Management and productivity: An interview with Nicholas Bloom

The following comes from an interview with Stanford University economist Nicholas Bloom available online at "Econ Focus", the economics magazine of the Federal Reserve Bank of Richmond.

EF: Another branch of your research has focused on how management practices affect firm and country productivity. Why do you think management practices are so important?

Bloom: My personal interest was formed by working at McKinsey, the management consulting firm. I was there for about a year and a half, working in the London office for industrial and retail clients.

There's also a lot of suggestive evidence that management matters. For example, Lucia Foster, John Haltiwanger, and Chad Syverson found using census data that there are enormous differences in performance across firms, even within very narrow industry classifications. In the United Kingdom years ago, there was this line of biscuit factories — cookie factories, to Americans — that were owned by the same company in different countries. Their productivity variation was enormous, with these differences being attributed to variations in management. If you look at key macro papers like Robert Lucas' 1978 "span of control" model or Marc Melitz's 2003 Econometrica paper, they also talk about productivity differences, often linking this with management.

Economists have, in fact, long argued that management matters. Francis Walker, a founder and the first president of the American Economic Association, ran the 1870 U.S. census and then wrote an article in the first year of the Quarterly Journal of Economics, "The Source of Business Profits." He argued that management was the biggest driver of the huge differences in business performance that he observed across literally thousands of firms.

Almost 150 years later, work looking at manufacturing plants shows a massive variation in business performance; the 90th percentile plant now has twice the total factor productivity of the 10th percentile plant. Similarly, there are massive spreads across countries — for example, U.S. productivity is about five times that of India.

Despite the early attention on management by Francis Walker, the topic dropped down a bit in economics, I think because "management" became a bad word in the field. Early on I used to joke that when I turned up at seminars people would see the "M-word" in the seminar title and their view of my IQ was instantly minus 20. Then they'd hear the British accent, and I'd get 15 back. People thought management was quack doctor research — all pulp-fiction business books sold in airports.

Management matters, obviously, for economic growth — if we could rapidly improve management practices, we would quickly end the current growth slowdown. It also matters for public services. For example, schools that regularly evaluate their teachers, provide feedback on best practices, and use data to spot and help struggling students have dramatically better educational outcomes. Likewise, hospitals that evaluate nurses and doctors to provide feedback and training, address struggling employees, and reward high performers provide dramatically better patient care. I teach my Stanford students a case study from Virginia Mason, the famous Seattle hospital that put in place a huge lean-management overhaul and saw a dramatic improvement in health care outcomes, including lower mortality rates. So if I get sick, I definitely want to be treated at a well-managed hospital.

EF: How much of the productivity differences that you just discussed are driven by management?

Bloom: Research from the World Management Survey that Raffaella Sadun, John Van Reenen, and I developed suggests that management accounts for about 25 percent of the productivity differences between firms in the United States. This is a huge number; to give you a benchmark, IT or R&D appears to account for maybe 10 percent to 20 percent of the productivity spread based on firm and census data. So management seems more important even than technology or innovation for explaining variations in firm performance.

Coincidentally, you do the same exercise across countries and it's also about 25 percent. The share is actually higher between the United States and Europe, where it's more like a third, and it's lower between the United States and developed countries, where it's more like 10 to 15 percent.

Now, you may not be surprised to learn that there are significant productivity differences between India and the United States. But you look at somewhere like the United Kingdom, and it's amazing: Its productivity is about 75 percent of America's. The United Kingdom is a very similar country in terms of education, competition levels, and many other things. So what causes the gap? It is a real struggle to explain what it is beyond, frankly, management.

EF: What can policy do to improve management practices?

Bloom: I think policy matters a lot. We highlight five policies. One is competition. I think the key driver of America's management leadership has been its big, open, and competitive markets. If Sam Walton had been based in Italy or in India, he would have five stores by now, probably called "Sam Walton's Family Market." Each one would have been managed by one of his sons or sons-in-law. Whereas in America, Walmart now has thousands of stores, run by professional nonfamily managers. This expansion of Walmart has improved retail productivity across the country. Competition generates a lot of diversity through rapid entry and exit, and the winners get big very fast, so best practices spread rapidly in competitive, well-functioning markets.

The second policy factor is rule of law, which allows well-managed firms to expand. Having visited India for the work with Benn Eifert, Aprajit Mahajan, David McKenzie, and John Roberts, I can say this: The absence of rule of law is a killer for good management. If you take a case to court in India, it takes 10 to 15 years to come to fruition. In most developing countries, the legal system is weak; it is hard to successfully prosecute employees who steal from you or customers who do not pay their invoices, leading firms to use family members as managers and supply only narrow groups of trusted customers. This makes it very hard to be well managed — if most firms have the son or grandson of the founder running the firm, working with the same customers as 20 years ago, then it shouldn't be surprising that productivity is low. These firms know that their sons are often not the best manager, but at least they will not rampantly steal from the firms.

The third policy factor is education, which is strongly correlated with management practices. Educated and numerate employees seem to more rapidly and effectively adopt efficient management practices.

The fourth policy factor is foreign direct investment, as multinational firms help to spread management best practices around the world. Multinational firms are typically incredibly well run, and that spills over. It's even true in America, where its car industry has benefited tremendously from Honda, Toyota, Mitsubishi, and Volkswagen. When these foreign car manufacturers first came to America, they achieved far higher levels of productivity than domestic U.S. firms, which forced the American car manufacturers to improve to survive.

The fifth factor is labor regulation, which allows firms to adopt strong management practices unimpeded by government. In places like France, you can’t fire underperformers, and as a result, it's very hard to enforce proper management.

EF: Do you expect America's productivity advantage to continue?

Bloom: On the above five criteria, the United States scores an "A" on four of them except education, where we score a "C." The United States has a weak school system and poor education standards compared to a number of our competitors. For example, based on OECD Pisa [Programme for International Student Assessment] scores, the U.S. educational system ranks in the mid-20s on math, below many European and East Asian countries. So improving educational standards is the most obvious way to improve management and ultimately growth, because poor education makes it harder to manage our firms. Fixing U.S. education will take more funding. But most importantly, it will require dismantling the cobweb of restrictions that teachers unions and politicians have put on schools, like tenure and seniority-based pay.

If you fix these five drivers of management, you're 95 percent of the way there. Most other factors seem of secondary importance compared to the big five of competition, rule of law, education, foreign direct investment, and regulations.

EF: Management practices can be viewed as "soft" technologies, compared to so-called "hard" technologies such as information technology. Do you see anything special about the invention and adoption of these "soft" technologies relative to "hard" technologies?

Bloom: The only distinction is that hard technologies, like my Apple iPhone, are protected by patents, whereas process innovations are protected by secrecy.

The late Zvi Griliches, a famous Harvard economist, broke it down into two groups: process and product innovations. Most people who think of innovation think of product innovations like the shiny new iPhone or new drugs. But actually a lot of it is process innovations, which are largely management practices.

Good examples would be Frederick Winslow Taylor and scientific management 100 years ago, or Alfred Sloan, who turned a struggling General Motors into the world's biggest company. Sloan pushed power and decision-making down to lower-level individuals and gave them incentives — called the M-form firm. It seems perfectly standard now, but back then firms were very hierarchical, almost Soviet-style. And then there was modern human resources from the 1960s onward — the idea that you want to measure people, promote them, and give them rewards. Most recently, we have had "lean manufacturing," pioneered by Toyota from the 1990s onward, which is now spreading to health care and retail. This focused on data collection and continuous improvement.

These have been major milestones in management technologies, and they've changed the way people have thought. They were clearly identified innovations, and I don't think there's a single patent among them. These management innovations are a big deal, and they spread right across the economy.

In fact, there's a management technology frontier that's continuously moving forward, and the United States is pretty much at the front with firms like Walmart, GE, McDonald's, and Starbucks. And then behind the frontier there are a bunch of laggards with inferior management practices. In America, these are typically smaller, family-run firms.

EF: What are the key challenges for future research on management?

Bloom: One challenge is measurement. We want to improve our measurement of management, which is narrow and noisy.

The second challenge is identification and quantification: finding out what causes what and its magnitude. For example, can we quantify the causal impact of better rule of law on management? I get asked by institutions like the World Bank and national governments which policies have the most impact on management practices and what size impact this would be? All I can do is give the five-factor list I've relayed here; it's very hard to give any ordering, and there are definitely no dollar signs on them. I would love to be able to say that spending $100 million on a modern court system will deliver $X million in extra output per year.

One way to get around this — the way macroeconomists got around it — is to gather great data going back 50 years and then exploit random shocks to isolate causation. This is what we are trying to do with the World Management Survey. The other way is a bit more deliberate: to run field experiments by talking with specific firms across countries.

In the New Zealand context its interesting to note Bloom's comments on the effects of foreign direct investment. Multinational firms help improve the standard of management in the host country and thus help improve productivity. Add this to the point that Eric Crampton noted about foreign firms paying their employees more, then foreign investment in New Zealand looks better than the anti-FDI crowd would have us believe. Also Bloom highlights the advantages of a flexible labout market. Given the small size of the internal New Zealand market Bloom's point about the importance of competition to good management practices emphasises the  need to keep New Zealand open to trade so that local produces face as much competition as possible from foreign firms.

Four principles for an effective state

The following four principles come from the 2014 Nobel prize winner in economics Jean Tirole. The original column was posted at VoxEU.org on 16 July 2007 (reposted 13 October 2014). Tirole argues that for the French state to meet the expectations of its citizens the state will have to become more effective. To do this requires, in Tirole's view, a four-pronged approach: restructuring, competition, evaluation and accountability.

Restructuring
Many countries have undertaken fundamental governmental reforms based on a consensus between political parties and unions. In the 1990s, the Swedish Social Democrats government made large cuts in the civil service. Ministers, who formulate overall strategy and make decisions on resource allocation, have to rely on a small number of civil servants. Operational details must therefore be delegated to a large number of independent agencies, each of which can recruit and remunerate their employees as they choose. These independent agencies operate under strict budgetary limits that ensure the sustained delivery of public services.

Around the same time, Canada cut government expenditure by 18.9% without social turmoil – and without greatly reducing health, justice, or housing programmes. They did this while maintaining tax levies, so the result was a reduced public deficit and falling public debt. Spending that could not be clearly justified in terms of the resulting service to the public was pruned. Subsidies for entrepreneurial projects and privatisation facilitated the elimination of one in six positions in the civil service. Indeed the sort of government reorganisation undertaken in Canada could only be dreamed of in France with its often nightmarish collection of laws and fiscal regulations. The Canadians have a single service for the calculation and collection of taxes and a one-stop-shop for government-business relations.

Competition
Contrary to common beliefs in France, head-on competition can produce high quality public services. In telecommunications, most countries, including France, have put a universal service obligation fund in place, which is compatible with competition between providers. It protects the smallest firms while ensuring that services are available in all regions of the country or to poor consumers.

When it comes to education, several countries (Belgium, the UK, Sweden) have tried voucher systems that give everyone access to education but create competition among schools for students. Such a system must be accompanied by clear and openly available information on schools so parents can make informed choices and “insider-ism” can be avoided (something that arose from the competition among the tracks in the French education system).

Competition can also be created via standardisation. In the healthcare realm, using more systematic comparisons between hospitals, or between the private and public sectors could help control costs. Sometimes the cost of treatment for a given disease varies by a factor of 2.5 with the variation having nothing to do with patient selection.

Evaluation
Every action of the State must be subject to a double independent evaluation. The first should be before the action: Is public intervention necessary? What are the costs and benefits? The second is after. Did it work? Was it cost effective? On this point, it would be necessary to require that the audit recommendations (for example, those of the Audit Court) be either followed according to a strict schedule, or rejected with a convincing justification.

Accountability
The 2001 Law (LOLF), adopted on the basis of a left-right consensus, is a small revolution in a country accustomed to the logic of budgetary processes. Embracing the logic of effectiveness, the law aims to transform public sector managers into true owners where their obligation to produce results goes hand in hand with the freedom to manage. Putting this principle into practice is certainly difficult. First of all, the objectives need to be clear and easily verifiable. Then, “accountability” must be introduced. For that, the objectives can’t be collective (as the failure of control of health expenses has shown), but must be the subject of rewards or sanctions. Lastly, one should be wary of the pernicious effects of “multi-tasking”. Incentives that are related to an easily measured objective (for example, the cost per student for a university, which can be easily reduced by teaching large numbers of students in large lecture halls) can cause one to ignore equally important objectives that one has neglected to measure (such as the quality of teaching or research). In other words, to construct good incentives, one has to evaluate actions comprehensively. That way, it’s clear that giving regulated enterprises more responsibility should go hand in hand with stricter safety and quality controls. The need for such controls is clear from the experience of British telecoms in 1984 and more recently, of British railways.

The French state does have something of a bad history when it comes to effectiveness. For example the French SOEs have not always been run well. In 1997, for example, the Economist magazine (`Banking's Biggest Disaster', vol. 344 issue 8024 July 5: 69-71) noted the near-bankruptcy of the then state-owned bank Credit Lyonnais. The magazine pointed out that the then French finance minister Dominique Strauss-Kahn had to admit that the bank had probably lost around Ffr100 billion (around US$17 billion). The bank had to be bailed out three times in the 1990s. The total cost to the French taxpayer of the whole debacle has been estimated at between US$20 and US$30 billion. Improving on such a record shouldn't be too difficult.

EconTalk this week

Joshua Angrist of the Massachusetts Institute of Technology talks to EconTalk host Russ Roberts about the craft of econometrics--how to use economic thinking and statistical methods to make sense of data and uncover causation. Angrist argues that improvements in research design along with various econometric techniques have improved the credibility of measurement in a complex world. Roberts pushes back and the conversation concludes with a discussion of how to assess the reliability of findings in controversial public policy areas.

A direct link to the audio is available here.

An updated version of "The Past and Present of the Theory of the Firm"

The Past and Present of the Theory of the Firm: A historical survey of the mainstream approaches to the fir...

EconTalk from last week

Gary Marcus of New York University talks with EconTalk host Russ Roberts about the future of artificial intelligence (AI). While Marcus is concerned about how advances in AI might hurt human flourishing, he argues that truly transformative smart machines are still a long way away and that to date, the exponential improvements in technology have been in hardware, not software. Marcus proposes ways to raise standards in programming to reduce mistakes that would have catastrophic effects if advanced AI does come to fruition. The two also discuss "big data's" emphasis on correlations, and how that leaves much to be desired.

A direct link to the audio is available here.

EconTalk for many, many weeks

Thomas Piketty of the Paris School of Economics and author of Capital in the Twenty-First Century talks to Econtalk host Russ Roberts about the book. The conversation covers some of the key empirical findings of the book along with a discussion of their significance.

Martha Nussbaum of the University of Chicago and author of Creating Capabilities talks with EconTalk host Russ Roberts about an alternative to GDP for measuring economic performance at the national level. She is a proponent of the capabilities approach that emphasizes how easily individuals can acquire skills and use them, as well as the capability to live long and enjoy life. Nussbaum argues that government policy should focus on creating capabilities rather than allowing them to emerge through individual choices and civil society.

David Autor of the Massachusetts Institute of Technology talks with EconTalk host Russ Roberts about the future of work and the role that automation and smart machines might play in the workforce. Autor stresses the importance of Michael Polanyi's insight that many of the things we know and understand cannot be easily written down or communicated. Those kinds of tacit knowledge will be difficult for smart machines to access and use. In addition, Autor argues that fundamentally, the gains from machine productivity will accrue to humans. The conversation closes with a discussion of the distributional implications of a world with a vastly larger role for smart machines.

EconTalk host Russ Roberts is interviewed by long-time EconTalk guest Michael Munger about Russ's new book, How Adam Smith Can Change Your Life: An Unexpected Guide to Human Nature and Happiness. Topics discussed include how economists view human motivation and consumer behavior, the role of conscience and self-interest in acts of kindness, and the costs and benefits of judging others. The conversation closes with a discussion of how Smith can help us understand villains in movies.

Luigi Zingales of the University of Chicago's Booth School of Business talks with EconTalk host Russ Roberts about Zingales's essay, "Preventing Economists' Capture." Zingales argues that just as regulators become swayed by the implicit incentives of dealing with industry executives, so too with economists who study business: supporting business interests can be financially and professionally rewarding. Zingales outlines the different ways that economists benefit from supporting business interests and ways that economists might work to prevent that influence or at lease be aware of it.

Robert Solow, Professor Emeritus at Massachusetts Institute of Technology and Nobel Laureate, talks with EconTalk host Russ Roberts about his hugely influential theory of growth and inspiration to create a model that better reflected the stable long-term growth of an economy. Solow contends that capital accumulation cannot explain a significant portion of the economic growth we see. He makes a critical distinction between innovation and technology, and then discusses his views on Milton Friedman and John M. Keynes.

Daron Acemoglu, the Elizabeth and James Killian Professor at the Massachusetts Institute of Technology, talks with EconTalk host Russ Roberts about his new paper co-authored with James Robinson, "The Rise and Fall of General Laws of Capitalism," a critique of Thomas Piketty, Karl Marx, and other thinkers who have tried to explain patterns of data as inevitable "laws" without regard to institutions. Acemoglu and Roberts also discuss labor unions, labor markets, and inequality.

Becky Liddicoat Yamarik, Hospice Palliative Care Physician, talks to EconTalk host Russ Roberts about the joys and challenges of providing care for terminally ill patients. The two discuss the services palliative care provides, how patients make choices about quality of life and when to stop receiving treatment, conflicts of interest between patients and families, and patients' preparedness to make these decisions.

Nobel Laureate Vernon L. Smith of Chapman University talks to EconTalk host Russ Roberts about how Adam Smith's book, The Theory of Moral Sentiments has enriched his understanding of human behavior. He contrasts Adam Smith's vision in Sentiments with the traditional neoclassical models of choice and applies Smith's insights to explain unexpected experimental results from the laboratory.

Emily Oster of the University of Chicago talks with EconTalk host Russ Roberts about why U.S. infant mortality is twice that in Finland and high relative to the rest of the world, given high income levels in the United States. The conversation explores the roles of measurement and definition along with culture to understand the causes of infant mortality in the United States and how it might be improved.

Nick Bostrom of the University of Oxford talks with EconTalk host Russ Roberts about his book, Superintelligence: Paths, Dangers, Strategies. Bostrom argues that when machines exist which dwarf human intelligence they will threaten human existence unless steps are taken now to reduce the risk. The conversation covers the likelihood of the worst scenarios, strategies that might be used to reduce the risk and the implications for labor markets, and human flourishing in a world of superintelligent machines.

James Otteson of Wake Forest University talks to EconTalk host Russ Roberts about his new book, The End of Socialism. Otteson argues that socialism (including what he calls the "socialist inclination") is morally and practically inferior to capitalism. Otteson contrasts socialism and capitalism through the views of G. A. Cohen and Adam Smith. Otteson emphasizes the importance of moral agency and respect for the individual in his defense of capitalism. The conversation also includes a discussion of the deep appeal of the tenets of socialism such as equality and the impulse for top-down planning.

Propriety and Prosperity: Adam Smith

A new collection of essays on Adam Smith has been announced. The following is from Gavin Kennedy at his Adam Smith's Lost Legacy blog:

Propriety and Prosperity

New Studies on the Philosophy of Adam Smith

Edited by David Hardwick, Leslie Marsh

$115.00

ISBN 9781137320681

Publication Date December 2014

Palgrave Macmillan

This book is a collection of specially commissioned chapters from philosophers, economists and political scientists, focusing on Adam Smith's two main works Theory of Moral Sentiments and Wealth of Nations. It examines the duality which manifests itself as an apparent contradiction: that is, how does one reconcile the view of human nature expounded in Theory of Moral Sentiments (sympathy and benevolence) and the view of human nature expounded in Wealth of Nations (self-interest)? New work by philosophers has uncovered the complex and nuanced connections between Smith's account of economic and moral motivation. His economic theory has presented conceptual challenges: the famous 'invisible hand' has proved an elusive concept much in need of scrutiny.

'Prosperity' in the title captures the economic side of Smith's thought. 'Propriety' points to his ethics. In recent philosophical scholarship two major shifts have occurred. One is that the originality of Smith's moral theory has been rediscovered and recognised. His account of sympathy is significantly different from Hume's: his idea of the 'impartial spectator' is independent, rich and complex and he is alert to the phenomenon of self-deception. The second shift is that Smith's image as an economic liberal has been drastically revised, reclaiming him from current ideological use in defence of free markets and the minimal state. Smith links economics, politics and ethics through notions of justice and utility in subtle ways that make the labels 'economic liberal' and 'laissez-faire theorist' at best inadequate and at worst misleading.

This collection was put together with a view to bringing Smith to a mainstream philosophy audience while simultaneously informing Smith's traditional constituency (political economy) with philosophically finessed interpretations.

1. Introduction; David F. Hardwick and Leslie Marsh
PART I: CONTEXT

2. Adam Smith as a Scottish Philosopher; Gordon Graham 

3. Friendship in Commercial Society Revisited: Adam Smith on Commercial Friendship; Spyridon Tegos

4. Adam Smith and French Political Economy: Parallels and Differences; Laurent Dobuzinskis

5. Adam Smith: 18th Century Polymath; Roger Frantz

PART II: PROPRIETY

6. Indulgent Sympathy and the Impartial Spectator; Joshua Rust

7. Adam Smith on Sensory Perception: A Sympathetic Account; Brian Glenney

8. Adam Smith on Sympathy: From Self-Interest to Empathy; Gloria Zúñiga y Postigo

9 . What My Dog Can Do: On the Effect of The Wealth of Nations I.ii.2; Jack Weinstein

PART III: PROSPERITY

10. Metaphor Made Manifest: Taking Seriously Smith's 'Invisible Hand'; Eugene Heath

11. The 'Invisible Hand' Phenomenon in Philosophy and Economics; Gavin Kennedy

12. Instincts and the Invisible Order: The Possibility of Progress; Jonathan B. Wight

13. The Spontaneous Order and the Family; Lauren K. Hall

14. Smith, Justice and the Scope of the Political; Craig Smith

Contributing Authors (In bold: scholars whom I know)

Laurent Dobuzinskis, Simon Fraser University, Canada

Roger Frantz, San Diego State University, USA

Brian Glenney, Gordon College, Massachusetts, USA

Gordon Graham, Princeton Theological Seminary, USA

Lauren K. Hall, Rochester Institute of Technology, USA

David F. Hardwick, The University of British Columbia, Canada

Eugene Heath, State University of New York at New Paltz, USA

Gavin Kennedy Heriot-Watt University, UK

Leslie Marsh, The University of British Columbia, Canada

Joshua Rust, Stetson University, USA

Craig Smith, University of Glasgow, UK

Vernon L. Smith, Chapman University, USA

Spyridon Tegos, The University of Crete, Greece

Jack Weinstein, University of North Dakota, USA

Jonathan Wight, University of Richmond, USA

Gloria Zúñiga y Postigo, Ashford University, USA

This looks like a very interesting set of essays, but the price!! Demand curves do slope downwards. I sometimes wonder if publishers know this simple fact.

Book award to Foss and Klein

This is from the website of the Society for the Development of Austrian Economics

2014 FEE Prize for the best book in Austrian economics is awarded to Nicolai Foss and Peter G. Klein’s Organizing Entrepreneurial Judgment

Comments read by Virgil Storr, Vice President of the SDAE, during the presentation of the 2014 FEE Prize for the best book in Austrian economics:

In Organizing Entrepreneurial Judgment: A New Approach to the Firm, Nicolai Foss and Peter G. Klein bridge the gap between studies of entrepreneurship and the theory of the firm. Despite both concepts becoming increasingly appreciated and studied by contemporary scholars in economics and management, Foss and Klein show that the existing theoretical and practical literature too often fails to adequately connect these theories. Seeking to correct this failing and drawing on insights from Austrian economics, Foss and Klein examine entrepreneurship as judgment decisions made by management under conditions of uncertainty. They show that these judgments are drivers of the economy and keys to understanding firm performance and organization.

For meaningfully adding to the Austrian literature on entrepreneurship and applying Austrian insights about entrepreneurship to the theory of the firm, the prize committee determined that Organizing Entrepreneurial Judgment: A New Approach to the Firm is deserving of the 2014 FEE Prize for the best book in Austrian Economics.

In a working paper of mine I say this about the Foss and Klein book (footnotes removed),

Foss and Klein 2012

A second recent approach to the firm that doesn't fit well into the Foss, Lando and Thomsen classification, but which also emphasises the entrepreneur, is that of Foss and Klein (2012) (FK). FK see their work as offering a theory of the entrepreneur centred around a combination of Knightian uncertainty and Austrian capital theory. While such a basis places their work outside the conventional theory of the firm, FK see themselves ``not as radical, hostile critics, but as friendly insiders" (Foss and Klein 2012: 248).

To understand the FK theory first consider the one-person firm. For FK it is the incompleteness of markets for judgement that explains why an entrepreneur has to form their own firm. Here ``judgement" refers to business decision making in situations involving Knightian uncertainty, that is, circumstances in which the range of possible future outcomes, let alone the likelihood of any individual outcome, is unknown. Thus decision-making about the future must rely on a kind of understanding that is subjective and tacit, one that can not be parameterised in a set of formal, explicit decision-making rules. But then how can we tell great/poor judgement from good/bad luck? A would-be entrepreneur may not be able to communicate to others just what his ``vision" of a new way to satisfy future consumer desires is in such a manner that other people would be able to assess its economic validity. If the nascent entrepreneur can not verify the nature of his idea then they are unlikely to be able to sell their ``expertise" across the market - as an consultant or advisor - or become an employee of a firm utilising his ``expertise" due to adverse selection/moral hazard problems and thus he will have to form his own firm to commercialise this ``vision". This reasoning for the formation of a firm is not entirely without precedence. Working within a standard property rights framework Rabin (1993) and Brynjolfsson (1994) show that an informed agent may have to set up a firm to benefit from their information for adverse selection and moral hazard reasons respectively. In addition to this the inability to convey his ``vision" to capital markets will limit an entrepreneur's ability borrow to finance the purchase of any non-human assets the entrepreneur requires. This means the the entrepreneur can not be of the Kirznerian penniless type. Non-human assets are important because judgemental decision making is ultimately about the arrangement of the non-human capital that the entrepreneur owns or controls. Capital ownership also strengthens the bargaining position of the entrepreneur relative to other stakeholders and helps ensure the entrepreneur is able to appropriate the rents from his ``vision".

Turning to the multi-person firm FK argue that the need for experimentation with regard to production methods is the underlying reason for the existence of the firm. Given that assets have many dimensions or attributes that only become apparent via use, discovering the best uses for assets or the best combination of assets requires experimenting with the uses of the assets involved. Thus entrepreneurs seek out the least-cost institutional arrangement for experimentation. Using a market contract to coordinate collaborators leaves the entrepreneur open to hold-up, collaborators can threaten to veto any changes in the experimental set-up unless they are granted a greater proportion of the quasi-rents generated by the project. By forming a firm and making the collaborators employees, the entrepreneur gains the right to redefine and reallocate decision rights among the collaborators and to sanction those who do not utilise their rights effectively. This means that the entrepreneur can avoid the haggling and redrafting costs involved in the renegotiation of market contracts. This can make a firm the least-cost institutional arrangement for experimentation.

With regard to the boundaries of the firm, FK argue that when firms are large enough to conduct activities exclusively within its borders - so that no reference to an outside market is possible - the organisation will become less efficient since the entrepreneur will not be able to make rational judgements about resource allocation. When there are no markets for the means of production, there are no monetary prices and thus the entrepreneur will lack the information they need about the relative scarcity of resources to enable them to make rational decisions about resource allocation and whether entrepreneurial profits exists. This implies that as they grow in size, and thus do more internally, firms become less efficient due to the increasing misallocation of resources driven by the lack of market prices. But the boundaries of firms seem to be such that firms stop growing before outside markets for the factors of production are eliminated and market prices become unavailable. So while this idea can explain why one big firm can not produce everything it seems less able to tell us why the boundaries of actual firms are where they are. Real firms seem too small for the lack of outside markets and prices to be driving large efficiencies.

For FK the internal organisation of a firm depends on the dispersion of knowledge within the firm. The entrepreneur will typically lack the information or knowledge to make optimal decisions. So the entrepreneur has to delegate decision-making authority to those who have, at least more of, the necessary information or knowledge. In doing this the firm is able to exploit the locally held knowledge without having to codify it for internal communication or motivating managers to explicitly share their knowledge. But the benefits of delegation in terms of better utilising dispersed knowledge need to be balanced against the costs of delegation such as duplication of effort - due to a lack of coordination of activities, moral hazard, creation of new hold-up problems and incentive alignment.

The things that sets the FK apart from the mainstream is the importance given in their theory to the entrepreneur and that they develop their theory utilising a combination of Knightian uncertainty and Austrian capital theory. But, unlike Spulber (2009), the questions they set out to answer are standard in that they want to explain the existence, boundaries and organisation of the firm.

Refs:

• Brynjolfsson, Erik (1994). `Information Assets, Technology, and Organization', Management Science, 40(12): 1645-62.
• Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm, Cambridge: Cambridge University Press.
• Rabin, Matthew (1993). `Information and the Control of Productive Assets', Journal of Law, Economics and Organization, 9(1) Spring: 51-76.
• Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations, Cambridge: Cambridge University Press.

2014 Nobel Prize in economics: Jean Tirole

A number of people seem more excited by this award than me, see for example, A Fine Theorem, Joshua Gans at Digitopoly and Tyler Cowen at Marginal Revolution. (Peter Klein at Organizations and Markets and Joseph Salerno at the Mises Economics Blog are less excited.)

Cowen does mention Tirole's survey article with Holmstrom on the theory of the firm which is well worth reading even if a few years old now. In a survey paper of mine on the theory of privatisation I say this about a paper by Laffont and Tirole (Jean-Jacques Laffont and Jean Tirole (1991). ‘Privatization and Incentives’, Journal of Law, Economics, & Organization, 7 (Special Issue) [Papers from the Conference on the New Science of Organization, January 1991]: 84-105.):

In the Laffont and Tirole (1991) model a firm is assumed to be producing a public good with a technology that requires investment by the firm’s manager. In the case of a public firm this investment can be diverted by the government to serve social ends. For example, the return on investment in a network could be reduced by the government if it were to allow ex post access to the general population. Such an action may be socially optimal but would expropriate part of the firm’s investment. A rational expectation of such an expropriation would reduce the incentives of a public firm’s manager to make the required investment. For a private firm, the manager’s incentives to invest are better given that both the firm’s owners and the manager are interested in profit maximisation. The cost of private ownership is that the firm must deal with two masters who have conflicting objectives: shareholders wish to maximise profits while the government purses economic efficiency. Both groups have incomplete knowledge about the firm’s cost structure and have to offer incentive schemes to induce the manager to act in accordance with their interests. Obviously the game here is a multi-principal game which dilutes the incentives and yields low-powered managerial incentive schemes and low managerial rents. Each principal fails internalise the effects of contracting on the other principal and provides socially too few incentives to the firm’s management. The added incentive for the managers of a private firm to invest is countered by the low powered managerial incentive schemes that the private firm’s managers face. The net effect of these two insights is ambiguous with regard to the relative cost efficiency of the public and private firms. Laffont and Tirole can not identify conditions under which privatisation is better than state ownership.

Cowen goes on to say,

It’s an excellent and well-deserved pick. One point is that some other economists, such as Oliver Hart and Bengt Holmstrom, may be disappointed they were not joint picks, this would have been the time to give them the prize too, so it seems their chances have gone down.

Hart and Holmstrom's chances may have gone up since they can now be given for their, separate and joint, work on different aspects of the theory of the firm.

So what's "moral" funding?

From the New Zealand Herald comes this gem,

Research funding from the dairying and soft drink industries could be declined on ethical grounds under proposals being worked through by the University of Canterbury.

The university is in the midst of a wide-ranging debate about ethical research funding - who academics should and shouldn't accept money from, and for what research purpose.

Currently, research funding from the tobacco and armaments industries could be declined.

Some academics have argued that should extend to certain industry-funded alcohol, gambling, dairying, mining and soft drink research.

Who the hell cares who funds research? Surely the issue is the quality of the research, not who funds it. If research is able to be published in peer-reviews journals or books hasn't it meet the standards required of academic research? After all if someone thinks you have said or done something wrong in your paper they can write a response to your work pointing out the error. Such a thing is not unusual.

Others believed there should be no prohibition and that the acceptance of funding should be left to individual moral judgements.

Some sanity after all.

Later we are told,

Professor Sally Casswell, a Massey University public health researcher with a particular focus on alcohol, said she strongly believed research funding should not be accepted from the alcohol industry.

But let me guess, she has no problems whatsoever about researchers taking money from anti-alcohol groups.

Such funding was an attempt by the industry to position itself as a partner in policy research, Professor Casswell said, but only industry-friendly policies were supported.

And of course the anti-alcohol groups support all research on alcohol not just industry-unfriendly work. You may not like the conclusions reached by some research but you should play the ball not the man.

Eric Crampton makes good sense on this issue:

However, Dr Eric Crampton, head of research at the NZ Initiative think-tank, said industry-funded research could be extremely valuable, so long as funding arrangements were disclosed and unethical behaviour could be censured.

Dr Crampton previously worked at the University of Canterbury's economics department and was frequently critical of research on the societal harm from alcohol.

He maintains an adjunct senior fellow position with the department.

One-fifth of his university position was funded through a grant from the Brewers Association of Australia and New Zealand, he said, "and everything that I did was totally up for anybody to look at or comment on, or censure me if I was behaving badly".

"It is distortionary to automatically believe that industry funding is bad and evil and that government money comes with no strings and no agenda."

Yes indeed. All research money comes with strings attached, that's why you judge research not on the source of funding but on the quality of the output produced. Unless, of course, you want to make sure your views are the only ones heard.

The Economics of World War I. 4

Another in the series of posts from The Economics of World War I at VoxEU.org

Endowments for war in 1914
Avner Offer 19 September 2014
Victory in World War I relied on three types of energy: renewable energy for food and fodder, fossil energy, and high explosive. This column argues that the Allies had a clear advantage in manpower, coal, and agriculture, but not enough for a quick decision. Mobilisation in continental economies curtailed food production, occasionally to a critical level. Technical competition was a matter of capacity for innovation, not of particular breakthroughs. Coercive military service and rationing of scarce energy and food had egalitarian consequences that continued after the war.

EconTalk this week

Elizabeth Green, author of the new book Building a Better Teacher: How Teaching Works (and How to Teach it to Anyone), talks with EconTalk host Russ Roberts about the art of teaching and the history of various reforms, mostly failed, trying to improve teaching in America. Specific topics include the theoretical focus of undergraduate education programs and various techniques being used in charter schools and elsewhere to improve teaching performance.

A direct link to the audio is available here.

This is simply a bad idea: Labour's asset buying fund.

From the Stuff website comes this news:

Labour is promising to create a new national asset buying fund, giving at least $100 million a year to help raise local ownership.

In the last major policy announcement before Saturday's election, leader David Cunliffe revealed the details of his planned sovereign wealth fund, NZ Inc.

and

Although Cunliffe said the fund would target strategic assets - such as port infrastructure or dairy processing plants - or invest in renewable energy companies, he agreed it could also buy farms or shares in privatised electricity companies.

Labour has said it would not rule out buying back the state assets partially sold in the current term, and the fund appears to be an attempt to court New Zealand First leader Winston Peters into coalition.

Peters has named foreign ownership as a key priority for coalition talks, promising a "buy back" programme of farmland during a speech in Tauranga this week.

While there are problems with the National government's partial "privatisation" policy (more on this below) the answer to these problems isn't to buy back the bits of the firms sold but rather to sell 100% of those SOEs. Also the government is very bad at picking winners to invest in. In addition xenophobia isn't a basis for determining what to invest in.

Why do we want  government ownership? If foreign ownership means a more efficient use of an asset then we want that asset to be in foreign hands. We get a more efficient, and wealthier, economy. If, on the other hand, "local ownership" is more efficient then local private investors will be able to buy and utilise the asset. to our advantage Thus there are either good efficiency reasons for foreign ownership or local ownership will occur without government ownership being necessary. Either way its not clear why we want government ownership.

The fundamental question to be asked is Where is the boundary between what activities the government should carryout and those the private sector should carryout? Insight into this question is provided in Hart, Shleifer and Vishny (1997). Here the issue examined is when should the government carryout production "in-house" and when should it contract out the production of a good or service. In this paper information problems are not the driving force of the analysis of contracting out. The provider of a service, either public or private, can invest his time in improving the quality of the service or reducing the cost of the service. Here quality has a broad interpretation. It can stand for how well prisons treat prisoners, how clean utilities keep the water, how well schools educate their pupils, how long it takes for a letter to reach a remote area or how innovative car makers are etc. The important assumption is that investments in cost reduction have negative effects on quality. Investments are non-contractible ex ante. For the case where the provider is a government employee he must obtain approval from the government to implement any innovation he has created. Given that the government has residual rights the employee will gain only a fraction of return on his investment. This gives him weak incentives to innovate. If the service provider in an independent contractor, i.e. the service has been contracted out, then he will have stronger incentives to both cut costs and improve quality. This is because he keeps the returns to his investment. The downside to private provision is that the incentives to cut costs are strong and the provider does not fully internalise the negative effects on quality of the reductions in cost. With public provision the incentive for excessive cost cutting are reduced as are the incentive for innovation and quality improvements. Costs are always lower under private ownership but quality may be higher or lower under a private owner. Hart, Shleifer and Vishny argue that the case for public provision is generally stronger when (i) non-contractible cost reductions have large deleterious effects on quality; (ii) quality innovations are unimportant; (iii) corruption in government procurement is a severe problem. On the other hand their argument suggests that the case for privatisation is stronger when (i) quality-reducing cost reductions can be controlled through contract or competition; (ii) quality innovations are important; (iii) patronage and powerful unions are a severe problem inside the government.

Hart, Shleifer and Vishny apply this analysis to several government activities using the available evidence on the importance of various factors. They conclude that the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for privatisation is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools.

So what assets does Labour think are "strategic"and thus should be used to produce in-house? And what is a "strategic asset" anyway? The term has no meaning within economics.

Its not clear that the government's past interventions have been in areas where the Hart, Shleifer and Vishny arguments would suggest the government should be involved. Banking, for example, is not a area where cost reduction come at the expense of quality, where innovation is unimportant or where there are any problem with government procurement. So why have the government owning a bank? Also government involvement in Air New Zealand is hard to justify on these grounds. As noted above, the case for private sector provision is stronger when quality reducing cost reduction can be controlled through competition, and the airline industry is very competitive, when quality innovations are important, and we want a high quality and innovative airline industry, and when patronage and powerful unions are a severe problem inside the government, which are things we wish to avoid with an airline. Here private provision makes sense.

So what will be invested in, and how will the assets be picked? And why should the government be involved in these businesses in the first place?

And what of governments, or their agents, picking winners? Some years ago economist Tim Harford had a piece up at Forbes.com in which he tries to unravel why governments so unerringly back losers. Harford points out that "[i]f you want to dismay an economist, just mention the phrase "national champion."" On hearing such a phrase economists automatically think of "wheezing corporate behemoths protected from domestic competition, propped up with generous government subsidies and shielded behind trade barriers." I suspect that the expression "strategic asset" would have much the same affect on economists. Not a pretty picture, it has loser written all over it. So, asks Harford, if governments want to back winners, Why are they so good at backing losers?. He answers,

Partly, it's because picking the winners is inherently a difficult job. Left alone, the market does a great job of rewarding the very best and cutting the rest down to size. Any corporation that gets big and stays big in a competitive environment is likely to be very good at what it does. A corporation that stays big only because of government backing probably won't be.

He then goes on to explain that government favouritism may have a somewhat more sinister logic behind it,

Namely, firms in emerging, competitive industries have virtually no incentive to lobby for government hand-outs, while firms in aging, shrinking industries have the most to gain.

The reason for this is simple he says,

Firms in an open, competitive, growing young industry have little to gain from government support. More government funding for, say, biotechnology, is going to mean more biotechnology companies, more competition and (perhaps) more innovation. That might be good for America, but probably not much good for any single biotech company. Sure, they'll all enjoy the government help, but each must weigh that assistance against the swarm of new competitors attracted by the handouts. No one firm would choose to hire top lobbyists and send them to D.C. to bring back the pork.

By contrast, firms in aging, shrinking, capital-intensive industries have everything to gain from government support. Because the industry is shrinking and it's expensive to enter--think steel mills--the government subsidies and tax breaks are probably not going to attract new competitors. If there are no new competitors, the old guard gets to pocket all the money.

D R Myddelton looked at a related question in his recent book They Meant Well: Government Project Disasters. In this work, published by the Institute of Economic Affairs in London, Myddelton asks How is it that so many major, government-sponsored projects can lose so much money? He points out that the the answer to this question does not lie with malign intentions on behalf of their promoters in government. On the contrary the supporters within government of such projects only have the best of motives, so why do these projects go so wrong?

Myddelton considers six projects covering a period of 80 years to find answers. He looks at The R. 101 airship, the groundnut scheme, nuclear power, Concorde, the channel tunnel and the infamous Millennium Dome. A recurring rationale for these grandiose projects has been to boost "national prestige", but this concept has little real value.

Myddelton's explanation for the continual failure of such projects is that failure results from mismanagement, lack of clear lines of responsibility and lack of accountability. The point is made that

[n]one of the six projects was well managed and many of the failures were down to politicians: installing inadequate or over-complex organisations, appointing incompetent managers, or insisting on excessive secrecy.

These problems have their roots in the wider economic problems of undertaking quasi-commercial ventures in the public, rather than in the private, sector. This results, argues Myddelton, in well-meaning politicians and government officials wasting huge sums of taxpayers' money.

The arguments of both Harford and Myddelton should make us apprehensive when governments start talking of "national champions" or "strategic assets" and starting want to back these notions with our money. Odds are things will end badly.

Folsom and Folsom (2014) looks at the history of government investments in the U.S. covering everything from beaver pelts to railroads to green energy, and again things ended badly.

In short, there are good reasons for thinking the government, or its agents, will pick losers rather than winners.

To return to the point made at the beginning that there are problems with the current government's policy of selling 49% of SOEs. To see the problems note that most of the privatisation programmes enacted around the world - including New Zealand, as well as the general political debates that have surrounded the sale of state assets, have taken place with little or no reference to the economic theory of privatisation. Taking a look at the literature on the contemporary incomplete contracts approach to privatisation we can conclude a number of things several of which are directly applicable to the 49% sale programme of the New Zealand government.

First, one of the most important results is what can be interpreted as ``existence results" that show that even in a world of totally benevolent governments privatisation can still be optimal. Secondly, it can be reasonably argued that the practice of selling less than 51% of an SOE does not constitute privatisation. Under such a plan the state remains the primary force responsible for deciding the outputs (and possibly the inputs) of the firm, rather than the market. This means that programmes such as the recent policy by the New Zealand government of selling just 49% of SOEs is not genuine privatisation. The results flowing from the papers utilising the British definition of privatisation implicitly assume that full control is transferred to the private sector. Thirdly some of the results above suggest that the government is involved in areas of the economy where private provision is more efficient. Sectors of the economy like banking, mining and airlines are examples of areas where innovation is likely to be important and competition can deal with any deleterious effects on quality, which suggests that public provision is less likely to be welfare enhancing. See the discussion of the Hart, Shleifer and Vishny paper above. Fourthly, a firm's ownership can depend on its investment requirements since different ownership structures result in different patterns of investment and thus depending on the desired nature of investments different forms of ownership can be optimal. Fifthly, an important driver of several of the results presented above is the degree to which politicians can interfere, ex post, with the operations of the firm. The lower the cost of interference the greater the likelihood of firms being induced to serve political rather than economic ends. This highlights the importance of post-privatisation regulation, and competition, to the outcome of an asset sales programme. Sixth there is an implicit assumption in the literature discussed above that economic efficiency is a major objective of privatisation but the, ex ante, conditions sometimes imposed by governments on the sale of assets often serve political rather than economic ends. Examples of such conditions are things like the New Zealand governments restrictions on foreign ownership and the desire to sell to ``Mums and Dads" which restricts the number of possible bidders. Such conditions also result in fragmented ownership making it difficult for owners to coordinate their efforts to effect the firm's behaviour. In addition given that each ``Mum or Dad" will own only a very small share of any of the firms, they have little incentive to become informed on the firm's activities since they will only capture a very small amount of any improvement in performance they could bring about. These factors suggest that in practice little will change in terms of the behaviour of the SOEs, they will remain, for all intents and purposes, government controlled entities. This contradicts the very reason for privatising SOEs in the first place.

The answer to the problems with the National government's asset sales programme is not a buy-back plan like that being suggested by Labour but rather the opposite: the sale of 100% of the SOEs in question.

Ref:

• Folsom Jr., Burton W. and Anita Folsoms (2014). Uncle Sam Can't Count: A History of Failed Government Investments, from Beaver Pelts to Green Energy, New York: Broadside Books.
• Hart, Oliver D., Andrei Shleifer and Robert W. Vishny (1997). `The Proper Scope of Government: Theory and an Application to Prisons', Quarterly Journal of Economics, 112(4) November: 1127-61.

How did the west get so rich?

In this audio Deirdre McCloskey is interviewed on the Tom Woods Show. Deirdre McCloskey, author of The Bourgeois Virtues, among many other books, discusses the real reason for why west got rich and why the traditional explanations fail.

A research agenda on NZ's productivity

One of the most discussed issues to do with the New Zealand economy is New Zealand's less than stellar history of productivity growth. We do OK for a couple of years every now and then, but we can't keep it up. Trying to explain this history is a complex and difficult task but one which the "Productivity Hub" - a part of Government Economic Network - was set up to help coordinate.

Patrick Nolan has a paper in Policy Quarterly - vol. 10 no. 2 May 2014 - outlining the development by the Productivity Hub of a "Forward Looking Agenda of Research" or FLARE. Yes you do have to wonder if they couldn't have come up with a better name.

Nolan writes,

The objective of FLARE is to provide a list of relevant research projects which would advance understanding of New Zealand's productivity issues and ultimately improve policy. A short-list of proposed projects for the next two years is shown in Figure 2.

Figure 2 is

One thing with regard to point 1 in Figure 2 is that the theory of firm-level productivity isn't based on the theory of the firm. It is based on the theory of production - think what you were taught about production in 2nd year micro, for a book length discussion see Rasmussen (2013). For a survey of the contemporary theory of the firm see Walker (forthcoming). The theories are very different and are useful for examining different aspects of the productivity puzzle. This bring me to a related point that Nolan makes,

Although these are largely descriptive questions, they are nonetheless important, as clearly identifying what you are dealing with is a useful starting point for analysis. Further, this descriptive analysis will provide a basis for an improved understanding of how changes take place at the level of the firm.

To fully understand such changes requires recourse to the boarder area of organisational economics (see Gibbons and Roberts 2013) rather than just an emphasis on the theory of the firm or on production economics. Looking in side the firm to see how changes in management, in corporate culture, incentives within the firm, internal labour markets etc alter productivity seems important.

Nolan goes on to say,

As Sautet (2000) noted, many currently accepted theories of the firm cannot provide insights into important market phenomena such as entrepreneurship.

While there is truth to Sautet's comment, this is an area in which progress is being made. Two recent examples are Spulber (2009) and Foss and Klein (2012) - for a quick summary of these works see sections 3.2 and 3.3 of Walker (forthcoming).

Nolan also notes, correctly, the importance of understand the data utilised in empirical studies.

This approach should also help to contribute to efforts to improve measures of productivity and understanding of their limits, including the differences between firm-based and economy-wide (macro) measures.

This point about difference in micro and macro measure highlighted by the debate over the so-called "Solow Paradox"- Robert Solow famously quipped in a 1987 review of the book “Manufacturing Matters: The Myth of the Post-Industrial Economy” that: “[y]ou can see the computer everywhere but in the productivity statistics”, a remark that has given rise to what is often called the “Solow productivity paradox”. It turns out that the paradox is a paradox only at the macro data level, micro-level data provides little evidence in support of Solow’s paradox. Pilat (2004: 11) explains “[s]tudies with firm-level data often find the strongest evidence for economic impacts of ICT.” Recent research on the productivity paradox based on firm-level data suggests that ICT use is beneficial to firm performance and productivity, even for industries and countries where there is no evidence at the more aggregate levels. This result holds for all countries in which micro-level studies have been carried out. For example, studies have found that ICT capital deepening increased labour productivity in services firms in Germany and the Netherlands. A close correlation between labour productivity and ICT use was found for Swiss firms. Another study looked at ICT use in Finland and concluded there are productivity-enhancing effects associated with ICTs. Yet more work found that greater use of ICTs was associated with higher labour productivity growth in the nineties for Canada. Another paper analysed U.K. data and found a positive effect on labour productivity and multi-factor productivity associated with the exploration of computer networks for trading. U.S. data was used to demonstrate that average labour productivity was higher in plants with computer networks with labour productivity being around 5 percent higher for such plants.

Serious thinking about the data used in empirical studies is not given enough emphasis.

There are  many other interesting and important issues raised in  Nolan's paper which if you are interested in New Zealand's productivity performance is well worth reading.

Refs.:

• Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm. Cambridge: Cambridge University Press.
• Gibbons, Robert and John Roberts (2013). The Handbook of Organizational Economics, Princeton: Princeton University Press.
• Pilat, Dirk (2004). ‘Introduction and Summary’. In OECD, The Economic Impact of ICT − Measurement, Evidence and Implications, Paris: Organisation for Economic Cooperation and Development.
• Rasmussen, Svend (2013). Production economics: The Basic Theory of Production Optimisation, Berlin: Springer-Verlag.
• Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations. Cambridge: Cambridge University Press.
• Walker, Paul (forthcoming). "Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective". Journal of Economic Surveys.

Mixed messages

From the back of a packet of throat lozenges I saw in the supermarket:

[...] Lozenges have been formulated to give effective and rapid relief from painful and inflamed sore throats. Their dual action formula contains a local anaesthetic to numb the throat while the two antibacterial agents help kill the bacteria which can cause sore throats and mouth infections.

followed by

The efficacy of an antibacterial agent in lozenges in reducing the severity or duration of throat infections has not been clinically established.

Now doesn't the second bit kinda undermine the first bit?!

The advantages of beer drinking

.... at least in Russia.

Understanding consumer behaviour is crucial for many economic questions. A new column - The persistence of consumption habits by Lorenz Kueng and Evgeny Yakovlev - at VoxEU.org looks at the persistence of consumer habits towards alcohol among Russian males. Beer sales expanded rapidly after the collapse of the Soviet Union both in levels and relative to vodka sales, driven mainly by the beer consumption of cohorts born in the 1980s and 1990s. The authors estimate that this trend will reduce the male mortality rate in Russia by one quarter in the next 20 years.

The conclusion of the paper is,

We study the implications of our results for the evolution of life expectancy of working age males, taking into account the persistent habits we uncovered. It is important to note that of the 40% alcohol-related deaths each year, only about 7% are due to alcohol poisoning. Over 30% are due to external causes related to alcohol intoxication, including vehicular and other accidents and homicides, and hence are also unrelated to long-run consequences of alcohol consumption, such as liver cirrhosis. To proceed with the analysis, we estimate a hazard model of death as a function of the share of alcohol consumed, controlling for many individual characteristics, in particular the level of total alcohol intake. The estimates show that consuming the same level of alcohol but doing so by using more vodka rather than beer is associated with a significantly higher mortality rate, both statistically and economically.

Using our results, we estimate that male mortality in Russia will decrease by one quarter within 20 years even under the status quo, that is, under the current set of policies and current levels of relative prices of alcoholic beverages. This will happen simply because new generations will be more accustomed to beer and will replace older generations with strong preferences for vodka. Since much of the gap in male life expectancy is due to occasional binge drinking (even holding fixed the average level of alcohol intake), which in turn is more likely to occur for males who prefer vodka, this shift in consumption habits toward beer has strong effects on life expectancy. Hence, this reduction in the male mortality rate will be the result of changes that occurred several decades ago.

So drinking beer rather than vodka has its positives.

I am confused about Coase and the division of labour

An intersting new working paper by Per L. Bylund considers Signifying Williamson's Contribution to Coase's Transaction Cost Approach: An Agent-Based Simulation of Transaction Costs and Specialization. The abstract reads,

This paper simulates Ronald Coase's transaction cost approach to firm organizing using agent-based modeling, and contextualizes and contrasts it with the earlier division-of-labor/specialization theory of the firm that Coase challenged and sought to replace. The simulation tests firm emergence by targeting the difference between the theories, especially Coase’s rejection of specialization as an explanation for integration in the firm. The results show little support for, and suggest a shortcoming to, Coase’s transaction cost theory. These findings indicate a potential relationship between the pre-Coasean theory and Williamson’s Transaction Cost Economics, which can help shed light on the latter’s significant influence in the theory of the firm. (Emphasis added).

It is the idea in bold that confuses me. Consider the following from an interview with Coase:

Wang: Microeconomics is about demand and supply. Compared with classical economics, marginal analysis clearly offers a deeper understanding of consumer choice. But I don’t think it is equally powerful in explicating production, the supply side of the economy.

Coase: To understand production, we have to go back to Adam Smith’s division of labor. It serves well as a starting point, even though the modern economy today has become far more complicated.

Wang: This must be Smith’s most undeserving failure. Modern economics is built on Smith’s framework of the “invisible hand”. But it leaves no room for the division of labor.

Coase: Modern economics shows little interest in production. I am not sure production function tells us anything about production in the economy.

Wang: Adam Smith used the pin factory as an example to develop his analysis of the division of labor. Today, to investigate the division of labor, we can no longer afford to confine our focus to a single firm. Instead, we have to study the organizational structure of production.

Coase: That’s right. The firm remains the cell of the economy, but the intricate relations and constant interactions among the cells determine economic dynamism.

Is this really a man challenging the division of labour?

Also consider this piece from Coase and Wang (2011):

Price theory is primarily concerned with resource allocation, with little to say about production and innovation. The study of the industrial structure of production offers a research program to bring the division of labor back to the center of economics, with direct implications for the study of innovation and entrepreneurship.

Again, does this sound like a man trying to replace the division as an explanation for production, rather the opposite I would think. Coase seems to be saying we need to emphasise the division of labour.

Ref.:

• Coase, Ronald H. and Wang, Ning (2011) 'The Industrial Structure of Production: A Research Agenda for Innovation in an Entrepreneurial Economy', Entrepreneurship Research Journal, 1(2): Article 1.

A "pretense of knowledge" problem? 2

In the comments section to my previous post on this topic Donal Curtin makes the point that

However, unfortunately but unavoidably, it is the job of regulators to set some prices in situations where important markets aren't functioning competitively. I'd prefer if it wasn't, and personally I'd fire the price regulation gun only as a last resort if all other more market-friendly options were exhausted. But that said, even generally pro-market governments find themselves setting some prices. I agree that the process is imperfect, and there are multiple methodology and other choices to make along the way each of which introduces room for error. But sometimes it has to be done, and as well as you can manage, and preferably (as ComCom tends to do) with investment-friendly "err on the high side" numbers, to keep investment flowing into the regulated sector. The opportunity cost point is fine, but I wonder if in practice it's addressed (albeit in some rough and ready fashion) when regulators set a rate of return equal to that earned by "similar" sorts of activity, given that they're likely to be the sorts of activities the regulated company would otherwise have pursued?

My point here would be, and let me go all Coaseian for a moment, that comparative institutional analysis is needed. The first thing the regulators have to show is that their "wrong solution" is likely to be better than the market "wrong solution". It is possible that the regulated outcome is worse that the unregulated one. As Coase said in an interview with Reason magazine in 1997:

Reason: You said you're not a libertarian. What do you consider your politics to be?

Coase: I really don't know. I don't reject any policy without considering what its results are. If someone says there's going to be regulation, I don't say that regulation will be bad. Let's see. What we discover is that most regulation does produce, or has produced in recent times, a worse result. But I wouldn't like to say that all regulation would have this effect because one can think of circumstances in which it doesn't.

Reason: Can you give us an example of what you consider to be a good regulation and then an example of what you consider to be a not-so-good regulation?

Coase: This is a very interesting question because one can't give an answer to it. When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies--perhaps all the studies--suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been. I was not willing to accept the view that all regulation was bound to produce these results. Therefore, what was my explanation for the results we had? I argued that the most probable explanation was that the government now operates on such a massive scale that it had reached the stage of what economists call negative marginal returns. Anything additional it does, it messes up. But that doesn't mean that if we reduce the size of government considerably, we wouldn't find then that there were some activities it did well. Until we reduce the size of government, we won't know what they are.

My issue is that regulators don't seem to think like this, they just seem to assume that whatever they do will be better than what it occurring without their intervention. And I just want them to show that their regulated outcome is likely to be better than the current, albeit imperfect, market situation.

How to misunderstand the Coase theorem 5

Someone else get it! James Johnson at the Monkey Cage gets the point that the Coase Theorem doesn't apply to the reclining seats in airplanes issue. He writes,

In a recent post Josh Barro provides an example by misinterpreting one theoretical argument commonly known as “the Coase Theorem.”

Barro is commenting on a fracas aboard United Airlines flight 1462 last week. One passenger attached an apparatus to the seat in front of him preventing the woman occupying that seat from activating its recline function. When asked by a flight attendant to remove the apparatus the man refused. This caused mayhem that resulted in the pilot diverting the flight so that both passengers could be removed from the plane and reported to the authorities.

Barro declares himself a frequent flier and unrepentant recliner. He seems genuinely perplexed by the animus toward people like himself, reflected in media commentary, this fracas reveals. In his defense Barro invokes the “Coase Theorem” which, he believes, provides useful advice for how to avoid situations like the one that erupted on United 1462. He poses this question: “If sitting behind my reclined seat was such misery, if recliners like me are ‘monsters,’ as Mark Hemingway of The Weekly Standard puts it, why is nobody willing to pay me to stop?” Unfortunately for Barro, the Coase Theorem does not support the conclusion he draws. If we consider what the Coase Theorem actually says, we won’t be surprised either by the events on United 1462 or by the fact that no one offers Barro money to change his reclining ways.

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Coase’s argument appears to generalize the virtues of decentralized market exchange, namely voluntary action generating efficient outcomes, to situations of strategic interdependence where markets tend to function poorly, if at all. For it to work, however, two conditions must hold. First, the initial distribution of property rights must be well defined. Second, transaction costs must be zero. This is where Barro goes astray. In the dispute between recliners and reclined upon, neither condition obtains.

Barro recognizes the first condition. He insists that, having purchased a seat with a recline option, passengers “own the right to recline.” Consequently, by installing an apparatus on the seatback in front of him, the man on United 1462, “usurped his fellow passenger’s property rights.” This claim is contestable. What is at issue is increasingly limited space and access to it. And if crew member instructions provide any indication, passengers “own the right” to the space under the seat in front of them where they are told to place their carry-on items. Recliners limit the reclined-upon passenger’s access to that space and any belongings stowed there. Moreover, passengers purchase a seat with a tray table and arguably “own the right” to use it for a variety of purposes. Reclining often interferes with that right as well. The airlines and the government treat recline function and tray tables as equivalent in their safety instructions: “In preparation for landing please make sure your tray table is stowed and your seat back is in the upright and locked position.” Despite his confident assertion, Barro is mistaken to assert that property rights to space for airline passengers are well-defined.

Even if you accept Barro’s view of property rights, what about transaction costs? Here Barro is sloppy. He depicts the dispute between recliners and reclined upon as one where “transaction costs are low.” Coase, however, insists that for his argument to work, transaction costs must be zero. Not low. Zero. Yet the reclined upon face substantial transaction costs. Most obviously, information problems abound, even beyond the ambiguous distribution of property rights. It would be costly to discern which type of person they might be bargaining with. Are they sitting behind an inveterate recliner and who might turn belligerent if asked not to recline, even for a price? Is the passenger in front of them a moralist who will take offense at the very suggestion of treating one another as bargaining partners rather than relying on norms of decency and respect? Other such possibilities are plentiful. Barro simply dismisses such problems because it suits his claim that, if only they would try, the reclined upon could easily buy off recliners like himself.

That property rights to the space around a seat are not well defined is the point I made in my first post on this issue. I am not so sure about Johnson's second point. I would say that transactions are low in that you know who you are bargaining with and its simple to bargaining with them, they are just in front of you. This doesn't mean that bargaining will not be hard. I don't see anything in the Coase Theorem that says bargaining must be easy, it just says whoever values the property right most will end up with it. May be only after some tough negotiations.

How not to run a company

At the Offsetting Behaviour blog Eric Crampton reminds us of one of the great stories about the inefficiency of the old Eastern Block. Eric writes,

Remember the story of the West German auto exec who, after touring the Trabant plant, wept because the value of the steel and other inputs going in exceeded the value of the car coming out? The Trabant plant was destroying value.

For those who don't know it, the story comes from a World Bank publication, Transition: a newsletter of the World Bank, Number 5-6, May-June 1996, page 15:

With a view to corporate takeover Volkswagen AG sent a Herr Heuss to Zwickau to find out how the Trabant (relatively cheap, East German cars) were made there. He emerged shocked from the huge plant, babbling "My God!" The Trabant operation was value-subtracting: valuable material, labor, and capital inputs went in at one end; shabby Trabies came out at the other, their bodies made from compacted trash. The final output was worth less than the sum of the inputs. What was not fully understood at the time was that East Germany's whole economy was value-subtracting and cost-unconscious.

I still can't get my head round the idea that "production" is value decreasing! But its something to keep in mind when there are those who would have the government take a much greater role in running the economy and owning firms. It doesn't doesn't always end well.

A "pretense of knowledge" problem?

Over at the, ever interesting, Economics New Zealand blog Donal Curtin writes,

Chorus got bowled like ninepins this morning by the Court of Appeal, having earlier been skittled by the High Court.

The cases were about the Commerce Commission proposing a big reduction in the price Chorus could charge for UBA, or as it is formally defined, "the additional UBA service component, which allowed access seekers to supply broadband services over Telecom’s copper access lines without investing in their own equipment or software". In other words, the bits and bobs that carry broadband traffic across the gap between the copper line from your place and the start of an ISP's network.

The reduction (roughly halving the price) had been based on a benchmarking exercise, where the Commission (as required by the Telecommunications Act) looked at the prices overseas for UBA as a quick and dirty proxy for what it might well cost here. There's lots more about the exact details of the benchmarking comparability exercise, but that's the gist of it.

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So now on we go to the Commission's final word on the UBA price, which will be determined by modelling the actual costs of an efficient provider in New Zealand (Chorus had exercised its right to object to the benchmark stab at the price and to have local costs estimated explicitly).

So what's my problem here? In short, it isn't the job of courts or regulators to determine costs or prices. About the only thing you can say about outcomes determined by such procedures is that they are wrong. As I noted in a post a couple of days ago, Dixit on costs, Avinash Dixit writes that,

In other words, opportunity costs are the correct measure. But these are based on expectations and calculations done within firms, and are not available in reported data.

If we accept this, then its not clear what basis the regulator or the courts have for determining costs and thus prices. At best these bodies have to deal with "reported data" but as noted such data misses some of the most important determines of opportunity costs. Without measures of theses how can a regulator or court arrive at any sensible view on what costs are?

Looks like there is a bit of the "pretense of knowledge" problem here.

Innovation, exports and technical efficiency

What are the effects of the size of the market in which a firm operates on the efficiency and productivity of the firm? According to a new working paper by M. Ángeles Díaz-Mayans and Rosario Sánchez-Pérez those Spanish firms involved in exporting, and thus facing a market much larger than just the local market, are more efficient and productive.

The abstract of the paper reads,

This paper analyses the relationship between exports, innovative activities and size and their effect over firms’ technical efficiency and then over their productivity. The analysis takes, also, into account other variables that could affect productivity as industrial sector, or firms’ financial conditions. We use a micro panel data set of Spanish manufacturing firms, during the period 2004–2009, to simultaneously estimate a stochastic frontier production function and the inefficiency determinants. The data source is published in the Spanish Industrial Survey on Business Strategies (Encuesta sobre Estrategias Empresariales, ESEE), collected by Fundación SEPI. Our results show that exporting firms are more efficient than non-exporting firms; and that small and medium-sized firms’ tent to be more efficient when they focus on international markets.

An obvious question this gives raise to is, Why? From the conclusion of the paper,

The inefficiency determinants can be due to environmental or firm specific factors. Here we focus on these firms specific factors to provide an explanation to the differences in technical inefficiency across Spanish manufacturing firms. Inefficiency tends to be smaller for firms with a higher ratio of gross investment over capital. Firms that account for this kind of investment become more competitive as a consequence of having a higher efficiency in their production process.

Also, we found that exporting firms are closer to the stochastic frontier. They have to be more competitive to sell in international markets. Only the most efficient firms survive in the highly competitive international market.

Size is another determinant of technical efficiency. Even though the impact of size in technical efficiency is not clearly determined in empirical and theoretical frameworks, here we obtain a positive and significant effect over efficiency. What it means that large firms are closer to the efficient frontier.

In addition, efficiency tends to be smaller for those firms with a higher proportion of external funds over value added.

None of these results seem counter-intuitive but you may ask about causation in some cases. For example does size help determine efficiency or does efficiency help determine size? That is, it is the more efficient firms that grow?

Anyway, more reasons for supporting free trade.

EconTalk this week

Paul Pfleiderer, C.O.G. Miller Distinguished Professor of Finance at the Graduate School of Business at Stanford University, talks with EconTalk host Russ Roberts about his recent paper critiquing what Pfleiderer calls "Chameleon Models," economic models that are thought to explain the real world with little analysis of the accuracy of their assumptions. Also discussed are Akerlof's market for lemons model, Friedman's idea that assumptions do not have to be reasonable as long as the model predicts what happens in the real world, and the dangers of leaping from a model's results to making policy recommendations.

A direct link to the audio is available here.

Innovation, inequality and economics: Edmund Phelps is interviewed by Mark Thoma

From VoxEU.org comes this video in which Edmund Phelps and Mark Thoma discuss a number of topics including Phelps's argument that a loss of dynamism in the western world is stalling innovation thereby reducing productivity growth and threatening future prosperity, graduate economics education, inequality and austerity.

EconTalk last week

Nathan Blecharczyk, co-founder and chief technology officer of Airbnb, talks with EconTalk host Russ Roberts about Airbnb, one of the earliest companies to use technology to allow individuals to share underused resources, and in the case of Airbnb, housing. Blecharczyk and Roberts discuss how a design conference and the Democratic National Convention got Airbnb started, how the company aligns incentives to overcome the trust problem of house-sharing, and the rise of technology and online social networks to make a new business model possible. Along the way, Blecharczyk gives his take on the role of luck vs. skill in entrepreneurial success and how Airbnb plans to expand its product offerings in the future.

A direct link to the audio is available here.

Dixit on costs

From Avinash Dixit's new book, Microeconomics: A Very Short Introduction, comes this discussion of costs and the supply curve. Dixit is discussing an example of calculating a short-run supply curve for crude oil.

Although this example makes the idea of a supply curve stand out vividly, it is merely illustrative. First, data are not available for all countries; for example Russia and China are omitted for want of cost data. Second, countries or regions are not the right unit of analysis. Ideally we should have data on lifting costs and capacities for all the thousands of individual wells. These differ greatly within a country; they would generate a smooth supply curve instead of the large steps shown. Finally and most importantly, lifting costs are not correct short-run marginal costs. Firms that operate the wells have the choice of leaving oil in the ground, thus producing at less than full capacity, if they believe that prices will rise in the future. In other words, opportunity costs are the correct measure. But these are based on expectations and calculations done within firms, and are not available in reported data. Therefore this example can be used to improve understanding of the ideas, but should not be taken literally (Emphasis added).

One implication of the bit in bold is that, at best, without detailed firm level data you cannot estimate a supply curve. But as expectations are subjective, at least to some degree, it may be impossible to get data on the opportunity costs at all. The expectations held by members of the firm will differ depending on the particular person being asked. Also even if that person can detail their expectations well enough to be part of a quantifiable data set, the data will change person by person. Thus the whole idea of an objective cost function that can be estimated from "the data" becomes untenable.

Now there's a thought that could ruin an econometrician's day.

You know your economy is in even more trouble when ......

This from the Economist magazine:

Venezuela is in trouble. Such trouble, in fact, that the central bank (BCV) has not published GDP figures since the beginning of the year and is two months behind with inflation figures. Leaks from inside the BCV suggest annual inflation is now well over 60% and that GDP fell by almost 5% in the first half of 2014. Shortages of food, medicines and other basic goods, including spare parts and tyres for vehicles, have reached critical levels. Representatives of private health clinics say more than half have suspended elective surgery for lack of crucial supplies and parts for medical equipment. The government plans to address shortages by fingerprinting customers to prevent them from buying extra goods to sell on the black market.

Dependent on oil revenues for 97 out of every hundred dollars in foreign earnings, and on imports for a large part of what it consumes, the country is heavily in debt to foreign suppliers, many of whom have cut off credit. But instead of adopting an adjustment plan, the government has continued to print money and introduce ever more stringent price and exchange controls. Massive price differentials with neighbouring Colombia have fuelled the contraband trade, to which the authorities have responded by closing the border at night.

You can't help but think that this can't end well.