclusions from simple panel data models, we disagree with the NRC report's judgment that cluster adjustments to correct for serial correlation are not needed. Our randomization tests show that without such adjustments the Type 1 error soars to 44 - 75 percent. In addition, the conclusion of the dissenting panel member that RTC laws reduce murder has no statistical support.

Our paper highlights some important questions to consider when using panel data methods to resolve questions of law and policy effectiveness. Although we agree with the NRC's cautious conclusion regarding the effects of RTC laws, we buttress this conclusion by showing how sensitive the estimated impact of RTC laws is to different data periods, the use of state versus county data, particular specifications, and the decision to control for state trends. Overall, the most consistent, albeit not uniform, finding to emerge from both the state and county panel data models conducted over the entire 1977-2006 period with and without state trends and using three different specifications is that aggravated assault rises when RTC laws are adopted. For every other crime category, there is little or no indication of any consistent RTC impact on crime. It will be worth exploring whether other methodological approaches and/or additional years of data will confirm the results of this panel-data analysis.

Now this is weird ....

even for the Greens. From the NZ Herald:

Meanwhile, the Green Parties of New Zealand, Australia and Canada are joining forces to campaign against the Trans-Pacific Partnership.

They issued a joint statement yesterday after Metiria Turei, co-leader of the NZ Greens, held a press conference in Canada with her counterpart from there.

Among the Greens' concerns is the prospect of the heavily protected Canadian dairy industry being de-regulated, removing safeguards which they say aim to preserve farmers' livelihoods.

Yes, but this is the point. Some Canadian farmers can't make a living without regulation and protection, so they should be doing something else. Also the farmer's lifestyle is costing Canadian taxpayer a huge amount. De-regulation would remove much of these costs to the Canadian taxpayer.

Hasn't Metiria noticed that New Zealand de-regulated its farming in the 1980s, and yes some farmers went under, but today farming is better and stronger then it ever was under the old protection and regulation regime.

De-regulation of the Canadian farming sector would in the short run hit some farmers hard but over time it would, like New Zealand did, come out more productive and stronger than it is now. Also the Canadian consumer would be better off as would New Zealand farmers. What is Metiria's problem?

EconTalk this week

Lee Ohanian of UCLA talks with EconTalk host Russ Roberts about the recession, the recovery, and the state of labor market. Ohanian describes the unusual aspects of this recession and recovery in the United States as shown by the labor market and the unusual performance of hours worked, productivity, and wages. He also discusses the behavior of business investment and speculates as to why this recession and the recovery has been so different in the United States. The conversation closes with a discussion of the role of the foreclosure process in encouraging unemployment.

A nice point

At the Homepaddock blog Ele Ludemann makes a nice point about the difference between what people say they want and what they are willing to pay for:

A survey established that New Zealanders support incentives to encourage clean industries and technologies.

The survey, of 2829 New Zealanders aged 18-plus, taken between July 5 and 16, 2012, asked recipients about their attitude toward incentives to encourage technologies such as marine energy and fuel-efficient cars,Carbon News reports.

All received strong support – with home insulation topping the list with nearly 100% backing.

The results showed that:

• 98.8 per cent support further subsidies to insulate un-insulated homes (1.3 per cent oppose).

• 78.4 per cent support incentives to develop biofuel from waste wood (2.8 per cent oppose).

• 74.5 per cent of respondents support reducing the annual registration fee for vehicles with smaller engines (6.7 per cent opposed).

• 72.3 per cent support incentives to develop wave and tidal power (9.1 per cent oppose).

• 64.7 per cent support cash incentives to buy fuel-efficient and lower-emissions cars (8.2 per cent oppose).

• 57.9 per cent support investing in alternative fuel technologies, such as those that capture and store emissions from coal-fired power stations (92 per cent oppose).

• 49.8 per cent support requiring standards on imported vehicles’ fuel efficiency to lift national fleet performance overall (10.7 per cent opposed).

The survey didn’t say if it asked respondents if they would be happy to pay for these incentives, nor if they were already doing what they could to support clean industries and technologies.

The last point above is a good one. The important thing to get people to reveal is what they are actually willing to pay for something. Just saying you favour X isn't the same as paying for X. Most people are more willing to do the former than the latter.

This is one reason why economists aren't too keen on survey data, what you really want is data on what people really do. Putting your money where your mouth is, is very different from just putting words where your mouth is. Or, talk is cheap.

How many of those answering the survey are will to pay more in tax to pay for the subsidies and incentive they say they favour? Are these same people willing to pay more for a used car because of the fuel efficiency requirement they support? And how much more?

More on the Christchurch rugby stadium

As noted in the previous post Sam Richardson has been continuing his thinking on the feasibility of a new covered rugby stadium for Christchurch over at his Fairplay and Forward Passes blog. He writes,

If tangible benefits and costs exist for these projects, then it is worth considering whether intangible benefits (and costs) do too. There is a small but not insignificant area of research that have examined the nature of intangible benefits and quantified them, using techniques such as demand analysis, travel cost methods and contingent valuation (all of which have been borrowed from recreational demand and natural resource economics). What is needed in the stadium context is some measure of net intangible benefits - that is, the 'warm fuzzies' from the stadium itself (which includes the retention of the franchise(s) it plays host to) less 'warm fuzzies' from the next best alternative, say repairing the east side of Christchurch. If the net warm fuzzies are positive, this suggests the project might well have some justification. What is the likelihood of this happening? A $500 million facility would be twice as expensive as the Forsyth Barr Stadium, and they've found the going tough. It would also be the largest amount ever spent on the construction of a sports facility in this country. Is the argument going to be that $500 million is going to pump some badly needed capital into the city and has to translate into some tangible benefits? Or will we see those behind the stadium blame the state of the local economy if the expected benefits don't materialise?

I agree that if we are to include "intangibles" in our calculus then it is the "net intangibles" that should be included. I guess my problem is whether or not we should include such things in the first place. First there is the question as to what gets measured, and how well it's measured, by the types of methods Sam mentions, but I will leave that aside. I want to make two other quick points. One, if we are to include intangibles for deciding on the subsidies for rugby stadiums, why not for all goods? Don't all goods have intangibles attached to them? I'm sure there are many, and large, intangibles that go along with Microsoft Windows so why don't we include these to justify a subsidy to be paid to Microsoft? Second, if there are intangibles with a rugby stadium what can't these benefits be turned into tangibles? For example, if there is a large amount of consumer surplus generated by a rugby stadium why can we turn that surplus into revenue for the stadium via, say, some form of nonlinear pricing? If this is done then the stadium should be able to be justified on a straight forward cost-benefit analysis.

Interesting blog bits

1. Sam Richardson on The departure of a key tenant: Implications for Christchurch's proposed stadium

   Sam continues his thinking on the feasibility of a new covered rugby stadium for Christchurch.

2. Elena Nikolova on What explains political institutions? Evidence from colonial British America

   Why do some states develop as democracies while others remain authoritarian? The question continues to puzzle social scientists. This column presents new data from 13 British American colonies from before the American Revolution. It shows that democratic institutions had a lot to do with the need to attract workers.

3. Yves Zenou and Jackline Wahba asks Do return migrants need their social capital for entrepreneurship?

   Are return migrants more likely to become entrepreneurs than non-migrants? This column, using data from Egypt, argues that although migrants lose their social networks whilst overseas, savings and human capital accumulation acquired abroad overcompensate for this loss. This makes return migrants more likely to start businesses.

4. Bill Kaye-Blake has been having Thoughts on the rate of return on capital

   I've found myself wondering what the average rate of return on capital really is. Some of the numbers that get tossed around are an 8% average stock market return over the long term, a 15% to 20% risky rate of return for capital invested in a business, and an 8% to 10% rate of return for business generally (which is the basis for the country’s discount rate).

5. John Cochrane asks Inevitable slow recoveries?

   The economy is stuck in slow growth, not the fast growth we should see after a steep recession.

6. Eric Crampton on Coercion everywhere: welfare edition

   It's hard to draw the line between coercion and choice. Some people see coercion in normal market transactions between consenting adults where relative wealth differences are large - prostitution markets are often banned as somehow coercive; most countries would ban me from selling you one of my kidneys for fear that the money offered had coerced me. I don't see any of those as being coercive; others do.

Stadiums in the context of natural disasters

Sam Richardson has been writing on the topic of stadiums in the context of natural disasters, in particular with regard to Christchurch, over at the Fair Play and Forward Passes blog. At one point he writes,

At the heart of this dilemma is a point that Matheson and Baade make beautifully, so I'll post it here:

Sports yields hedonic value, in other words, and the quality of life benefit it imparts is a luxury affordable in affluent communities rather than an activity that helps a community achieve affluence. Sport for the most part is properly viewed as a luxury good and not a productive resource.

What this seems to be saying is that if you are rich you can afford lots of warm fuzzies and if you are poor you can't. I would point out that Christchurch is really poor right now. I would also note that most things generate warm fuzzies to some degree, so if we are to count fuzzies for the calculation on whether or not to spend money on sports stadiums we need to count them for all good and services that the council could spend money on.

Sam continues,

Therein lies the crux of the argument, and it is here that we are likely to see the more passionate divergences of opinion. There is no doubting the importance and potential quality of life value of sports in Christchurch. The initial call of whether the investment makes sense is largely dependent on this value, I believe, and how it stacks up to the costs. This is a complex value, as one must also factor in the role of the sports environment including the new temporary stadium, as well as the impact on other facilities in the city and surrounding areas. As I have mentioned in my earlier posts on this issue, complicating matters further is the role of sports in the context of the rebuilding city's priorities. Do Christchurch policymakers see the stadium as a luxury good or a potential productive resource?

As Sam himself points out,

There are sound reasons why a facility in Christchurch is unlikely to generate tangible benefits, [...]

So productive resource doesn't look likely. Thus we are left with, "luxury good". The problem I see here is that even if we accept the idea of including warm fuzzies in our calculations my point above about most goods producing them comes in play. As Eric Crampton has noted

The covered rugby stadium is tipped to cost $506 million

You would have to generate a lot of warm fuzzies to justify spend $500 million and if you are going to spend that amount of money is a rugby stadium the most cost effective generator of warm fuzzies. I mean just how many hip replacement could you do for $500 million or how many cancer treatments could people get for that amount? Won't these thing also generate a lot of warm fuzzies? Improved health would I'm sure increase the quality of life for many people. Or how many warm fuzzies could be generated by spending $500 million on repairing the east-side of Christchurch?

There is also the obvious question of how do you include warm fuzzies in any analysis? It is far from clear how you could measure such things.

John Cochrane interview

An interview with John Cochrane on the Tom Keene show on Bloomberg TV.

Plain packaging

The policy of ‘plain packaging’ for tobacco products is an issue here and many other places around the world. The idea is being discussed in the U.K. right now. The Adam Smith Institute has argued against plain packaging. It has published a report by Chris Snowdon on the subject.

The executive summary of the report reads:

1. The UK government is considering the policy of ‘plain packaging’ for tobacco products. If such a law is passed, all cigarettes, cigars and smokeless tobacco will be sold in generic packs without branding or trademarks. All packs will be the same size and colour (to be decided by the government) and the only permitted images will be large graphic warnings, such as photos of tumours and corpses. Consumers will be able to distinguish between products only by the brand name, which will appear in a small, standardised font.

2. As plain packaging has yet to be tried anywhere in the world, there is no solid evidence of its efficacy or unintended consequences.

3. Focus groups and opinion polls have repeatedly shown that the public does not believe that plain packaging will stop people smoking. Even ardent antismoking campaigners do not make such a claim. Instead, activists assert that nonsmokers take up the habit as a result of seeing “glitzy” tobacco packaging. This claim lacks plausibility and is bereft of empirical evidence.

4. One in nine cigarettes smoked around the world is counterfeit or smuggled.The illicit market lowers prices, fuels underage consumption, deprives the treasury of tax revenue and makes an unhealthy habit still more hazardous. It is hard to think of a policy that could delight counterfeiters more than standardising the design, shape and colour of cigarette packs.

5. The wholesale confiscation of an industry’s brands and trademarks represents an unprecedented assault on commercial expression. It not only tramples on the principles of a free market, but it may also be illegal. Expert opinion, including that of the European Communities Trade Mark Association, the British Brands Group and the International Trademark Association, says that plain packaging is an infringement of intellectual property rights and a violation of international free trade agreements to which the UK is a signatory.

6. Anti-smoking lobbyists claim that plain packaging will not be imposed on other industries in the future, but this is a hollow reassurance in the light of the accelerating war on alcohol, sugar, salt and fat. What happens to tobacco tends to happen to other products sooner or later. Public health organisations around the world have been applying the blueprint of antitobacco regulation to other products for years. Sin taxes and advertising bans are increasingly common for certain types of food and drink, and various campaigners have called for graphic warnings to be placed on bottles of alcohol. It should be no surprise that in Australia, where a plain packaging law was passed in 2011, activists are already demanding that ‘junk food’ be sold in generic packaging. Australian anti-smoking lobbyists, meanwhile, say that the next step after plain packaging is to force the tobacco industry to make cigarettes “foul-tasting”.

7. Plain packaging is not a health policy is any recognisable sense. It neither informs nor educates. On the contrary, it limits information and restricts choice. It will serve only to inconvenience retailers, stigmatise consumers and encourage counterfeiters. Wholesale expropriation of private property to make way for public propaganda represents an unacceptable intrusion into an already over-regulated marketplace which will set a dangerous
precedent for other products.

I'm not sure that counterfeit or smuggled cigarettes is, yet, a big problem in New Zealand , so point 4 may not apply here. The other points, however, would seem to be relevant to out debate.

New Zealand's olympic success

Over at the ever interesting Fairplay and Forward Passes blog Sam Richardson asks, New Zealand's Olympic success - what's in it for us? A good question. At one point Sam writes,

What perked my ears, though, was this comment:

[Canterbury University senior lecturer in Management Ekant] Veer said New Zealand was a sports crazy country and a successful Olympic campaign often had huge impact on the nation’s mood.
"Which, in turn, can lead to increased productivity at work, improved relationships, increased consumer spending and all manner of behaviours that are positive for this nation."

In reply Sam makes the point,

I'm not aware of much in the way of evidence that supports the economic arguments mentioned above (increased productivity at work and increased consumer spending).

My question would be isn't anyone going to ask what the opportunity cost of sport funding is? What would happen if we put the money used for sport into health or education or welfare or ........? With a bit more money going into education maybe Canterbury University won't have had to fire as many members of the management department. Or what if we just gave it back to the taxpayer, wouldn't that do wonders for the taxpayer's mood?

EconTalk this week

Tammy Frisby of Stanford University's Hoover Institution talks with EconTalk host Russ Roberts about the likelihood of U.S. tax reform in the near future. Frisby reviews the changes in tax policy over the last 30 years focusing on the changes of the 1980s, looking at both the economics and politics of past changes. The conversation then turns to the present and the possible changes that might be coming as the Bush tax cuts expire on January 1, 2013.

The wonder that is empirical economics

Being a theoretical type I am am always impressed by the wonder that is empirical economics. Now over at the NYU DRI blog Bill Easterly has come up with another example as to why we should hold empirical economics in such high esteem:

Using data conveniently available from the Peruvian, Ecuadorean, Bolivian, and Chilean Olympic trials, the study compared athletes who just made the Olympic team with those who just fell short. This rigorous regression discontinuity design allowed the study to identify the effect of Olympic participation on Olympic medals.

The study found on average zero effect of Olympic participation on Olympic medals. This study found no evidence that the Olympics produces Olympic medals.

Business cycles explained

In this series of videos from LearnLiberty, Professor Tyler Cowen gives a quick introduction to different views on the business cycles.

EconTalk this week

Josiah Ober of Stanford University talks with EconTalk host Russ Roberts about the economy of ancient Greece, particularly Athens. Ober notes that the standard view of ancient Greece is that it was very poor. Drawing on various kinds of evidence, Ober argues that Greece was actually quite successful, and that the average citizen of ancient Athens lived quite well by ancient standards. He suggests two possible explanations for Greece's economic success--an openness of the political process that reduced transaction costs and encouraged human capital investment or innovation and cross-fertilization across Greek states. The conversation also explores the nature of evidence for understanding antiquity and the prospect for future discoveries pertaining to ancient Greece.

Fixed v.floating exchange rates

There is an on going debate over which of fixed or floating exchanges rate is best. At the Free Banking blog Kurt Schuler writes on Milton Friedman's views on exchange rates. He writes

The key to reconciling Friedman’s apparently contradictory positions is to understand that clean fixed and clean floating exchange rates, though differing in their degree of nominal rigidity, are similar in that both give market forces free rein. Under a clean fixed exchange rate, the nominal exchange rate is fixed and market forces determine the nominal monetary base. Under a clean floating exchange rate, the nominal monetary base is in the short term fixed (or perhaps a better word would be "set") and market forces determine the nominal exchange rate.

The important thing to take from this is that clean forms of both exchange rate systems work. But keep in mind the word clean in that sentence. In the real world nether system is clean so the real question is which system works best when governments intervene?

Schuler goes on the write,

The overall impression Friedman's statements on exchange rates leave is that he considered flexible exchange rates to be the system most desirable and most politically sustainable for large and medium-size economies that were politically independent and able to keep inflation relatively low.

Does New Zealand meet these conditions?

EconTalk .... for four weeks

Nobel Laureate Joseph Stiglitz of Columbia University talks with EconTalk host Russ Roberts about the ideas in his recent book, The Price of Inequality. Stiglitz argues that the American economy is dysfunctional, benefitting only those at the very top while the bulk of the workforce sees little or no gain in their standard of living over recent decades. Stiglitz blames this result on deregulation and the political power of the financial sector and others at the top. He wants an increase in regulation and the role of government in the economy and a more transparent Federal Reserve Bank that he blames for coddling the financial sector. The conversation also includes a discussion of the Keynesian multiplier.

Gary Taubes, author of Why We Get Fat, talks with EconTalk host Russ Roberts about why we get fat and the nature of evidence in a complex system. The current mainstream view is that we get fat because we eat too much and don't exercise enough. Taubes challenges this seemingly uncontroversial argument with a number of empirical observations, arguing instead that excessive carbohydrate consumption causes obesity. In this conversation he explains how your body reacts to carbohydrates and explains why the mainstream argument of "calories in/calories out" is inadequate for explaining obesity. He also discusses the history of the idea of carbohydrates' importance tracing it back to German and Austrian nutritionists whose work was ignored after WWII. Roberts ties the discussion to other emergent, complex phenomena such as the economy. The conversation closes with a discussion of the risks of confirmation bias and cherry-picking data to suit one's pet hypotheses.

David Brady, Professor of Political Science and the Graduate School of Business at Stanford University and a senior fellow at Stanford's Hoover Institution talks with EconTalk host Russ Roberts about the November elections in the United States. Brady argues that while the economy favors the challenger, Mitt Romney, current polling data gives a slight edge to President Obama in both the popular vote and the electoral college. The data all suggest that House will stay Republican and the Senate will either go slightly Republican or be tied. Brady also discusses why this may change over the next few months, the importance of the independent vote, and Romney's strategy in choosing a running mate.

Scott Atlas, Senior Fellow at Stanford University's Hoover Institution and author of In Excellent Health, talks with EconTalk host Russ Roberts about the U.S. health care system. Atlas argues that the U.S. health care system is top-notch relative to other countries and that data that show otherwise rely on including factors unrelated to health care or on spurious definitions. For example, life expectancy in the United States is unexceptional. When you take out suicides and fatal car accidents, factors that Atlas argues are unrelated to the health care system, the United States has the longest life expectancy in the world. A similar change occurs when measuring infant mortality--foreign data do not include as many at-risk births as in the United States and the measure of a birth is not comparable. In a number of other areas including cancer survival rates, access to hip replacement surgery and waiting times to see a physician, Atlas argues that the United States is also at or near the top. The discussion concludes with a discussion of access to health care for the poor and the failure of Medicaid.