A conversation with Israel Kirzner

Israel Kirzner, now Professor Emeritus at NYU, is among the foremost scholars in the continuing development of the Austrian school of economic theory. He has extended our understanding of the workings of a free society, illuminated the role of entrepreneurs in the process of economic discovery, and shed new light on the dynamics of market forces. In this interview, recorded in 2000, Kirzner explores these differences, as well as his experiences as student of Ludwig von Mises, his interaction with other Austrian greats such as Friedrich Hayek, and his career as a professor at New York University. He displays his keen understanding of the differences between the Austrian school and neo-classical economics, and how Austrian economics affords new and exciting avenues for future work.


More information is available at Newmedia at UFM.edu.

John Roemer on workable socialism

John E. Roemer recently published a paper in Analyse & Kritik on "Thoughts on Arrangements of Property Rights in Productive Assets". The abstract reads,

State ownership, worker ownership, and household ownership are the three main forms in which productive assets (firms) can be held. I argue that worker ownership is not wise in economies with high capital-labor ratios, for it forces the worker to concentrate all her assets in one firm. I review the coupon economy that I proposed in 1994, and express reservations that it could work: greedy people would be able to circumvent its purpose of preventing the concentration of corporate wealth. Although extremely high corporate salaries are the norm today, I argue these are competitive and market determined, a consequence of the gargantuan size of firms. It would, however, be possible to tax such salaries at high rates, because the labor?supply response would be small. The social-democratic model remains the best one, to date, for producing a relatively egalitarian outcome, and it relies on solidarity, redistribution, and private ownership of firms. Whether a solidaristic social ethos can develop without a conflagration, such as the second world war, which not only united populations in the war effort, but also wiped out substantial middle-class wealth in Europe?thus engendering the post-war movement towards social insurance?is an open question.

Peter Boettke at the Coordination Problem blog makes a good point about Roemer's paper,

Roemer seems to be suggesting that if the population could coordinate around a solidaristic social ethos, then the social-democratic model, perhaps even the market socialist model, might be workable. I have always found these arguments weak whether they are made by libertarians, conservatives, progressives, or socialist. It amounts to arguing that the entire system turns of the moral character of the individuals who populate the system. If everyone was a libertarian (socialist), then we could have a libertarian (socialist) world. But think about that for a second, the more everyone coordinates around the norm, the greater the potential scope for gain by opportunistically violating that norm.

Roemer's argument  looks like a version of the idea that "the world would be perfect if only we could make people perfect", which may be true but I don't like your chances of making people perfect.

Boettke continues,

So rather than rely on moral character to make the argument work, I have always been more attracted to instituitonal solutions that do not require for their working improved moral character let alone a fundamental change in human nature. Instutitional problems demand institutional solutions. Human beings do have the Smithian propensity to truck, barter and exchange, as well as Smithian sentiments about others --- that is our better nature --- but human beings are also haunted by the Hobbesian propensity to rape, pillage and plunder, and sentiments such as envy, jealousy, resentment, and loathing of the other. Which propensity manifests itself is a function of institutional environment in which we interact with each other and with nature. The logic of the situation rules, not a sense of solidarity. Solidarity, instead, is a by-product of institutions. So back to the test --- is a proposed system coherent -- are the means chosen consistent with the ends sought? --- and is a proposed system vulneralbe --- can opportunistic actors disrupt the ability of the system to achieve its goals?

One of the great things about competitive markets is that they harness the Hobbesian propensities and often create social good out of them, As Keynes noted,

It is better that a man should tyrannize over his bank balance than over his fellow-citizens and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative.

The effect of minimum wages on employment

Recently Eric Crampton at Offsetting Behaviour wrote,

I suppose it's also relevant that Obama wants a substantial hike to the US minimum wage. A dark side of me wants him to do it, just so we can get some clean estimates of just how bad the disemployment effects would be.

Some people would claim that the disemployment effects would be zero or even that the effects on employment would be positive. But economists, by and large, go for there being a disemployment effect of minimum wage increases. Wilson (2012) summaries economists thinking on this as,

The main finding of economic theory and empirical research over the past 70 years is that minimum wage increases tend to reduce employment. The higher the minimum wage relative to competitive-market wage levels, the greater the employment loss that occurs. While minimum wages ostensibly aim to improve the economic well-being of the working poor, the disemployment effects of a minimum wages have been found to fall disproportionately on the least skilled and on the most disadvantaged individuals, including the disabled, youth, lower-skilled workers, immigrants, and ethnic minorities.

and

In 2006 David Neumark and William Wascher published a comprehensive review of more than 100 minimum wage studies published since the 1990s. They found a wider range of estimates of the effects of the minimum wage on employment than the 1982 review by Brown, Gilroy, and Kohen. The 2006 review found that “although the wide range of estimates is striking, the oft-stated assertion that the new minimum wage research fails to support the traditional view that the minimum wage reduces the employment oflow-wage workers is clearly incorrect. Indeed . . . the preponderance of the evidence points to disemployment effects.”

Nearly two-thirds of the studies reviewed by Neumark and Wascher found a relatively consistent indication of negative employment effects of minimum wages, while only eight gave a relatively consistent indication of positive employment effects. Moreover, 85 percent of the most credible studies point to negative employment effects, and the studies that focused on the least-skilled groups most likely to be adversely affected by minimum wages, the evidence for disemployment effects were especially strong. In contrast, there are very few, if any, studies that provide convincing evidence of positive employment effects of minimum wages. These few studies often use a monopsony model to explain these positive effects. But as noted, most economists think such positive effects are special cases and not generally applicable because few low-wage employers are big enough to face an upward-sloping labor supply curve as the monopsony model assumes.

Ref:

• Wilson, Mark (2012). "The Negative Effects of Minimum Wage Laws" Policy Analysis, June 21, No. 701, Cato Institute.

Interesting blog bits

A little midweek relaxing local reading:

1. Bill Kaye-Blake on Summary theories of the firm
   

   I can't recommend this posting too highly ...!!!!

2. Eric Crampton on Lockean Parking
   

   In the Lockean framework, private property can be appropriated from the commons through the mixing of labour. If you mix your labour with the untilled soil, leaving as much and as good yet for others to till, then that tilled soil is yours. You have homesteaded it.

3. Matt Nolan on ICT, factor shares, employment, and inequality
   

   Matt is am going to take you on a journey of a series of fortunate events, and at the end hopefully he has a point!

4. Donal Curtin asks Why are we where we are on this league table?
   

   League tables are always fascinating, and I came across a rather suggestive one in the January 11 issue of the Economist, in an article, 'Setting out the store', which was making the case for governments to sell off more of their assets.

5. Not PC on "Trickle Down"
   

   "Trickle down" does exist. It emanates from government.

6. Brennan McDonald on University As Consumption Good
   

   The literature generally looks at university as an investment. You incur costs – foregone wages, tuition, lower income etc. for a few years in the hope of earning a higher labour market income after graduation but it's hard to classify university as an investment if almost everyone is treating it like a consumption good.

Transaction costs

Per Bylund on twitter:

Why do scholars call "whatever cost I'm interested in" *transaction* costs? #TCE notes misalignment, costs of realigning trans to market!
— Per Bylund (@PerBylund) February 4, 2014

A good question which has be recognised for many years. As Coase himself has written,

Williamson agrees with what he terms my "grim assessment" of the position in 1970. However, he ascribes the non-use of my thesis, so often acclaimed as a "fundamental insight," to the fact that it has not been made "operational." As he said in 1975: "Transaction costs are appropriately made the centerpiece of the analysis but these are not operationalized in a fashion which permits one to assess the efficacy of completing transactions as between firms and markets in a systematic way." Williamson has reaffirmed this view in 1985 and 1986. I think it is largely correct.

The term is used too widely and can mean almost anything these days. When referring to what are now called "transaction costs" Coase was referring to the costs of using the market but today we see comments about transaction costs within firms! On this basis the boundaries of a firm are where transaction costs equal transaction costs.

Age and scientific genius

Just to make those in "middle age" feel better, entrepreneurial creativity may peak at middle age rather than in early age. It is commonly argued that successful technology companies are founded by people in their 20s, but are people really more creative early on?

A new NBER working paper by Benjamin Jones, E.J. Reedy, and Bruce Weinberg looks at the relationship between age and scientific creativity. The paper discusses the widely accepted empirical finding that scientific creativity — measured by high-profile scientific contributions such as Nobel Prizes — tends to peak in middle age. They also review more recent research on variation in creativity life cycles across fields and over time. Jones, for example, has observed that the median age of Nobel laureates has increased over the 20th century, which he attributes to the rapid growth in the body of accumulated knowledge one must master before making a breakthrough scientific contribution (the “burden of knowledge” thesis).

So "old" doesn't mean non-creative.

Age and Scientific Genius
Benjamin Jones, E.J. Reedy, Bruce A. Weinberg
NBER Working Paper No. 19866
Issued in January 2014
NBER Program(s): LS

Great scientific output typically peaks in middle age. A classic literature has emphasized comparisons across fields in the age of peak performance. More recent work highlights large underlying variation in age and creativity patterns, where the average age of great scientific contributions has risen substantially since the early 20th Century and some scientists make pioneering contributions much earlier or later in their life-cycle than others. We review these literatures and show how the nexus between age and great scientific insight can inform the nature of creativity, the mechanisms of scientific progress, and the design of institutions that support scientists, while providing further insights about the implications of aging populations, education policies, and economic growth.

(HT: Organizations and Markets.)

A conversation with Ronald Coase

Ronald Coase (1910-2013), the greatest economist of the 20th century, is interviewed by legal scholar Richard A. Epstein. In the course of the 2001 interview a broad number of subjects are discussed, involving the intellectual activities Coase carried out, ranging from his interest in economics and law, his transition from socialism up to the various publications and theories laid out by him. The discussion includes discourse on the hows and whys of Coase's analyses, providing insights on topics like business firms, transaction costs, externalities and durable goods. We also learn what lead Coase to write articles such as "The Nature of the Firm", "Durability and Monopoly", "The Lighthouse in Economics" as well as "The Problem of Social Cost", which was considered to be the basis of what is known as the Coase theorem.


More information is available at Newmedia at UFM.edu.

A conversation with Armen A. Alchian

Recognized as one of the most influential voices in the areas of market structure, the theory of the firm, law and economics, resource unemployment, and monetary theory and policy, in this 2001 interview, Armen Alchian (1914-2013) outlines the "UCLA tradition" of economics which he founded and explores the many unanticipated consequences of self-seeking individual behaviour.

Additional materials are available at Newmedia at UFM.edu.

EconTalk this week

Erik Brynjolfsson of MIT and co-author of The Second Machine Age talks with EconTalk host Russ Roberts about the ideas in the book, co-authored with Andrew McAfee. He argues we are entering a new age of economic activity dominated by smart machines and computers. Neither dystopian or utopian, Brynjolfsson sees this new age as one of possibility and challenge. He is optimistic that with the right choices and policy responses, the future will have much to celebrate.

Direct link to audio.

The Big Mac Index

The 2014 Big Mac Index is available from the Economist magazine.

THE Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries. For example, the average price of a Big Mac in America in January 2014 was $4.62; in China it was only $2.74 at market exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 41% at that time.

According to the Big Mac Index the New Zealand dollar is about right

New Zealand January 2014 Price: $4.57 (NZ$5.50)
Raw index: undervalued by 1.1%
Actual exchange rate: 1.20
Implied exchange rate: 1.19 (Local price divided by dollar price)

So people should stop complaining about the "too high" exchange rate.

But why does inequality matter? 2 (updated)

Brennan McDonald offers an answer to the question from my previous blog posting here. Brennan writes

• Inequality is on the agenda because the media are writing about it
• The media are writing about it because envy is as old as the hills and journalists earn rubbish wages so anyone on a higher income is a fair target for them
• Most journalists’ eyes glaze over when they see numbers so clear discussion is not possible
• So despite a lot of evidence to suggest that maybe income and wealth inequality in New Zealand isn’t as bad as it’s made out to be, that conclusion doesn’t get page views so emotive language rules how the discussion is framed

I fear that to a large degree he is right, but this just moves the problem back one stage, Why are the media talking about it? A some point I assume its because they think something bad is caused by inequality so I ask what is the something and what is the evidence that inequality caused that something?

Also I would like to think well of my fellow economists so I hope they have a better reason for worrying about inequality than envy and that their eyes don't glaze over at the sight of numbers and thus they can undertake a clear and rational discussion of the topic. Starting with why they are concerned with the topic at all.

Update: Matt Nolan writes Are we all confusing status competition and ‘inequality’: Short answer, yes

But why does inequality matter?

There seems to be lots of talk on the blogs these days about inequality (e.g. here, here and here), but no one bothers to explain why we should care about it, it just seems to be taken as a given that we should care. Over at the The Fly Bottle blog Will Wilkinson writes,

I’m tired of arguing about inequality. It’s frustrating. It’s unproductive. Nobody is really interested in the analytical arbitrariness and moral insidiousness of measuring intra-national economic inequality. Nobody is really interested in the fact that multiple mechanisms–some good, same bad, some neutral–can produce the same level of measured inequality, rendering the level of inequality, taken in isolation, completely useless as a barometer of social or economic justice. Nobody really cares. Because many different combinations of causes can produce the same level of inequality, it’s not so clear that high inequality, as such, can reliably cause anything. The consequences of inequality depend on the mechanisms driving inequality. Nobody cares.

To Will I say, some people seems to care, at least people writing New Zealand based economics blogs seem to care, but they don't tells us why. The highlighted bits in the Wilkinson quote seems to me to make a couple nice points in that it seems to me that inequality is a useless measure of anything that matters and its not clear, to me at least, what exactly inequality causes.

So will those bloggers among you who are so fired up about the evils of inequality please explain why you are so agitated about it.

Thanks.

EconTalk this week

Nina Munk, journalist and author of The Idealist: Jeffrey Sachs and the Quest to End Poverty, talks with EconTalk host Russ Roberts about her book. Munk spent six years following Jeffrey Sachs and the evolution of the Millennium Villages Project--an attempt to jumpstart a set of African villages in hopes of discovering a new template for development. Munk details the great optimism at the beginning of the project and the discouraging results after six years of high levels of aid. Sach's story is one of the great lessons in unintended consequences and the complexity of the development process.

Direct link to audio.

How not to think about the firm 2

In a previous post on How not to think about the firm I briefly commented on a post at the Fresh economic thinking blog by economist Cameron K Murray on Time for a new theory of the firm. In the comments section to my post Cameron has kindly left the following message,

Hi Paul, I'm glad you've contributed to the discussion, and congrats on yours Surveys publication (which is actually quite a good read).

I must note that perhaps you've missed the point here. Neoclassical theory still dominates the analysis of firm production decisions, even if it leaves the internal organisation questions unanswered. Our theory improves on this by adding the existence of economies of scale as a necessary condition for production to even take place. This suggests a reason for firm existence considering that economies of scale tend not to be the preserve of a sole trader or even small business.

Indeed, one could argue that the reduction in transaction costs arising from being within the boundary of a single firm is part of the economies of scale. We don’t rule out incomplete contracts or any type of transaction cost. But of course that is not the focus of the paper.

I plan to expand on many of the points I made in the blog post in the coming weeks, and I'd appreciate any comments/feedback given your expertise in this are in general.

I think part of the different views here goes back to the point I made about the change in the questions asked by the theory of the firm in the last 30-40 years. To a large degree today's theory of the firms doesn't ask about a firm's production decisions (however a number of people are trying to include such ideas within the contemporary framework). As I have said elsewhere,

What we have seen since the 1970s is a movement away from the theory of the firm being seen as developing a component of price theory, namely the component which asks, How does the firm act in factor and product markets?, to the theory being concerned with the firm as a subject in its own right.

This, I think, means that Cameron's problems sits a bit outside the modern theory of the firm.

A second point here would go back to my zero transaction cost comment. In such a world any economies of scale can be achieved without the use of a firm. In a world of zero transaction costs any institutional arrangement can mimic any other institutional arrangement. So even if there are economies of scale a firm is not necessary to take advantage of them.

Easterly on Gates

The 2014 Bill and Melinda Gates’ Annual Letter is out:

By almost any measure, the world is better than it has ever been. People are living longer, healthier lives. Many nations that were aid recipients are now self-sufficient. You might think that such striking progress would be widely celebrated, but in fact, Melinda and I are struck by how many people think the world is getting worse. The belief that the world can’t solve extreme poverty and disease isn't just mistaken. It is harmful. That’s why in this year’s letter we take apart some of the myths that slow down the work.

Bill Easterly responds,

Mr Gates says there has been much progress, but that “we’ll need to apply human ingenuity and act on our compassion” to keep it going. Conversely, he equates the idea that “the world is getting worse” to the idea that “we can’t solve extreme poverty and disease”. For Mr Gates, apparently, much depends on what “we” do. But who are “we”, and who put us in charge? Mr Gates seems to have in mind the global elite whose most prominent representatives were this week assembled in Davos: political leaders, business executives, philanthropists, academics and functionaries from international institutions such as the World Bank.

[ ... ]

The progress that Mr Gates celebrates is the work of entrepreneurs, inventors, traders, investors, activists – not to mention ordinary people of commitment and ingenuity striving for a better life. Davos Man may not be ready to acknowledge that he does not hold the fate of humanity in his gilded hands. But that need not stop the rest of us.

Do heads of academic departments have real effects?

A big question for any HOD! Well the answer appears to be yes, which will please the HODs.

There is one robust predictor of a department's future research output. After adjustment for a range of personal and institutional characteristics, departmental research productivity improves when the incoming department Chair's publications are highly cited.

What can I say other than I must send this to the HOD of Econ.

The result comes from a new working paper "Leadership and the Research Productivity of University Departments" by Amanda H. Goodall, John M. McDowell and Larry D. Singell.

The unpleasant legacy of the crisis: public debt and low trend growth in the Eurozone

In this audio from VoxEU,org Nicholas Crafts talks to Viv Davies about Crafts recent work on the threatening issue of public debt in the Eurozone. Crafts maintains that the implicit fault line in the EZ is evident; several EZ economies face a long period of fiscal consolidation and low growth and that a different sort of central bank might be preferable. They also discuss the challenges and constraints of banking, fiscal and federal union.

How not to think about the firm

Eric Crampton alerted me to this posting at the Fresh economic thinking blog on Time for a new theory of the firm. The upshot of the posting is that its author doesn't like the standard neoclassical theory of the firm and thinks we need a new theory of the firm to replace the neoclassical one. Let me make two quick comments.

1. He's a bit out of date. The neoclassical model hasn't been the mainstream theory of the firm since around the 1970s so the call to replace it is only 40 odd years too late. The major difference between the (neoclassical) mainstream theories of the past and the mainstream theories of the present is that the focus − in terms of the questions the theory attempts to answer − of the post-1970 mainstream literature is markedly different from that of the earlier (neoclassical) mainstream theory. The theory of the firm for Ronald Coase, Oliver Williamson, Bengt Holmstrom or Oliver Hart is a very different thing from that of Arthur Pigou, Lionel Robbins, Jacob Viner, Joan Robinson or Edward Chamberlin. The questions the theory seeks to answer have changed from being about how the firm acts in its various markets; how it prices its outputs or how it combines its inputs, to questions about the firm’s existence, boundaries − including the dividing line between state and private enterprises − and internal organisation. That is, in the mainstream theory there has been a movement away from seeing the theory of the firm as simply developing one component (albeit an important component) of price theory, namely the element concerned with the factor and product market behaviour of producers, to the theory being concerned with the firm as a important economic institution in its own right. For anyone who is interested in some of what the current mainstream in the theory of the firm is I suggest checking out the forthcoming paper in the Journal of Economic Surveys entitled "Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective" by ... well .... errr .... modesty forbids me.
2. There are no firms in the neoclassical or I suspect in the "replacement" model we are being offered. Both models work implicitly within zero transaction cost frameworks and within such settings firms have no role. As Foss (2000) puts it,

   With perfect and costless contracting, it is hard to see room for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and wouldn't need the services of the intermediaries known as firms (Foss 2000: xxiv).

   Or as Foss, Lando and Thomsen (2000) summarise things:
   

   [t]he pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure,contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist (Foss, Lando and Thomsen 2000: 632).

   In short, you need incomplete contracts to explain why firms exist.

Refs.:

• Foss, Nicolai J. (2000). ‘The Theory of the Firm: An Introduction to Themes and Contributions’. In Nicolai Foss (ed.), The Theory of the Firm: Critical Perspectives on Business and Management (pp. xv-lxi), London: Routledge.
• Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics (vol. III, pp. 631-58), Cheltenham U.K.: Edward Elgar Publishing Ltd.

EconTalk this week

Jonathan Haidt of New York University and author of The Righteous Mind talks with EconTalk host Russ Roberts about his book, the nature of human nature, and how our brain affects our morality and politics. Haidt argues that reason often serves our emotions rather than the mind being in charge. We can be less interested in the truth and more interested in finding facts and stories that fit preconceived narratives and ideology. We are genetically predisposed to work with each other rather than being purely self-interested and our genes influence our morality and ideology as well. Haidt tries to understand why people come to different visions of morality and politics and how we might understand each other despite those differences.

Pyramids v. privatisation

One way to think about privatisation is that it is a way for a government to commit to a policy of non-intervention in the operation of a firm. Selling a business maximises the "distance" between the government and the firm and increases the political cost to interference with the firm. But is it the only way? One common business structure seen around the world is a pyramid-type organisation. In such a the controlling owner at the top of the pyramid controls a firm indirectly through layers of intermediate companies. Such a structure is common among government owned organisations, the question is Why?

An answer to the second question above involves answering the first question. In short the use of pyramid structures is a way for government to attempt to commit to a policy of non-intervention without going the whole way to privatisation. A pyramid is a (partial) way of separating firms from political interference.

The development of organisational pyramids give governments more credibility in committing to nonintervention than simply a policy prescription that calls for increased delegation of decision rights to managers of SOEs. This is because the complex organisational structure of pyramids increases the government's cost of obtaining sufficiently timely information to interfere in the day-to-day operations of the firm, and thus prevents an intervening government from imitating a pyramidal strategy. The added complexity of the pyramid structure reduces the "bosses" access to the information needed to intervene in the day-to-day operations of a firm at the bottom of the pyramid and thus protects the managers of that firm from the interference of government officials leaving the managers more exposed to market forces.

Such a organisational structure will not be as effective as actual privatisation - the discipline of bankruptcy, for example, will be weaker under any form of government ownership than it would be under private ownership - but is likely to be more efficient than direct control by government ministers or officials. In situation where privatisation is difficult or impossible for political reasons a pyramid structure may be a second-best solution.

To test this idea that pyramids act to insulate managers from political interference, Fan, Wong and Zhang (2013) focus on the case of China. The Chinese setting, they argue, has several important advantages for this purpose. First, in China, state assets and their controlling ownership are not freely transferable across firm boundaries. As a result, state owners almost always possess 100% of the equity ownership of a pyramid’s firms, which precludes equity financing from serving as the primary reason for a pyramidal structure. Further, because state owners are unable to use outright sales as a means to transfer decision rights in a firm to a third party, as is typical in a market economy, a transfer of decision rights that increases autonomy can be achieved only via a mechanism—such as a pyramid—which is short of an actual transfer of ownership. Second, China’s market economy is young. This allows us to investigate corporate pyramids near their inception, during a time when decentralization has been a chief part of the country's market reforms. Third, China’s markets and geographic regions provide sufficient variation in institutional settings to facilitate measurement of controlling owners' (i.e., local governments’) incentives to decentralise decision-making power to firm managers through pyramidal organisational structures.

Their empirical evidence is consistent with the hypothesis outlined above. In particular, using a comprehensive sample of 742 initial public offering (IPO) firms, majority owned by local governments in China, they find that local governments form more extensive pyramids when they have incentives to lower firm political costs arising from interference. The government's weaker incentives to intervene induce it to credibly transfer decision rights to management through pyramids. While the reduction of SOE political costs leads to more decentralisation of power through pyramid formation, adding more layers could increase agency costs, as the higher information costs make monitoring more difficult. Their empirical results show that more extensive pyramidal structures are associated with stronger legal or market discipline on firm managers, indicating that stronger institutions reduce agency problems arising from empowering management. Further supporting the conjecture that pyramids insulate firms from government intervention, they find a significant positive association between the number of pyramidal layers and the extent of firm managerial professionalism, employment efficiency, total factor productivity, and profitability. In additional analyses, they survey government officials in charge of state asset management and find evidence that managers of the firms who are part of pyramid structures have more decision rights than managers of the firms who are directly linked to the governments.

Thus pyramids achieve some of the depoliticisation aims of privatisation in cases where privatisation itself is, at least in the short term, impossible.

Ref.:

• Fan, Joseph P. H., T. J. Wong, and Tianyu Zhang (2013). 'Institutions and Organizational Structure: The Case of State-Owned Corporate Pyramids', Journal of Law Economics and Organisation 29(6): 1217-1252.

Interesting blog bits

1. Lynne Kiesling on Interpreting Google's purchase of Nest

   Were you surprised to hear of Google’s acquisition of Nest? Probably not; nor was I. Google has long been interested in energy monitoring technologies and the effect that access to energy information can have on individual consumption decisions.

2. Joshua Gans asks How will Google adjust Nest?

   The rationale for the acquisition of Nest seems to be similar to YouTube. Google will provide capabilities and investments that will allow Nest to scale.

3. Jason Sorens with More on Rodrik & Globalization
   

   The LSE’s EUROPP blog has published my critique of Dani Rodrik’s The Globalization Paradox.

4. John List and Omar Al-Ubaydli on The generalisability of experimental results in economics
   

   Lab and field experiments help us understand human behaviour as they increase our confidence in causal effects in regard to different economic problems. This column highlights the relevance of experimental data and discusses the value of lab in comparison to field experiments. While lab experiments are the only applicable way-to-go in a number of situations, they tend to inflate scrutiny. This could artificially modify behaviour, and would potentially threaten the causal interpretation of the estimates. The debate about lab versus field experiments is far from settled. However, what economists do agree about is that to obtain convincing causal effects relating to human behaviour, a joint consideration of a number of methods would be superior to using any single one in isolation.

5. Richard Posner on Bureaucracy and Efficiency

   The term “bureaucracy” refers to administration by a multi-tiered hierarchy of trained, nonpolitical professionals guided by written rules (thus minimizing discretion). Historically it referred to governmental administration, but nowadays the term is applied to the administration, in the characteristic bureaucratic form, of any institution.

6. Gary Becker on Competition and the Efficiency of Bureaucracies

   Whether an organization is “efficient” cannot be defined in any absolute sense, but only relative to feasible alternatives. Therefore, it is reasonable to conclude that a large bureaucratic organization is efficient if it manages to thrive in a competitive sector; that is, a sector with easy entry of organizations with different decision-making structures. For if potential entrants were more efficient than the bureaucratic organizations, they would enter the sector and out-compete the bureaucracies.

7. Tomohiko Inui, Ryoji Matsuoka and Makiko Nakamuro ask More time spent on television and video games, less time spent on studying?
   

   Parents worry that their children waste too many hours playing video games or watching TV that would be better spent studying. Whereas past research has focused on teenagers, this column presents evidence on the causal effects of study and leisure hours for children of elementary school age, when key lifetime habits are being developed. Video entertainment is found to be a less significant determinant of time spent studying than parental involvement (such as supervision).

8. Daron Acemoglu and James Robinson on Democracy's pains
   

   Disillusionment with political leaders is spreading across the globe. In the United States, the approval ratings of the President and the Congress are at all-time lows, and probably for good reason. There is general dissatisfaction with the ruling class across much of Europe, particularly in the South. But this is much broader than a Western world phenomenon.

9. Joakim Ruist on The fiscal consequences of unrestricted immigration from Romania and Bulgaria
   

   The lifting of transitional access restrictions for Romanian and Bulgarian workers is a hotly debated topic in the EU with big implications for public finances in destination countries. This column presents analysis of immigrants in Sweden, which never imposed access restrictions when these two countries joined the EU. Romanian and Bulgarian migrants to Sweden under this unrestricted regime make a sizeable positive contribution to Swedish public finances. Contributions can be expected to be even larger in the UK and Ireland.

10. Jennifer L. Castle and David F. Hendry on The real wage–productivity nexus
    

    During the Great Recession, UK real wages have fallen rather than the usual unemployment reaction. Nevertheless, this column argues that a structural break in the wage inflation/unemployment trade-off has not occurred. There has been a constant relationship between real wages and productivity since 1860. The key to the constancy is to the joint modelling of dynamics, location shifts, relevant variables and non-linearities.

EconTalk this week

Laurence Kotlikoff of Boston University talks with EconTalk host Russ Roberts about the fiscal health of the federal government of the United States. Kotlikoff argues that the U.S. government is essentially bankrupt because future taxes will fall hundreds of trillions of dollars short of expected expenditures. Kotlikoff argues this problem can be solved by redesigning our tax code, but without changes such as this, large reductions in spending or large increases in tax rates will be necessary.

The minimum wage and the working poor

Whatever bad effects the minimum wage may have at least one argument in its favour is that it helps the working poor. This much is obvious.

It maybe obvious, but is it true?

Maybe not according to a paper in the Southern Economics Journal. Joseph J. Sabia and Richard V. Burkhauserf ask "Mínimum Wages and Poverty: Will a $9.50 Federal Minimum Wage Really Help the Working Poor? And their answer: "[ ... ] we find that state and federal minimum wage increases between 2003 and 2007 had no effect on state poverty rates" and "[o]ur results suggest that raising the federal minimum wage continues to be an inadequate way to help the working poor."

Sabia and Burkhauserf look at the effects of recent changes to state and federal minimum wage rates in the U.S. From 2003 to 2009, the federal hourly minimum wage rose in steps from US$5.15 to US$5.85, and from US$6.55 to US$7.25. Between 2003 and 2007, 28 states increased their minimum wages to a level higher than the federal minimum.

Sabia and Burkhauserf write,

Using data drawn from the March Current Population Survey (CPS), we find no evidence that minimum wage increases between 2003 and 2007 lowered state poverty rates. Moreover, we find that the newly proposed federal minimum wage increase from $7.25 to $9.50 per hour, like the last increase from $5.15 to $7.25 per hour, is not well targeted to the working poor. Only 11.3% of workers who will gain from an increase in the federal minimum wage to $9.50 per hour live in poor households, an even smaller share than was the case with the last federal
minimum wage increase (15.8%). Of those who will gain, 63.2% are second or third earners living in households with incomes twice the poverty line, and 42.3% live in households with incomes three times the poverty line, well above $50,233, the income of the median household in 2007.

and they continue

With an average employment elasticity of -0.6 for minimum wage workers aged 16-29 without a high school diploma and an elasticity of -0.2 for other minimum wage workers, we estimate that nearly 1.3 million jobs will be lost if the federal minimum wage is increased to $9.50 per hour, including 168,000 jobs currently held by the working poor. We estimate that average employment elasticities greater (in absolute value) than —0.86 will cause net monthly earnings losses to the set of low-skilled workers who are affected by this proposed minimum age legislation.

Overall Sabia and Burkhauserf argue that the proposal to raise the federal minimum wage to US$9.50 per hour is unlikely to do much to reduce poverty because (i) most workers (89.0%) who are affected are not poor, (ii) many poor workers (48.9%) already earn hourly wages greater than $9.50 per hour, and (iii) the minimum wage increase is likely to cause adverse employment effects for the working poor.

In short the Sabia and Burkhauserf results suggest that increases in the minimum wage will do little to reduce poverty and help those who are the working poor.

Ref.:

• Joseph J. Sabia and Richard V. Burkhauserf (2010). "Mínimum Wages and Poverty: Will a $9.50 Federal Minimum Wage Really Help the Working Poor?", Southern Economic Journal 76(3), 592-623.

Employment, markets, contracts, and the scope of the firm

Birger Wernerfelt has a new working paper out to do with the theory of the firm. Wernerfelt is most well known for his pioneering work on the resource-based view of the firm. In his new  paper Wernerfelt looks at the economic functions of firms, contracts, and markets and characterise the optimal scope of the firm. Governance structures appear as equilibria and are compared in terms of production costs - determined by a tradeoff between standardisation and adaptation, - and adjustment costs – sometimes incurred when new prices have to be agreed upon. Under natural conditions, employment, markets, or sequential contracting weakly dominate all other equilibria. As firms become larger, gains from standardisation come at the cost of increasingly poor adaptation, ultimately bounding their scope.

To get an intuitive sense of Wernerfelt's argument, suppose that a business needs a worker for a specific service. (For example, an apartment building has to have a bannister fixed.) The main emphasis of the paper  is on two aspects of the situation:

1. Which experiences should the ideal worker have, and
2. How should the parties agree on compensation?

As the demands of a job vary with the business and the service, gains from specialisation mean that workers who have experience with either of the two will do better. (Carpenters and superintendents, respectively, are examples of these two types of workers.) The ways in which compensation can be agreed upon depend on the type of worker best used. Service-specialists will work for a new business in every period and have the ability to sell their labour in a larger market. Business-specialists will work for the same business in every period and can thus be on a single long term - or a series of short term contracts. Since bilateral bargaining is costly, the relative attractiveness of these two types of contracts depends on the frequency with which needs change. While adaptation is good, change is costly. Workers are best when they can approach every task in the same way: Consistently going for the same objective such as high speed, low cost, or perfection. So the most efficient workers will perform the same service for the same business in every period: Perfect adaptation to both service and business with no changes from period to period. This creates incentives to grow the business to the point where it can employ such service-specialists (as when very big landlords have their own carpenters). If the opportunities for such growth are limited, some “different but similar” businesses can combine and use a service-specialist whose approach (way of doing things) is imperfectly adapted to the businesses, but still not too far off. (Property companies with a mixed portfolio of real estate.) The scope of the firm is determined by the point at which the resulting mal-adaptation becomes too severe. (It may not be appropriate to use the same approach to carpentry in a barn and a high end office building.)

Wernerfelt's paper is Employment, Markets, Contracts, and the Scope of the Firm and the abstract reads:

We look at the economic functions of firms, contracts, and markets and characterize the optimal scope of the firm. Governance structures appear as equilibria and are compared in terms of production costs - determined by a tradeoff between standardization and adaptation - and adjustment costs – sometimes incurred when prices have to be agreed upon. Under weak conditions, employment, markets, or sequential contracting weakly dominate all other equilibria. As firms become larger, they lose their focus and gains from standardization decrease, ultimately bounding their scope. The model does not rest on non-standard assumptions and is consistent with the managerial literature on the scope of the firm. Its predictions depend on several factors that do not play a role in other contemporary theories of organization.

The great escape: health, wealth and the origins of inequality

In this audio interview from VoxEU.org Angus Deaton talks to Viv Davies about Deation's recent book ‘The Great Escape: health, wealth and the origins of inequality’, that explains how inequality is the catalyst for the great escape from poverty and how the world is better because of it. They discuss the state of inequality in the US, economic growth in China and India and the ineffectiveness of international aid. Deaton stresses the importance of understanding that human well being will be achieved only through a holistic approach.

More information is available here.

EconTalk this week

Anthony Gill of the University of Washington and host of the podcast Research on Religion talks with EconTalk host Russ Roberts about the economics of religion. The conversation focuses on the relationship between religion and the State--how does religion respond to a State-sanctioned monopoly? Why do some governments allow religious liberty while others deny it? The conversation concludes with a discussion of how property rights interact with religious freedom.

Did PPP hold in medieval Europe?

The concept of Purchasing Power Parity (PPP) is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.

The well known Big Mac Index from the Economist magazine is an example of one measure of the law of one price, which underlies purchasing power parity. The Index is used to measure the amount a county's currency is under or over valued based on the assumption that a Big Mac costs the same in different countries when each countries prices are converted into a single currency, the US dollar.

A newly released working paper considers the question of does PPP hold, not for the modern economies of the world which the Big Mac Index considers, but for the economies of medieval Europe. The results of the study are such that the researchers conclude that medieval financial markets were so well functioning that PPP did hold.

The paper is Did Purchasing Power Parity Hold in Medieval Europe? by Adrian R. Bell, Chris Brooks and Tony K Moore. The abstract for the paper reads:

This paper employs a unique, hand-collected dataset of exchange rates for five major currencies (the lira of Barcelona, the pound sterling of England, the pond groot of Flanders, the florin of Florence and the livre tournois of France) to consider whether the law of one price and purchasing power parity held in Europe during the late fourteenth and early fifteenth centuries. Using single series and panel unit root and stationarity tests on ten real exchange rates between 1383 and 1411, we show that the parity relationship held for the pound sterling and some of the Florentine florin series individually and for almost all of the groups that we investigate. Our findings add to the weight of evidence that trading and arbitrage activities stopped currencies deviating permanently from fair values and that the medieval financial markets were well functioning. This supports the results reported in other recent studies which indicate that many elements of modern economic theories can be traced back over 700 years in Europe.

Harold Demsetz named a Distinguished Fellow of the American Economics Association

As Peter Boettke noted on twitter

The AEA gets some things right sometimes ... Harold Demsetz is indeed one of the great microeconomic thinkers of... http://t.co/vYuOKK9QNi
— Peter Boettke (@PeterBoettke) January 4, 2014

And Boettke is right, Demsetz is one of the great microeconomic thinkers of the last century. To me his work is on the theory of the firm has been innovative and controversial and has simulated much of the more recent work on the theoretical approaches to the firm.

The AEA statement on Demsetz's honour reads:

Harold Demsetz is one of the most creative and deep microeconomists of the 20th century. Several of his contributions anticipated subsequent research by years or even decades, and have offered unusually insightful analyses of fundamental problems of economic theory.

Demsetz’s most famous paper “Production, Information Costs, and Economic Organization” (with Armen Alchian, American Economic Review 1972) is one of the most cited papers in all of economics. It analyzes the fundamental question first raised by Coase, “What is a firm?” and tries to understand the difference between contracts occurring inside the firm (for example, with employees) and those occurring in the market (for example, with customers). Alchian and Demsetz argue that some contracts are efficiently brought inside the firm because doing so reduces the costs of monitoring of performance, especially when production occurs in teams. Alchian and Demsetz’s approach has been challenged by more recent developments, such as Grossman and Hart (1986), but remains a classic in the theory of the firm.

In 1968, Demsetz asked the question, “Why regulate utilities?” and argued that it is more efficient to get potential suppliers to compete in prices and terms by offering customers contracts than to control prices. Demsetz’s framing of the problem has become the dominant approach to the modern theory of regulation, see for example, Laffont and Tirole (1993).

In the same year, Demsetz published “The Cost of Transacting” in the Quarterly Journal of Economics, which raised fundamental questions about the determinants of transaction costs, and empirically documented the negative relationship between transaction costs and trading volume on different stocks on the New York Stock Exchange. The enormous subfield of finance now known as market microstructure begins with this hugely original article.

In 1967, Demsetz published a short but tremendously insightful article in the American Economic Review, called “Toward a Theory of Property Rights,” in which he analyzed the amount of property rights protection from the efficiency perspective. The article argued that property rights are expensive to enforce, and that institutions enforcing them arise efficiently when the benefit of secure property rights outweigh the costs of these institutions. Today, the economic study of institutions is a massive field, and Demsetz’s article can be justly seen as a founding contribution.

In 1985, together with Kenneth Lehn, Demsetz published an empirical article in the Journal of Political Economy, called “The Structure of Corporate Ownership: Causes and Consequences.” In that article, the authors document high ownership concentration of US firms in some sectors, such as newspapers and sports teams, and argue that the amenity potential of running these businesses (now known as “private benefits of control”) explains ownership concentration. In modern corporate finance, concentrated corporate ownership is seen as a norm rather than an exception, and private benefits of control as central determinants of ownership structures. Here again, Demsetz’s work came early, and accurately grasped both the empirical reality and the fundamental theoretical issues.

The number of areas in which Harold Demsetz’s contributions have stood the test of time is remarkable. His work is highly original, independent of prevailing intellectual currents, and enduring.

Nozick on free enterprise in America

Matt Zwolinski at the Bleeding Heart Libertarians blog has posted a copy of a little known article by Robert Nozick on free enterprise in America. The article is “Free Enterprise in America,” and was written for the Britannica Book of the Year, 1976.

Zwolinski writes,

For Nozick scholars, the piece is interesting largely for the insight it gives us into Nozick’s non-philosophical views of capitalism. Almost all of the essay is about factual matters – the history of capitalism, the functioning of the price system and of property rights, and the effects of government intervention. Since there’s not a whole lot of that material in Anarchy, State and Utopia, and since what is there is widely dispersed throughout the book, it’s useful to have Nozick’s views on these matters summarized in a short, accessible way.

And for those who aren’t Nozick scholars, it’s still a nice short reference piece on free enterprise in America! Left-libertarians will, and properly I think, take issue with its idea that America is mostly a free-enterprise system with just some government distortions. But that qualification aside, it’s a good short read, and one that would make a nice accompaniment in the classroom to Nozick’s more substantial philosophical work on libertarianism.

Nozick concludes his article by saying,

The United States broke away from mercantilist England and stood, though imperfectly, for liberty (including economic liberty) and for property rights. These two ideals are right not only for their economic and productive fruits and for the allowing of new ideas to be tried out, picked up, imitated, and modified, important though these be, but also they are right, important, and valuable in themselves. If we fail to stop the drift away from these ideals, the drift in which England has preceded us, the apparent dismal fate of the country we broke away from will become our own.

A warning that applies to most countries even now.

John Cochrane interview

The Federal Reserve Bank of Richmond has published an interview with Professor John Cochrane in their Econ Focus magazine.

A sample of the questions:

• Does the 2010 Dodd-Frank regulatory reform act meaningfully address runs on shadow banking?
• So what do you think is the most promising way to meaningfully end "too big to fail"?
• Do you think there's any reason to believe recessions following financial crises should necessarily be longer and more severe, as Carmen Reinhart and Kenneth Rogoff have famously suggested?
• Many people have asked whether the finance industry has gotten too big. How should we think about that?
• What are your thoughts on quantitative easing (QE) — the Fed's massive purchases of Treasuries and other assets to push down long-term interest rates — both on its effectiveness and on the fear that it's going to lead to hyperinflation?
• Both fiscal and monetary policies have been on extreme courses recently. What are your thoughts on how they might affect each other as they move back to normal levels?
• Switching gears to finance specifically, what do you think are some of the big unanswered questions for research?
• You wrote an op-ed on an "alternative maximum tax." What’s the idea there?
• Can transfers really help the bottom half of the income distribution?
• Which economists have influenced you the most?

But its the answers that are important.

Blaug on the Cambridge controversy

I have just discovered that there are economists out there who are still going on about the Cambridge controversy, an old and largely forgotten battle between the two Cambridges - UK and Massachusetts - on (non)questions like what are the problems encountered with the concept of an aggregate production function; what to make of the so-called "Sraffa Revolution" - more accurately described by the historian of economic thought Mark Blaug as "the Rip-van-Winkle phenomenon": that is, the solution with linear programming techniques of a question ("the invariable measure of value") that may have made some empirical sense in Ricardo's corn-economy world but whose solution in a modern industrial input-output economy makes no empirical sense at all (as Harry Johnson once put it) and, of course, double switching.

Mark Blaug concludes his book "The Cambridge Revolution: Success or Failure?", London: Institute of Economic Affairs, 1974, by saying

The Cambridge UK theories are certainly logically consistent, even if they do not always hang together in a logically consistent total framework of theories. They are possibily more realistic in some of their basic assumptions, although that statement is itself highly ambiguous. But they are not simpler, they are not more elegant, they are totally incapable of producing testable predictions. Whatever is wrong with neoclassical economics (and who can doubt that there is much to complain of?), it wins hands down on all possible criteria.

But there are those, it would seem, on the UK (losing?) side that will not let the debate die.

Growing like China: understanding the puzzle of China's economic transition

In this short audio from VoxEU.org Fabrizio Zilibotti talks to Viv Davies about Zilibotti's award-winning paper ‘Growing Like China’ (co-authored with Zheng Song, Kjetil Storesletten and Yikai Wang) that addresses the puzzle of the combination of high growth and high return to capital in China with a growing foreign surplus. They also discuss pensions and demographic transition in China, factors that are driving the country’s growth and the country’s future role in the global economy.

General equilibrium in contemporary economics

Thanks to Gavin Kennedy over at the Adam Smith's Lost Legacy blog I was alerted to this article by Paul Seabright in The Moscow Times. Seabright opens his piece by saying,

For the last half-century, the world's leading universities have taught microeconomics through the lens of the Arrow-Debreu model of general competitive equilibrium. The model, formalizing a central insight of Adam Smith's "The Wealth of Nations," embodies the beauty, simplicity and lack of realism of the two fundamental theorems of competitive equilibrium, in contrast to the messiness and complexity of modifications made by economists in an effort to capture better the way the world actually functions. In other words, while researchers attempt to grasp complex, real-world situations, students are pondering unrealistic hypotheticals.

(Below GE denotes general equilibrium.)

I would argue that Seabright misrepresents much of contemporary economics and economics teaching here. As I noted in a working paper on The past and present of the theory of the firm: A survey of the development of the mainstream approaches to the firm in economics,

A final point about the models of the firm discussed in this essay is that they highlight a general issue to do with post-1970 microeconomics, that is, the retreat from the use of general equilibrium (GE) models.

In a footnote I add,

When discussing the influence of Gerard Debreu [Debreu is most famous for his work on GE] on economics Duppe (2010: 2-3) nicely sums up the fate of GE as well. "From the point of view of today Debreu's influence on the body of economics could be called zero, in that general equilibrium theory (GET) is the economics of yesterday. While GET had mirrored most analytic advances in economic theory before Debreu, after Debreu most theoretical innovations came as alternatives to GET (from game theory to complexity theory)". Historian of economic thought Roger Backhouse writes that "[i]n the 1940s and 1950s general-equilibrium theory [ ... ] became seen as the central theoretical framework around which economics was based" (Backhouse 2002: 254) and that by the "[  ... ] early 1960s, confidence in general-equilibrium theory, and with it economics as a whole, as at its height, with Debreu's {\em Theory of Value} being widely seen as providing a rigorous, axiomatic framework at the centre of the discipline" (Backhouse 2002: 261), but "[  ...  ] there were problems that could not be tackled within the Arrow-Debreu framework. These include money (attempts were made to develop a general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models, often dealing only with a specific part of the economy or with a particular problem. The search for ever more general models of general competitive equilibrium, that culminated in Theory of Value, was over" (Backhouse 2002: 262). One set of particularly problematic results for general equilibrium are the Sonnenschein-Mantel-Debreu (SMD) theorems. "In part because of a conviction that progress could not be made in general equilibrium theory, there was a substantial redirection in economic theory. As the results in SMD theory became well known, for example through Wayne Shafer and Hugo Sonnenschein's survey (1982), economists began to question the centrality of general equilibrium theory and put forward alternatives to it. Thus in the ten years following the Shafer-Sonnenschein survey, we find a number of new directions in economic theory" (Rizvi 2006: 230).

I go on to noted that,

As early as 1955 Milton Friedman was suggesting that to deal with "substantive hypotheses about economic phenomena" a move away from Walrasian [GE] towards Marshallian [partial equilibrium] analysis was required. When reviewing Walras's contribution to GE, as developed in his Elements of Pure Economics, Friedman argued,

"[e]conomics not only requires a framework for organizing our ideas [which Walras provided], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall" (Friedman 1955: 908).

By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

I illustrate this point with reference to the theory of the firm and contract theory.

All the models discussed in the working paper are partial equilibrium models, but as I note, in this regard the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Most of modern microeconomics, such as incentive theory incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back on GE theory and has worked almost exclusively within a partial equilibrium framework.

One major influence on the development of the theory of the firm has been contract theory. But contract theory is a good example of the contemporary theory's increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of GE. As Salanie (2005: 2) has argued,

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

One of the main features of the teaching of modern microeconomics is the emphasis on issues in economics which GE does not handle well. As an example of this consider the contemporary theory of the firm. The current literature on the theory of the firm can be seen as being divided into two general groups based on which of two of the standard assumptions of GE theory, namely symmetric information and complete contracts, is violated when modelling the firm. In contract theoretic terms the former gives rise to principal-agent type models and the latter to incomplete contract type theories. The necessity of having to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms, or other important economic institutions. Bernard Salanie has noted that,

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

But economics students are taught about the areas of economics were GE theory breaks down. They all learn about game theory, asymmetric information, industrial organisation, incentive theory etc etc and all these areas utilise partial, rather than general, equilibrium theory in an effort to overcome shortcomings in the current approach to GE.

EconTalk for many weeks

Doug Lemov of Uncommon Schools and author of Teach Like a Champion talks with EconTalk host Russ Roberts about teaching and education. Drawing on his experience working in charter schools with children in poverty, Lemov discusses what makes a great teacher and a great school. Lemov argues that practice and technique can transform teaching and education. The conversation concludes with a discussion of how EconTalk might be made more valuable to its listeners.

Wally Thurman of North Carolina State University and PERC talks with EconTalk host Russ Roberts about the world of bees, beekeepers, and the market for pollination. Thurman describes how farmers hire beekeepers to pollinate their crops and how that market keeps improving crop yields and producing honey. Thurman then discusses how beekeepers have responded to Colony Collapse Disorder--a not fully understood phenomenon where colonies disband, dramatically reducing the number of bees. The discussion closes with the history of bee pollination as an example of a reciprocal externality and how Coase's insight helps understand how the pollination market works.

Judith Curry of the Georgia Institute of Technology and blogger at Climate Etc. talks with EconTalk host Russ Roberts about climate change. Curry argues that climate change is a "wicked problem" with a great deal of uncertainty surrounding the expected damage as well as the political and technical challenges of dealing with the phenomenon. She emphasizes the complexity of the climate and how much of the basic science remains incomplete. The conversation closes with a discussion of how concerned citizens can improve their understanding of climate change and climate change policy.

Richard Fisher, President of the Federal Reserve Bank of Dallas, talks with EconTalk host Russ Roberts about the problems with "too big to fail"--the policy idea that certain financial institutions are too large to face the bankruptcy or failure and need to be rescued or bailed-out. Fisher argues that "too big to fail" remains a serious problem despite claims that recent financial regulation has eliminated it. Fisher discusses various ways to deal with too-big-to-fail, including his own preferred policy. The last part of the conversation deals with quantitative easing and monetary policy during the crisis.

Weather and revolting peasants

Over history it would seem possible that weather shocks, which effect food supply, could affect the probability of peasant revolts. When food is in short supply peasants are more likely to revolt. While such a hypothesis may seem reasonable, is there any evidence to back it up? Thanks to a new article in The Economic Journal there is. At least for China.

I use data covering 267 prefectures over four centuries to investigate two questions about historical China. To what extent did weather shocks cause civil conflict? And to what extent did the historical introduction of (drought resistant) sweet potatoes mitigate these effects? I find that before the introduction of sweet potatoes, exceptional droughts increased the probability of peasant revolts by around 0.7 percentage points, which translates into a revolt probability in drought years that is more than twice the average revolt probability. After the introduction of sweet potatoes, exceptional droughts only increased the probability of peasant revolts by around 0.2 percentage points.

The article is Weather Shocks, Sweet Potatoes and Peasant Revolts in Historical China by Ruixue Jia.

Sometimes common sense does make sense.

EconTalk this week

Lant Pritchett of Harvard University and author of The Rebirth of Education talks with EconTalk host Russ Roberts about the ideas in the book. Pritchett argues that increases in years of schooling for students in poor countries do not translate into gains in education, learning, or achievement. This tragic situation is due to corruption and poor incentives in the top-down educational systems around the world. School reforms that imitate successful systems fail to take into account the organic nature of successful school systems that cause various external attributes to be effective. The conversation concludes with a discussion of school systems in rich countries and possible lessons for reform that might apply there.

Collaboration, stars, and the changing organisation of science

The NBER has released a new working paper on Collaboration, Stars, and the Changing Organization of Science: Evidence from Evolutionary Biology by Ajay Agrawal, John McHale and Alexander Oettl.

The abstract reads:

We report a puzzling pair of facts concerning the organization of science. The concentration of research output is declining at the department level but increasing at the individual level. For example, in evolutionary biology, over the period 1980 to 2000, the fraction of citation-weighted publications produced by the top 20% of departments falls from approximately 75% to 60% but over the same period rises for the top 20% of individual scientists from 70% to 80%. We speculate that this may be due to changing patterns of collaboration, perhaps caused by the rising burden of knowledge and the falling cost of communication, both of which increase the returns to collaboration. Indeed, we report evidence that the propensity to collaborate is rising over time. Furthermore, the nature of collaboration is also changing. For example, the geographic distance as well as the difference in institution rank between collaborators is increasing over time. Moreover, the relative size of the pool of potential distant collaborators for star versus non-star scientists is rising over time. We develop a simple model based on star advantage in terms of the opportunities for collaboration that provides a unified explanation for these facts. Finally, considering the effect of individual location decisions of stars on the overall distribution of human capital, we speculate on the efficiency of the emerging distribution of scientific activity, given the localized externalities generated by stars on the one hand and the increasing returns to distant collaboration on the other.

Now this makes sense. As we become more specialised, as the division of labour becomes greater, we each know more about less and thus collaboration offers increasing returns. Also if we think of the falling cost of communication as falling transaction costs then greater inter-departmental collaboration makes sense. This is because there is an asymmetry in the way that falling communication costs affects intra-departmental and inter-departmental transaction costs. Things like the internet, skype and email will not affect intra-departmental transaction costs much, if at all, but they will lower the transaction costs of inter-departmental collaboration. And thus we should expect to see greater use of the relatively cheaper option. Also one could see the increasing difference in institutional rank as being, in part, due to the now lower costs for up-and-comers, who may be starting their careers at lower ranked institutions,  to collaborate with "stars".

Henry Simons and laissez faire

For those not up on these things Henry C. Simons was an economist at the University of Chicago - he started teaching in the department of economics and later become the first professor of economics in the law school - and author of a pamphlet, A Positive Program for Laissez Faire: Some Proposals for a Liberal Economic Policy. This work was discussed by Ronald Coase when he gave the 1992 Henry C. Simons Memorial Lecture at the University of Chicago Law School.

Coase notes that the pamphlet was more an essay in political philosophy than economics and

[...] when it did touch on economics, or at any rate on those parts of economics in which I was interested, his views were such as to provoke serious reservations. He thought that the regulation of railroads and public utilities generally had been a dismal failure. And what was his solution for this problem? He argued that "the state should face the necessity of actually taking over, owning, and managing directly, both the railroads and the utilities, and all other industries in which it is impossible to maintain effectively competitive conditions." Carrying out Simons's proposals would have involved the nationalization of a large part of American industry, perhaps the greater part. It is a strange route to laissez-faire and brings to mind the proposals of Oskar Lange and Abba Lerner for market socialism.

Strange indeed. But what of industries other than railways and utilities?

For other industries, those not candidates for nationalization, Simons said that "there still remains a real alternative to socialization, namely, the establishment and preservation of competition as the regulative agency." But how was this to be accomplished? He thought that the antitrust laws should be used to bring about a drastic restructuring of American industry. "The Federal Trade Commission must become perhaps the most powerful of our governmental agencies." I can give the flavor of Simons's approach by describing some of his proposals regarding the corporation:

There must be an outright dismantling of our gigantic corporations. . . . Few of our gigantic corporations can be defended on the ground that their present size is necessary to reasonably full exploitation of production economies: their existence is to be explained in terms of opportunities for promoter profits, personal ambitions of industrial and financial "Napoleons", and advantages of monopoly power. We should look forward to a situation in which the size of ownership units in every industry is limited to the minimum size of operating plant requisite to efficient, but highly specialized production—and even more narrowly limited, if ever necessary to the maintenance of freedom of enterprise.

What Simons had in mind is made clearer in a footnote: "It will be necessary to revise notions commonly accepted (especially by courts) as to the maximum size of firm compatible with effective competition. The general rule and ultimate objective should be that of fixing in each industry a maximum size of firm such that the results of perfect competition would be approximated even if all firms attained the maximum size. One may suggest, tentatively, that in major industries no ownership unit should produce or control more than 5 percent of the total output."

It is interesting to see that the attempt to limit the size of firms in this way is driven by desire to apply the idea of  "perfect competition" to the real world. Competition is seen in terms of an 'end state' rather than a process, as it is for the Austrian school, and so to achieve a 'competitive' outcome the real world must be forced to meet the requirements of that end state. This without considering what the actual results of such an policy would be.

If this was his approach to the structure of industries, what were his views on other areas of industrial economics such as advertising,

"It is a commonplace that our vaunted efficiency in production is dissipated extravagantly in the wastes of merchandising. ... If present tendencies continue, we may soon reach a situation where most of our resources are utilized in persuading people to buy one thing rather than another, and only a minor fraction actually employed in creating things to be bought."

Coase continues by noting,

In making such statements and generally in dealing with industrial organization, Simons provides no empirical backing for his contentions, makes no serious investigation of what the effects of his proposals would be on the efficiency with which the economic system would operate, nor does he consider whether the Federal Trade Commission would be likely to do what he wanted or whether, even if it wanted to do so, it would be possible for it to acquire the information necessary to implement his proposals.

If this is a positive program for laissez faire, I hate to think what a negative one would be like!

I guess economics thinking at the University of Chicago has changed over the years. Coase notes,

Simons's approach is the very antithesis of that which was to become dominant as a result of the emergence of that new subject, law and economics. Stigler's description of Simons is eminently just: Simons was a Utopian.

While Simons's arguments may be rejected by economists today its interesting to ask how many Utopians there are outside of economics still.

Ref.: The quotes from Coase come from:

• Coase, R.H. (1993). 'Law and Economics at Chicago', Journal of Law and Economics, 36(1, Part 2) April: 239-54.

Managerial control versus performance pay

One of the most obvious problems in any employment relationship is moral hazard. What the boss wants workers to do and what the workers actually do can be two very different things. Two of the most common methods firms utilise to try to deal with this problem are the use of performance pay and managerial control. In the empirical literature the performance pay aspect of this solution has received much greater attention than has the managerial control aspect.

In a recent NBER working paper Kirabo Jackson and Henry Schneider examine how an experiment in managerial control affected revenue at an auto repair firm. When the firm provided detailed checklists to mechanics, and managers monitored their use, revenue was 20 percent higher under the experiment. They compare this effect to that of quasi-experimental increases in mechanic commission rates. The managerial-control effect is equivalent to that of a 10 percent commission increase.

These results suggest that managerial control can be a viable alternative to performance pay for the mitigation of the effects of moral hazard. Furthermore, the managerial-control treatment was larger for mechanics that had higher commission rates, suggesting that in this context managerial control and performance pay are complements. The results also support the theoretical prediction that the optimal incentive contract depends on the level and quality of monitoring.

When they investigated the forces underlying the results, Jackson and Schneider find that the mechanics under the managerial-control treatment increase revenue through doing more repairs on each car and working more hours each week. In contrast, mechanics that received commission increases, increased revenue by substituting away from low-revenue repairs toward high-revenue repairs and getting customers to consent to higher price repairs, with no increase in time on the job or number of repairs conducted. Because this shifting toward more expensive repairs may reflect mechanics exploiting their informational advantage over customers, the result underscore the possibility that pay-for-performance may encourage undesirable worker actions.

Also the behaviour of the mechanics is adversely affected because as they only receive a fraction of the firm's revenue, the additional compensation for mechanics for conducting a more thorough inspection of a car is insufficient to offset the associated effort and time costs. Jackson and Schneider's calculations based on their results indicate that a modest transfer of the profits due to checklist use from firm to mechanic could compensate mechanics for their additional costs and achieve a sizable Pareto improvement.

The Jackson and Schneider study shows that increased managerial control can reduce moral hazard, something that has not often been tested empirically. Evidence is also provided that shows that increased managerial control can generate complementarities with performance pay, most likely in settings with multiple complementary tasks. Given the widespread emphasis on performance pay as an incentivising tool, their results suggest that managerial control may be an additional important tool for designing compensation schemes.