Kevin Bryan on Bengt Holmstrom and the black box of the firm

Kevin Bryan writes at VoxEU.org on the key contributions of Bengt Holmstrom to the theory of contracts and its application to the theory of the firm. Bryan opens by saying,

Holmström’s contribution lies most centrally in the area of formal contract design. Imagine that you want someone – an employee, a child, a subordinate division, an aid contractor or, more generally, an ‘agent’ – to perform a task. How should you induce them to do this?

If the task is ‘simple’ – meaning that the agent’s effort and knowledge about how to perform the task most efficiently is known and observable – you can simply pay a wage, cutting off payment if effort is not being exerted. When only the outcome of work can be observed, if there is no uncertainty in how effort is transformed into outcomes, knowing the outcome is equivalent to knowing effort, and hence optimal effort can be achieved via a bonus payment made on the basis of outcomes.

All straightforward so far. The trickier situations, which Holmström and his co-authors have analysed at great length, are when neither effort nor outcomes are directly observable.

Consider paying a surgeon. You want to reward the doctor for competent, safe work.

Perhaps a real world example of such a contract may help illustrate that is happening here. Below are details of the contract for surgeons on the ships that transported colonists to the province of Canterbury in New Zealand in the 1850s.

So real people where into incentives contracts long before economists started formal investigation of them!!!

The British economist Edwin Chadwick was also thinking about  about such issues in the mid-1800s. Chadwick pondered the question of incentives for the transportation of prisoners from the UK to Australia. Chadwick noted:

​[I]n the first instance, a capitation payment was made on embarkation, and this resulted in the loss of half the conve​cts put on board ; by degrees that loss was reduced to one-third ; but when, under the auspices of a new colonial administration, the system was altered to a capitation payment for all the convicts that were landed at their destination, the contrast was ​very​ ​ striking indeed, and tho owners of the vessels carried surgeons, and the best means were devised for landing the largest possible number at the port for which they were bound.

But as Byran notes that Holmstrom was aware that in general, in the modern case, it is very difficult to observe perfectly what the surgeon is doing at all times, and basing pay on outcomes has a number of problems:

1. First, the patient outcome depends on the effort of not just one surgeon, but on others in the operating room and prep table. Team incentives must be provided.
2. Second, the doctor has many ways to shift the balance of effort between reducing costs to the hospital, increasing patient comfort, increasing the quality of the medical outcome, and mentoring young assistant surgeons. So paying on the basis of one or two tasks may distort effort away from other harder-to-measure tasks. There is a multitasking problem.
3. Third, the number of medical mistakes, or the cost of surgery, that a hospital ought to expect from a competent surgeon depends on changes in training and technology that are hard to know, and hence a contract may want to adjust payments for its surgeons on the performance of surgeons elsewhere. Contracts ought to take advantage of relevant information when it is informative about the task being incentivised.
4. Fourth, since surgeons will dislike risk in their salary, the fact that some negative patient outcomes are just bad luck means that you will need to pay the surgeon very high bonuses to overcome their risk aversion. When outcome measures involve uncertainty, optimal contracts will weigh ‘high-powered’ bonuses against ‘low-powered’ insurance against risk.
5. Fifth, the surgeon can be incentivised either by payments today or by keeping their job tomorrow, and worse, these career concerns may cause the surgeon to waste the hospital’s money on tasks that matter to the surgeon’s career beyond the hospital.

Holmström wrote the canonical paper on each of these topics. His 1979 paper shows that any information that reduces the uncertainty about what an agent actually did should feature in a contract, since by reducing uncertainty, you reduce the risk premium needed to incentivize the agent to accept the contract.

It might seem strange that contracts in many cases do not satisfy this ‘informativeness principle’. For example, CEO bonuses are often not indexed to the performance of firms in the same industry. If oil prices rise, essentially all oil firms will be very profitable, and this is true whether or not a particular CEO is a good one. Bertrand and Mullainathan (2001) argue that this is because many firms with diverse shareholders are poorly governed.

Bryan continues,

Much of Holmström’s work in the 1980s and 1990s tried to square the gap between theory and empirics by finding justifications for the simplicity of many real world contracts that can be rationally justified.

Written jointly with Paul Milgrom, the famous ‘multitasking’ paper published in 1991 notes that contracts shift incentives across different tasks in addition to serving as risk-sharing mechanisms and as methods for inducing effort. Since bonuses on task A will cause agents to shift effort away from hard-to-measure task B, it may be optimal to avoid strong incentives at all (just pay teachers a salary rather than a bonus based only on test performance) or to split job tasks (pay bonuses to teacher A who is told to focus only on mathematics test scores, and pay salary to teacher B who is meant to serve as a mentor).

That outcomes are generated by teams also motivates simpler contracts. Holmström’s 1982 article on incentives in teams points out that if both my effort and yours is required to produce a good outcome, then the marginal product of our efforts are both equal to the entire value of what is produced, hence there is not enough output to pay each of us our marginal product. What can be done?

Alchian and Demsetz had noticed this problem in 1972, arguing that firms exist to monitor the effort of individuals working in teams. With perfect knowledge of who does what, you can simply pay the workers a wage sufficient to make the optimal effort, then collect the residual as profit.

Holmström notes that the monitoring isn’t the important bit; rather, even shareholder-controlled firms where shareholders do no monitoring at all are useful. The reason is that shareholders can be residual claimants for profit, and hence there is no need to distribute profit fully to members of the team.

A brief discussion of a simple version of Holmstrom's 1982 paper, due to Kim C. Border, and its relationship to Alchian and Demsetz's work is given in chapter 4 of The Theory of the Firm: An overview of the economic mainstream.

Bryan goes on:

Free-riding can therefore be eliminated by simply paying team members a wage of X if the team outcome is optimal, and zero otherwise. Even a slight bit of shirking by a single agent drops their payment precipitously (which is impossible if all profits generated by the team are shared by the team), so the agents will not shirk. Of course, when there is uncertainty about how team effort transforms into outcomes, this harsh penalty will not work, and hence incentive problems may require team sizes to be smaller than that which is first-best efficient.

A third justification for simple contracts is career concerns: agents work hard today to try to signal to the market that they are high-quality, and do so even if they are paid a fixed wage. This argument had been made less formally by 2013 Nobel laureate Eugene Fama, but Holmström in a 1982 working paper (finally published in 1999) showed that this concern about the market only completely mitigates moral hazard if outcomes within a firm are fully observable to the market, or the future is not discounted at all, or there is no uncertainty about agent’s abilities. Indeed, career concerns can make effort provision worse; for example, agents may take actions to signal quality to the market that are negative for their current firm.

A final explanation for simple contracts comes from Holmström’s 1987 paper with Milgrom. They argue that simple ‘linear’ contracts, with a wage and a bonus based linearly on output, are more ‘robust’ methods of solving moral hazard because they are less susceptible to manipulation by agents when the environment is not perfectly known. [...]

These ideas are reasonably intuitive, but the way Holmström answered them is not. Think about how an economist before the 1970s, like Adam Smith in his famous discussion of the inefficiency of sharecropping, might have dealt with these problems. These economists had few tools to deal with asymmetric information, so although economists like George Stigler (1961) analysed the economic value of information, the question of how to elicit information useful to a contract could not be discussed in any systematic way.

These economists would also have been burdened by the fact that the number of contracts one could write are infinite. So beyond saying that under a contract of type X does not equate marginal cost to marginal revenue, the question of which ‘second-best’ contract is optimal is extraordinarily difficult to answer in the absence of beautiful tricks like the revelation principle, partially developed by Holmström himself.

And when thinking about agency costs and innovation Bryan writes,

Holmström’s work is brilliant in how it clarifies many puzzles that are tricky to understand without thinking about incentives within a firm. For example, why would a risk-neutral firm not work enough on high-variance moonshot-type R&D projects? This is a question Holmström asks in his 1989 paper. Four reasons:

• First, in Holmström and Milgrom’s 1987 linear contracts paper, optimal risk-sharing leads to more distortion by agents the riskier the project being incentivised, so firms may choose lower expected value projects even if they themselves are risk-neutral.
• Second, firms build reputation in capital markets just as workers do with career concerns, and high-variance output projects are more costly in terms of the future value of that reputation when the interest rate on capital is lower (for example, when firms are large and old).
• Third, when R&D workers can potentially pursue many different projects, multitasking suggests that workers should be given small and very specific tasks so as to lessen the potential for bonus payments to shift worker effort across projects. Smaller firms with fewer resources may naturally have limits on the types of research a worker could pursue, which surprisingly makes it easier to provide strong incentives for research effort on the remaining possible projects.
• Fourth, multitasking suggests that agent’s tasks should be limited, and that high-variance tasks should be assigned to the same agent, which provides a role for decentralising research into large firms providing incremental, safe research, and small firms performing high-variance research. A deep understanding of how these types of internal incentives aggregate into explanations for why firms appear the way they do can best be achieved by a thorough reading of Holmström and Milgrom’s beautiful 1987 paper, “The Firm as an Incentive System”.

You know that your economy is in trouble when .....

Tim Worstall at the Forbes blog writes,

The stirring achievements of Bolivarian socialism as practised in Venezuela never cease to amaze. They’ve managed to create, at one time, an entire country running out of beer. The banknotes cost more to print than they are worth. A fertile tropical nation has widespread food shortages. They’ve even managed that the place sitting on the world’s largest oil reserves has to import oil from the United States. To add to this list of blows struck against the imperialist yankees we can now add the possible bankruptcy , or at least default on its debts, of the monopoly oil company sitting on top of that ocean of oil which is the world’s largest reserves.

Quite a list of achievements. It would be funny if the costs to the Venezuelan people weren't so high. It is the people who pay in terms on increasing poverty and hardships. Such outcomes do suggest mismanagement by the government of  the economy on a massive scale.

The problems with the state oil company, in Worstall's view, include,

This is that Venezuela’s oil is very heavy and thus needs large capital investment for it to continue to be extracted. The basic operating method of the Chavez and then Maduro administrations has been to skimp on that capital spending and then spend the money saved on consumer imports into Venezuela. Largely as a means of buying political support despite their complete and total mismanagement of the domestic economy. There were also further borrowings using the oil company as the legal form doing the borrowing, again to fund such spending upon consumers.

But, obviously, borrowing spent on rice doesn’t increase the ability of the oil company to produce more oil to pay back the borrowings. Production, and thus income, has been falling, even without any influence of the falling oil price itself.

You can indeed buy bread and circuses with resource rents. But do too much of it and you’ll not have the capital to keep those resource rents coming.

All this doesn't say much for Bolivarian socialism.

Production and the firm

This lecture was presented by Peter Klein at the 2013 Mises University, hosted by the Mises Institute in Auburn, Alabama, on 23 July 2013.

The New Zealand Initiative on inequality and poverty

As most readers will be aware the New Zealand Initiative recently published a second report on inequality and poverty. This report, The Inequality Paradox: Why inequality matters, follows on from their earlier report, Poorly Understood: The state of poverty in New Zealand.

Now at the Sand Pit blog  they have listed 21 major messages and arguments from their research. (The references in parenthesis are to the Inequality Paradox report, unless otherwise stated.)

1. Increased housing costs are hitting those on low incomes hardest, and to a very severe degree. (Figure 28.) Getting more houses built is a critical issue, regardless of economic inequality.
2. There is substantial material hardship in New Zealand households. Specifically, around 4% of the population are “doing without” to a severe degree and 11% to a less severe degree. For children the proportions are higher, at 8% and 18% respectively. For the elderly they are lower, at 1% and 3% respectively. The overall proportions are similar to an average for a group of EU countries. (Table 5 of the Poorly Understood report.)
3. It is wrong and potentially counter-productive to conflate relatively low incomes with poverty or hardship. Claims that quarter of a million of children or more (25%+) are living in poverty because they are in relatively low income households are gross exaggerations.
4. Economic inequality rose markedly from the mid-1980s to the mid-1990s on all three of the main measures: pre-tax market income, disposable income and consumer spending. The share of the top 1% rose sharply in particular. Changes in household structure, socio-demographic attributes, employment outcomes and economic returns could account for perhaps 50% of the rise in disposable income inequality during this period.
5. Current income is a poor indicator of hardship. Specifically, only around 40-50% of those experiencing relatively low current incomes are also experiencing hardship, and some on higher incomes are experiencing hardship.One reason is that low income is a temporary situation for a considerable proportion of households, another is that the elderly can be asset rich but income poor.But a real difficulty is that unanchored relative income measures don’t tell us anything about actual living standards, eg poverty. Our Poorly Understood report shows that current welfare benefits are much higher, inflation adjusted, than what was deemed to be an adequate wage for a labourer to earn in order to be able to support a dependent spouse and three children back in 1936. The Ministry of Social Development’s authoritative annual statistical reviews of well-being and inequality show that real income growth has markedly reduced the proportion of households falling below an earlier real income threshold.
6. Consumer spending is a better indicator of living standards. More recent Motu research has found that it is also a much better indicator of self-assessed well-being.
7. Consumer spending inequality rose from the mid-1980s to the mid-1990s, but by 2013 it had returned to around its mid-1980s level, despite the housing cost issue. (Figure 9)
8. Contrary to what the public is continually told, disposable income inequality has not trended up since the mid-1990s on the most commonly cited measure (the Gini coefficient). Market income inequality has actually trended down. (Figures 4 and 5.) The paradox is that newspaper headlines featuring inequality have risen more than 8-fold in the last decade.
9. Much market income inequality arises from substantial differences in hours of paid work and wage differentials that are related to differences in educational achievement (a proxy for skill) and age (a proxy for experience and responsibility). (Figures 23-27.) What else would we expect?
10. The share of top income earners in private income was much higher in the first half of the last century than it is today. A long decline occurred from the 1950s to the late 1980s. (Figure 3.)
11. The big rise in the pre-tax income share of the top 1% of income earners in the late 1980s occurred at a time of severe recession, major company collapses and tax reforms that sharply increased the tax take from top income earners overall while reducing the tax rate on the last dollars of their income. (Figures 3 and 10.) It is implausible that the real pre-tax market incomes of this group accelerated upwards during this period. It is plausible that a lot more of their incomes became taxable. The real rise in income inequality in New Zealand could be overstated to some degree for this reason. The (more modest) rise in spending inequality might be a better indicator. Moreover, since the mid-1990s the income share of the top 1% has, if anything, trended down not up. (Figure 1.) Since the early 1990s household income growth has been reasonably proportionately shared on MSD’s calculations. (Figure 8.)
12. The proportion of top income earners in New Zealand who are salary and wage earners, has risen in the last decade, contrary to the Thomas Piketty thesis of a growing dominance by the passive income of inherited wealth.
13. Our report is dubious about the quality of wealth distribution measures. For a start the measures ignore human capital and the net present value of NZS. But for what it is worth, the wealth share of the wealthiest 1% in New Zealand is not out of line with that in the member countries of the OECD. (Figure 15.) It is actually right at the bottom end of the spectrum for estimates that adjust for the under-reporting of wealth by the richest. (Figure 36.)
14. It is ridiculous to attribute the sharp 1988-1991 rise in the share of the top 1% to the decline in unionisation in the years following the Employment Contracts Act 1991
15. Our top executives are only paid a small fraction of what top Australian executives and their pay is a lower multiple of worker pay. (Table 1 and text.)
16. On the limited evidence available, income mobility in New Zealand is comparable to that in other countries. (Figures 21 and 22.)
17. One response to the call that the rich should be “asked” to pay more in tax is that they already do. Indeed, on Treasury numbers the top 40% of households by income are the only ones that pay any income or GST over and above what they receive in return through the welfare system and health and education benefits in kind.
18. It is very important that market incomes are fairly earned and are seen to be fairly earned. Anything else corrodes community trust and cohesiveness. There should be a strong presumption against corporate welfare, including bail-outs for bankers.
19. Survey evidence for New Zealand suggests that it is widely held that beneficiaries are responsible for their own situation and that high incomes in New Zealand are a reward for talent. (Table 4.) But there is also considerable concern about the degree of economic inequality in New Zealand. (Table 2.)
20. Survey evidence globally and in New Zealand also indicates that the public is widely ignorant concerning the degree of economic inequality and that people’s policy preferences tend to reflect their perceptions rather than reality, where there is a difference. (Figure 36.)
21. An ongoing public debate about economic inequality is important so that valid concerns are addressed and invalid concerns are identified.

So those who wish to complain about the great evils of the New Zealand Institute's research but can't be bothered actually reading it now have a nice numbered list of things to get all hot and bothered about.

A response to the latest NZI report by Max Rashbrooke is available here. He argues that the most fundamental omission in the report is its failure to deal in any significant way with the long-running consequences of widened inequality. But I find myself asking, Why do we care if inequality has increased, assuming it in fact has? Is poverty not the real problem? The two are not necessarily the same thing. He does agree however that "housing costs are a big problem, particularly for lower earners". As point 1 above says "Getting more houses built is a critical issue, regardless of economic inequality".

Peter G. Klein on government and big business

This video was recorded at the Mises Institute in Auburn, Alabama, on 29 July 2016.

Business owners, employees and firm performance

Business Owners, Employees and Firm Performance is a new working paper, by Mika Maliranta and Satu Nurmi, from the Research Institute of the Finnish Economy (ETLA).

The abstract reads:

The novel Finnish Longitudinal OWNer-Employer-Employee (FLOWN) database was used to analyze how the characteristics of owners and employees relate to firm performance as determined by labor productivity, survival and employment growth. Focusing on the role of the owner’s formal education and previous experience as an employee, the results show that previous experience in a high-productivity firm strongly predicts high productivity and probability of survival for the entrepreneur’s new firm. This can be interpreted as evidence of knowledge spillover through labor mobility. Strikingly, firms established in times of intensive excess job reallocation were found to exhibit superior productivity performance in the later phases of their life cycles.

The conclusion to the paper includes,

The diversified paths of primary owners and their employees are reflected in future company performance. Previous employer quality, measured in terms of relative productivity, is transferred through owners and employees as knowledge spillover related, for example, to technology or management. High-quality owners create firms capable of achieving and maintaining sustained high performance in terms of productivity, survival and employment growth.

Our results lend support to the view that employees’ entrepreneurial skills nurtured in high-productivity firms can be transferred to achieve higher productivity, especially in entrepreneur-owner firms. First, there is a strong positive relationship between the productivity level of the previous firm (where the owner worked as an employee) and the productivity level of the firm where the owner now works. Second, there is evidence of considerable employee mobility from high-productivity firms to ownership of a new firm (where the owner also works). These findings are consistent with the view that the transition of employees from high-productivity firms to entrepreneurship is an important business dynamic, driving knowledge spillover in the economy. Our results also indicate intensive employee mobility from low-productivity firms toward new and young firms, representing an important element of creative destruction. The reallocation of employees in creative destruction means that a greater share of the employees provide labor inputs to productively managed firms

and

Our results demonstrate the importance of considering owner and employee characteristics separately but in parallel in any analysis of firm performance, as owner and employee background and skills may play different roles in the development of employment and productivity. In addition, this analysis indicates a need to deal separately with entrepreneur-owner and pure owner firms. In entrepreneur-owner firms, an owner’s technically orientated education was found to impact positively on productivity performance and survival probability, but no such relationship was found in pure owner firms. One explanation for this difference is that closer owner links to production are needed to successfully exploit technical education and previous experience. In contrast, the potential contribution of pure owners pertains to factors that cannot be captured by measures of education and experience.

One interpretation of this is the perhaps not too surprising result that the human-capital of an entrepreneur-owner matters for the performance of a newly created firm. Knowledge gained from experience as an employee of a high productivity firm can be transferred to the firm of the entrepreneur-owner. Newer firms have relatively younger and more educated human capital but are more dependent on the older firms for an inflow of know-how.

Why falling prices are good for business

Introduced by Murray Sabrin, Joseph Salerno spoke on "Why Falling Prices Are Good for Business" at Ramapo College in New Jersey on October 4.

Dr. Salerno's portion of the talk begins at 6:20. The lecture is followed at the one-hour mark by a panel discussion covering business cycles, the Fed, interest rates, and financial crises.

The Elemental Case for Free Trade

From the Cafe Hayek blog comes this great piece from Don Boudreaux on The Elemental Case for Free Trade. Everybody, especially politicians, should read and think about this.

The following are remarks delivered by Professor Boudreaux on October 14th, 2016, in Atlanta, GA, at Hillsdale College’s 10th annual Free Market Forum.

I.

The positive economic case for free trade is straightforward. Here I distill it into ten – well, as you’ll see, really eleven – elemental points.

First, nothing about political borders justifies treating trades that cross those borders differently than trades that don’t. Whatever benefits result from you trading with someone in Kentucky are no less available when you trade with someone in Korea. Whatever economic problems – real or imaginary – are caused by you trading with someone in Korea are no less likely when you trade with someone in Kentucky.

Second, all economic activity is ultimately justified by how much it enables us to expand our consumption, not by how much it enables us to expand our production. Consumption is the end; production is the means. Of course, production is an essential means; we cannot expand consumption without expanding production. But production is not the ultimate purpose of economic activity. If you disbelieve me, ask yourself how much you’d pay for a sawdust-nail-‘n’-cardboard pie that took its well-meaning baker several days to produce. If you answer “nothing,” then you get this point.

Third, specialization expands output. And the greater the amount of specialization, the greater the output. A medical profession made up only of family-practice physicians will save fewer lives and reduce less pain than a medical profession made up of specialists such as neurosurgeons, podiatrists, cardiologists, ophthalmologists, and – my favorite (because many years ago one of these specialists saved my young son’s life) – pediatric gastroenterologists.

Fourth, specialization requires trade. A pediatric gastroenterologist based in New York City today enjoys a high standard of living, but only because many people willingly pay him to specialize in that highly specialized line of work and willingly accept his money in exchange for what they produce. This physician is rich only because he trades with others. If farmers, carpenters, tailors, airline pilots, and economics professors were unwilling to trade with him, he’d have no time to practice pediatric gastroenterology. He’d instead have to grow his own food, build his own home, and make his own clothing. He, and the rest of us, would be much poorer.

Fifth, specialization increases with the size of the market. The greater the number of consumers and producers, the larger is the scope for each producer to focus on a narrow specialization. This fact is why large cities have niche restaurants, such as vegan Lebanese, and highly specialized physicians, such as pediatric gastroenterologists, while small towns don’t feature restaurants and trades so highly specialized.

Points four and five working together spark self-reinforcing improvement: more trade promotes more specialization which, in turn, promotes more trade. Economies grow and standards of living improve.

Sixth, an important consequence of expanding the area of trade – of increasing the size of the market – is what economists call “increasing returns.” Doubling the number of people who trade freely with Americans causes the GDP of this larger economy to more than double. Per-capita GDP rises for all of these people who trade freely with each other. Compare medical care in an economy that features among its health-care professionals only 100 family-practice physicians to medical care in an economy with, say, 20 family-practice physicians and 180 specialists, such as pediatric gastroenterologists.

Seventh, there’s no limit to the degree to which labor can specialize and to which, as a result, total output can expand and expand at an increasing rate – that is, exhibit increasing returns. Put differently, the degree to which labor can specialize and cause total output to expand isn’t limited to, or defined by, the size of any particular country. Nor does the size of any particular country define a point beyond which the growth of specialization and output slows or becomes less reliable.

That is, even in a country as geographically large and as heavily populated as the United States, nothing in economic theory or history suggests that expanding the boundaries of our trading patterns externally – that is, beyond our borders – results in less expansion of our consumption and production than when we expand the boundaries of our trading patterns internally. We in Georgia or Virginia stand to gain just as much by expanding our trade with Mexicans as we stand to gain by expanding our trade with New Mexicans. There’s no reason not to have a global economy without economic boundaries.

Eighth, economic competition is good and it works just as effectively across political boundaries as it does within political boundaries. Competition disciplines firms, it spurs entrepreneurial creativity, and it discovers and encourages – much like a process of natural selection – what works best economically. Importantly, the competition that comes from free trade directs workers and other resources into those lines of productive activities at which each is most efficient. There’s simply no reason to neuter with trade restrictions the competition that comes from abroad simply because that competition isn’t home-grown.

Ninth, as Julian Simon taught, human beings in market economies are the ultimate resource. The ultimate resource isn’t land or petroleum or deposits of iron ore or of gold; it’s not factories or software or tractors; it’s not inventories of wheat or of rolled steel or of cash on hand. It’s human creativity and ingenuity. Indeed, it’s only because human creativity made them so that petroleum and iron ore and wheat and you-name-it are resources. Without human creativity these things would be mere raw materials, mere globs of molecules, that are no more valuable or useful to human beings than they are now to antelopes and hamsters.

And yet human creativity is one of the few resources that has consistently gotten more scarce over the course of the past 250 years.

We know that human creativity has gotten more scarce because its market price has risen enormously over the past few centuries in the market-oriented world. For example, the real hourly pay of the average American worker is today, conservatively estimated, about 60 times higher than it was in 1790.[1] This rise in the price of labor signals that it is has become more scarce relative to the demand for human labor.

In contrast, most other resources and productive inputs – including energy, metals, and transportation services – have become, and are still becoming, less scarce, if we judge them (as we should) by the trends in their real prices. They’re becoming less scarce precisely because we have more creative human beings contributing to the market economy.

Free trade maximizes the ability of the people of a country both to contribute their own creativity and effort to the global economy and to tap into the creativity and effort of the billions of other ultimate resources that reside in other countries. We tap into that creativity directly when we offshore productive tasks to foreign workers. We tap into it indirectly when we buy goods produced by foreign workers and entrepreneurs. Why would we wish to artificially reduce our and our fellow citizens’ access to supplies of the ultimate resource?

Tenth, restrictions on trade inevitably are driven by special-interest-group politics. Even if a sound theoretical case can be made for trade restrictions, it’s simply unrealistic to expect the state to be guided by that case. Instead, politicians and bureaucrats will only use that case as cover to create monopoly privileges for politically influential producer groups.

I here, at the last minute, add an eleventh point to the elemental case for free trade. I was reminded of this point just this morning by an e-mail from my great colleague Walter Williams. Walter asked me to remind you that countries don’t trade with each other; people trade with each other. China doesn’t trade with America. Individuals who reside on that part of the earth that we today call “China” choose to trade with other individuals who reside on that part of the earth that we today call “America” and who choose to trade with people in China.

That’s it. That’s the elemental economic case for free trade.

II.

But there’s a second part to the case for free trade. It’s the part that’s been constructed in response to the multitude of misunderstandings that have arisen over the centuries with regard to trade.

This second part to the case for free trade is the longer part. The reason is that the capacity for misunderstanding and mischaracterizing trade is enormous. Many falsehoods require many corrections.

Here I’ve time only to mention a few pieces of this second part of the case for free trade.

First, over the long-run free trade causes no net loss of jobs. Put differently – and harkening back to a point made above – any change in consumer spending causes some workers to lose jobs while creating jobs for other workers. International trade isn’t unique on this front. The jobs lost today to imports are replaced tomorrow by other jobs.

And these other jobs are, overall, better than the lost jobs because they are the ones at which the workers in the country have a comparative advantage. The jobs lost are ones at which the workers have a comparative disadvantage.

If you worry that the loss of particular jobs today cannot be made up for by the creation of new jobs, consider that in 1950 the U.S. workforce contained roughly 60 million people, with roughly 57 million jobs. The unemployment rate in 1950 was 5.3 percent. Today, the size of the U.S. workforce is about 160 million, with about 152,000 jobs. In 66 years, the number of workers and the number of jobs in America have each increased by a bit more than 150 percent. The rate of unemployment today is a not-too-shabby five percent.

Over the long run, the number of jobs is determined not by the freedom of trade but by the size of the labor force, by the flexibility of labor markets, and by workers’ willingness and abilities to remain unemployed as they search for better job offers. What free trade does is to replace worse jobs with better jobs; protectionism protects worse jobs by preventing the creation of better ones.

Another objection to free trade is that it is undesirable if it creates trade deficits. This is an egregious fallacy, because another name for trade deficits is “capital surpluses.” Every cent of a U.S. trade deficit is a cent invested by foreigners in America or in dollar-denominated assets. These investments not only return the dollars to the U.S., they also signal that the U.S. is a relatively attractive place to invest. Further, by enlarging our capital stock, they enrich us.

If commenters started referring not to “our trade deficit” but to “our capital surplus” – an exactly equivalent term – there’d be much less misunderstanding and mischief caused by this accounting artifact.

Finally here, it’s a myth that high-wage Americans can’t compete against low-wage foreigners.

Specialization arises according to comparative advantage, which doesn’t stop operating as the wages of workers in a nation rise relative to wages elsewhere. But this point is esoteric. Another point is that low wages reflect low productivity. Americans’ wages are higher than Chinese wages because American workers on average are more productive than Chinese workers. So next time someone says “We can’t compete against low-wage foreigners,” translate that claim into its equivalent: “We can’t compete against low-productivity foreigners.” The latter claim sounds as silly as it really is.

III.

I close not with economics but with ethics. After all is said and done my support for free trade is grounded in ethics, regardless of the economics. I believe deeply that if you work and earn income honestly, that income is yours to use as you choose. You may use it to buy tomatoes from your neighbor or to buy tomatoes from a farmer in Mexico. It’s your money. It belongs neither to the state nor to any domestic producer.

Yet protectionist arguments rest on the premise that your neighbor has some positive claim on your income. If you are prohibited from buying tomatoes from Mexico, or – more commonly today – penalized with a tariff for doing so, the state is insisting that domestic tomato growers have an ethical claim on part of your income. If you do not spend your income as the state, or as domestic tomato growers, deem best, you will be penalized. Tomato-growers’ economic well-being is elevated above yours. I find this presumption, which undergirds nearly all protectionist policies, to be reprehensible and ethically indefensible.

Ed Glaeser on building effective and functioning cities

Professor Ed Glaeser, IGC research programme director, explains why cities are the best pathway to prosperity and outlines three lessons from over 30 years of economics research on urbanisation.

For just how long are there "behavioural" responses to contract changes?

In a recent paper in the American Economic Review (vol. 106, no. 2, February 2016, pp.316-58) Rajshri Jayaraman, Debraj Ray and Francis de Véricourt look at the Anatomy of a Contract Change.

The abstract reads:

We study a contract change for tea pluckers on an Indian plantation, with a higher government-stipulated baseline wage. Incentive piece rates were lowered or kept unchanged. Yet, in the following month, output increased by 20 to 80 percent. This response contradicts the standard model and several variants, is only partly explicable by greater supervision, and appears to be "behavioral." But in subsequent months, the increase is comprehensively reversed. Though not an unequivocal indictment of "behavioral" models, these findings suggest that nonstandard responses may be ephemeral, and should ideally be tracked over an extended period of time.

So we see behavioural responses in the short-run but they fade over the longer term. What does this tell us about the likely long-term effects of Walmart's much publicised "efficiency wage" experiment?

Jayaraman, Ray and de Véricourt conclude their article by saying,

Our study suggests that classical monetary incentives ultimately dominate, despite a possibly “behavioral” response in the shorter term. More generally, our findings speak to a literature in behavioral economics that highlight both the interaction between “intrinsic” and “extrinsic” motivations, as well as the dynamic evolution of those motivations following a policy change: see Gneezy and Rustichini (2000) and Gneezy, Meier, and Rey-Biel (2011). This literature emphasizes how the introduction of financial incentives might erode more social incentives (reciprocity, gratitude, or fair play).

In this paper the baseline relationship is an employment contract. The transaction is monetary to begin with, and gratitude, reciprocity and prosocial behavior are secondary considerations. Do prosocial motivations ultimately hold sway? It would appear not: they matter in the short run, but do not persist. Ultimately, in this labor market setting, monetary incentives come to dominate their nonpecuniary counterparts. This is not to argue that agents are never driven by notions of the social good, or that loyalty to an employer cannot be nurtured. But, particularly in markets where the fundamental relationship is delineated along economic lines, we need to be alert to the possibility that long- and short-term effects differ, and consequently to the hurried classification of many important economic phenomena as fundamentally “behavioral.”

At the very least these results suggest that it is important to examine responses to a policy change, not just immediately after the change but for a substantive period of time afterwards since short and long-term responses can differ substantially.

UK migration: separating fact and fiction

From the Royal Economic Society website comes a piece on UK migration: separating fact and fiction. Perhaps the most interesting part of the article is

For the UK, the existing evidence does not indicate a clear impact of immigration on employment, and only very modest effects on wages at the low end of the wage distribution, but positive effects further up the distribution. He illustrated that migrants tend to upgrade their labour status over time, often starting in work which is below their skill and educational attainment and moving up into more appropriate skill level employment over time.

Also interesting is the comment that in fact economic issues have little impact on people's views on immigration. The finding of the research discussed is that

When discussing attitudes to immigration, Dustmann noted that economic factors were not a key determining issue. Social and cultural factors are much more important, as his research with David Card and Ian Preston has shown.

Part of the problem with whole immigration debate is lack of knowledge.

He pointed out that it is quite typical that people do not know basic facts about migration, and he illustrated that by showing that individuals vastly overestimate the numbers of immigrants in their country, with higher overestimates the lower someone’s educational level.

What of the the fiscal consequences of migration? What of the cost of publicly provided services?

Finally he presented evidence for the UK that immigrants are less likely to claim benefits or live in social housing than the native population. Further detailed analysis of the fiscal contribution of immigrants shows that those who came to the UK after 2000, and in particular those from EU countries, made a substantial net fiscal contribution.

Perhaps this last result isn't too surprise if we think that immigrants are not a random selection from their home country, but are more likely to be risk-takers and entrepreneurs.

Overall the effect of immigration, on the UK at least, looks positive. We should keep such results in mind when discussing immigration into New Zealand.

2016 NZAE conference papers are now available online

Copies of papers made available by the authors for 2016 New Zealand Association of Economists Conference are now available online.

Happy reading!

Yes we can run trade deficits forever

Over at the EconLog blog Scott Sumner has blogged on Why America can run trade deficits forever. The logic, of course, applies to any county. Summer writes,

The US has been running large current account deficits for many decades. Commenters often suggest that this means we are becoming a debtor nation, living beyond our means. This is not true.

The US earns more from our foreign investments overseas that foreigners earn on their investments in the US. China earns $65 billion selling goods to the US, and fritters the money away in loans to places like Venezuela. Meanwhile our multinational corporations make shrewd investments overseas, which bring lots of money back to the US economy.

The international accounts balance out perfectly, once you include trade in goods, services, and assets. The overall balance of payments deficit is precisely zero, if measured properly. Some countries, such as China, are relatively good at exporting goods. They run a positive trade balance. The US is relatively good at international investment---we run a persistent trade deficit, financed by our profits on overseas investments. Or we sell the Chinese "goods" such as houses in LA, that don't count as US exports because they are not physically moved overseas.

Our balance of payments accounting doesn't really correspond to what's going on in the real world. If we sold the Chinese mobile homes, and put them on a ship to China, they'd count as exports. It sounds crazy, and it is, but that's how the accounting is done.

This does not mean that we live beyond our means. GDP in the US is much larger than US consumption. Over time, we are becoming wealthier and wealthier. If countries like China ever became more adept at international investment, then the US would have to share a greater proportion of its GDP with the rest of the world.

In the comments to the post Don Boudreaux writes:

Nice job - but why do you suggest that America's trade (or current-account) deficit requires that Americans consistently earn profits on their foreign investments? It seems to me that all that is required for Americans to run capital-account surpluses consistently or even indefinitely is that foreigners continue, year after year, to find America to be a relatively more attractive place to invest than Americans find non-American places. Indeed, if we Americans were so very good at investing abroad that we consistently profit on most such investments, that reality - by steadily increasing our foreign investments relative to foreigners' investments in America - would put downward pressure on our current-account deficit.

Any interesting response to the Summer post comes from Phil in the comments,

A perpetuation of this transfer will lead to major trouble. To understand why, take a wildly fanciful trip with me to two isolated, side-by-side islands of equal size, Squanderville and Thriftville. Land is the only capital asset on these islands, and their communities are primitive, needing only food and producing only food. Working eight hours a day, in fact, each inhabitant can produce enough food to sustain himself or herself. And for a long time that's how things go along. On each island everybody works the prescribed eight hours a day, which means that each society is self-sufficient.

Eventually, though, the industrious citizens of Thriftville decide to do some serious saving and investing, and they start to work 16 hours a day. In this mode they continue to live off the food they produce in eight hours of work but begin exporting an equal amount to their one and only trading outlet, Squanderville.

The citizens of Squanderville are ecstatic about this turn of events, since they can now live their lives free from toil but eat as well as ever. Oh, yes, there's a quid pro quo--but to the Squanders, it seems harmless: All that the Thrifts want in exchange for their food is Squanderbonds (which are denominated, naturally, in Squanderbucks).

Over time Thriftville accumulates an enormous amount of these bonds, which at their core represent claim checks on the future output of Squanderville. A few pundits in Squanderville smell trouble coming. They foresee that for the Squanders both to eat and to pay off--or simply service--the debt they're piling up will eventually require them to work more than eight hours a day. But the residents of Squanderville are in no mood to listen to such doomsaying.

Meanwhile, the citizens of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island? So the Thrifts change strategy: Though they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land. And eventually the Thrifts own all of Squanderville.

At that point, the Squanders are forced to deal with an ugly equation: They must now not only return to working eight hours a day in order to eat--they have nothing left to trade--but must also work additional hours to service their debt and pay Thriftville rent on the land so imprudently sold. In effect, Squanderville has been colonized by purchase rather than conquest.

In reply to this argument Don Boudreaux writes:

The scenario you describe is possible. But it does not undermine the larger point made by Scott. The reason is that you implicitly assume throughout your tale that all of Squanderville's trade deficit becomes Squanderville's debt and that none, or too little, of that debt is used to finance the production of capital that will increase future output in Squanderville. Given the name of that mythical country, that is not a bad assumption.

But in reality any real country can run a trade (or current-account) deficit without incurring a smidgen of debt - such as, for example, when producers in country F simply hold some of the currency they earn by selling goods to denizens of country D, or when producers in country F use some of these earnings to buy shares of stock in businesses headquartered in country D, or when producers in country F use some of these earnings to build factories or retail outlets in country D.

When Ikea, for example, builds a store in Newark, New Jersey, the stock of capital in America increases as the U.S. trade 'deficit' thereby rises. It's true that some higher proportion of capital in the U.S. is now owned by people whose passports are issued by a foreign government, but so what? From my perspective as an American I am no poorer because of this Swedish investment in NJ, and I am likely wealthier: I can now get more furniture at lower prices and, perhaps, I might even get a better job working at that Ikea store (or, alternatively, my wage in my current job at Acme Furniture Retailer in Hackensack, NJ, might be bid up due to the resulting additional competition for workers such as myself)

There are other reasons why your tale fails to capture the full range of reasons why country D's consistent trade deficits are not necessarily a problem for the people of country D, but I'll not list them here.

In reality, country D's consistent trade deficits in fact do not imply that country D is mortgaging its future to foreigners. Country D's trade deficit might very well be both a signal that the people and economy of country D are growing stronger and more prosperous over the long run and fuel for that stronger growth, for stronger growth in country D is what more capital investment in country D's private economy causes regardless of the nationalities of the investors. (The trade deficits that the U.S. has run for most of its history are almost certainly generally of this happy sort. Witness, for example, the British investments that helped in the 19th century to finance the building of railways in America.)

Further, the fact that country D's trade deficit, in any particular circumstance, might in fact be the result of such mortgaging as you describe in your tale is a reflection not of trade policy but of the high time preferences (or, if you prefer, the economic myopia) of citizens of country D. High-time-preferences (or myopia) among the citizens of D - whether expressed purely privately or through the agency of government borrowing - might indeed be a problem, but it is neither one that will be solved by trade restrictions nor one that even requires that the citizens of D trade with foreigners at all. Such profligacy as you rightly suggest is damaging over the long run is perfectly possible to play out exclusively within the borders of country D, without D running a trade deficit.

Much of the issue here is just a misunderstanding of an accounting convention, what gets recorded where in the national accounts. The so-called "trade deficit" or current-account deficit may be a symptom of something being wrong somewhere in the economy, but it is not in and of itself a problem.

Understanding moral repugnance

Julio J. Elias, Nicola Lacetera and Mario Macis have a new column at VoxEU.org that looks at Understanding moral repugnance: The case of the US market for kidney transplantation.

In their column Elias, Lacetera and Macis note that certain 'repugnant' transactions, such as the sale of organs, are prohibited on moral grounds, despite there being substantial potential efficiency gains from having such transactions. Their column uses a survey-based experiment to explore public perceptions of the morality–efficiency trade-off in the context of the kidney procurement system in the USA. Respondents are found to accept higher levels of repugnance for higher levels of efficiency. These results suggest room for efficiency concerns alongside moral and ethical considerations.

Elias, Lacetera and Macis use a survey-based choice experiment to address questions about the morality--efficiency trade-off and quantify the trade-off between the morality and the efficiency of alternative kidney procurement systems. They find that although systems that allow for payments to donors do raise stronger moral concerns than a system with no payments, a majority of individuals would be willing to accept a more repugnant system provided that it produced a sufficiently large additional number of transplants.

The repugnance-efficiency trade-off

We recruited 2,918 US residents through Amazon Mechanical Turk. After providing an overview of the state of organ procurement and allocation in the US, we asked the participants to consider three alternative procurement systems to increase living undirected kidney donations:

• A system based on unpaid donors with allocation based on priority rules determined by the patients’ medical situation, age, time on the waiting list, etc. (corresponding to the current system).
• A system where donors would receive $20,000 from a public agency, with allocation based on the same priority algorithm.
• A system of individual, private transactions, where donors would receive $20,000 from the organ recipient (out of pocket or through privately purchased insurance, for example).

After receiving this information, respondents expressed their opinion about these systems related to their morality in terms of ethical concerns emphasised in philosophy and bioethics studies (e.g. Delmonico et al. 2002). We asked the subjects how coercive, exploitative, unfair to the patients, unfair to the donors, and against human dignity they thought each system was, and an overall assessment of how much a system was in contrast with the respondent’s values

Respondents were then asked to assume that each system would result in a given efficiency in terms of the kidneys for transplantation procured, and to choose their preferred system. The efficiency levels were randomly determined, and each participant was presented with three choice opportunities, in a sequential manner.

The unpaid-donor system received low repugnance ratings – that is, individuals, for the most part, did not express moral concerns about this system. The two paid-donor systems received, in general, higher repugnance ratings than the unpaid-donor system. However, there was a large difference according to whether the system contemplated payments by a public agency or by the recipients in private transactions, with the latter resulting as the most repugnant system.

Looking at choices, the results show that the likelihood of respondents choosing a particular combination of repugnance and efficiency increased with the level of efficiency and decreased with repugnance. Respondents thus preferred options with higher efficiency and those considered less repugnant, but also acknowledged, through their choices, a general trade-off between these two characteristics.

We estimated the size of these trade-offs employing discrete choice models. The median respondent would favour payments to organ donors made by a public agency if it increased the annual supply of kidneys by about 6 percentage points; this corresponds to about 2,000 additional kidneys, which would reduce the shortage by around 11% and would result in $250 million saved annually by taxpayers.

However, to accept a system based on private transactions, the median respondent would require about a 30 percentage point increase in supply, corresponding to 10,000 extra kidneys procured (which would reduce the shortage by more than 50%), and $1.26 billion in savings for taxpayers. This difference in the estimated trade-offs appears to derive from the fact that the public agency paid-donor system was considered less repugnant than the private transactions system along all of the morality features that we included. In particular, participants rated the public agency system as being equally ‘fair to the patients’ as the unpaid donor system (these two systems allocated organs to patients based on the same priority rules), whereas private transactions (in which the allocation is purely market-based) were considered highly unfair.

There was heterogeneity in the population, ranging from respondents with ‘deontological’ preferences who were not willing to allow payments, irrespective of the expected number of lives saved, to ‘consequentialist’ individuals who placed a large weight on efficiency over moral concerns. This heterogeneity did not generally relate to the respondents’ socio-demographic characteristics, but was correlated to broader attitudes as measured by a set of moral dilemmas typically used in psychology, thus providing further evidence that ethical views in these choices are central.

The author's conclusion is,

Alvin Roth stresses that “we need to understand better and engage more with the phenomenon of ‘repugnant transactions’, which often serves as an important constraint on markets and market design.” The prohibition on payments to kidney donors is one important example of this phenomenon. Our research suggests that individual choices based on repugnance considerations respond in a predictable ways to efficiency information, but also that ethical views play a crucial role in these preferences.

Supplying evidence and promoting studies on such sensitive topics might therefore lead to greater awareness and improved policy design based on the actual preferences of a population. In the case of introducing regulated payments for organ donors and their families in particular, the evidence is particularly strong that informing society about the potential benefits of economic incentives does impact the acceptability of this transaction.

Because individual preferences appear to depend on expected efficiency in addition to ethical considerations, pilot trials testing the outcomes of different arrangements may enhance the ability of a population to determine the preferred organ procurement and allocation system.

David Neumark discusses the effects of the minimum wage with Glenn Loury

In this video from Bloggingheads.tv Glenn Loury (Brown University) and David Neumark (University of California, Irvine) discuss the effects of the minimum wage.

Trump's only economist

The New Yorker has a profile by Adam Davidson of the only economist supporting Trump and his ideas on trade. The guy is Peter Navarro, a professor of economics and public policy at the University of California, Irvine. The following piece from the article is interesting.

Trump’s views on trade are crude: there are winners (them) and losers (us), and there is one simple solution that will fix everything (threat of a trade war). How Trump came to these views is not totally clear, but his thinking, especially on trade and China, has certainly been influenced by Peter Navarro, a professor of economics and public policy at the University of California, Irvine. Being the only economist—and one with a Harvard Ph.D. at that—on Donald Trump’s economic team, Navarro provides a patina of legitimacy. (The others on Trump’s economic team are businesspeople who donated to the campaign and several people from the far right of Republican economic thought.) Navarro’s views on trade and China are so radical, however, that, even with his assistance, I was unable to find another economist who fully agrees with them. Should Donald Trump overcome the odds against him now and be elected President, Navarro would likely become the single most powerful economic adviser in the United States. (Emphasis added)

The bit in bold really says it all, no one agrees with this guy. In fact, as I have noted before, everybody seems to disagree with him. To have all of Paul Krugman, Greg Mankiw and Don Boudreaux attacking you takes some doing, but Trump, and his advisers, have achieved this (dis)honour.

Trumponomics is just weird, and potentially dangerous.

How much does management matter?

Can productivity gaps be explained by differences in management? In this short video, from VoxEU.org, Raffaella Sadun presents her research in management and the differences between being a micro-manager and a coordinator.

In short. micro-management can be bad for you.

Hart and/or Holmstrom and the theory of the firm.

One part of the contribution of Hart and Holmstrom that has not been emphasised in other coverage of the Nobel award is their huge contribution to the theory of the firm, both separately and together. I wish to briefly cover this area. In doing so I draw on material from The Theory of the Firm: An Overview of the Economic Mainstream. See also Walker (2015).

One grouping in the literature on the firm is referred to as the ‘firm as a solution to moral hazard in teams approach’. This is an area where Holmstrom has been active. In a paper, Holmstrom (1982), he looks looks at the incentive problems of teams and identifies possible solutions. Holmstrom assumes that the members of the team each take actions which are unobservable to the monitor but the overall result of the combined actions is observable. What Holmstrom shows is that it is only under very restrictive assumptions that the monitor can ensure that efficient effort levels will be provided by each team member. The monitor can do this by designing a sophisticated incentive scheme. But Holmstrom shows that given unobservable effort levels, the requirements for the incentive scheme to be a Nash equilibrium, to balance the budget and to be Pareto optimal, cannot be met together. More specifically, a budget-balancing incentive scheme cannot reconcile the Nash equilibrium requirement and Pareto optimality because each team member will equalise the costs and benefits of extra effort; that is, if the team revenue is increased by the efforts of a single member, then that member should receive that revenue to ensure that they are properly motivated. But as the monitor only knows that team revenue has increased and not the effort levels of each individual member, then all members of the team would have to each receive the extra revenue to ensure that the hardworking member is rewarded for his or her efforts. But this will, obviously,violate the balanced budget condition. This suggests that there is an advantage, in terms of incentives, in the team not having to balance their budget.

Another group in the literature is the ‘firms as an incentive system view’. This approach to the theory of the firm was developed by Holmstrom and Milgrom (1991, 1994), Holmstrom and Tirole (1991) and Holmstrom (1999). In their view the firm is characterised by a number of factors: (1) the employees do not own the non-human assets of the firm; (2) the employees are subject to a ‘low-powered incentive scheme’; and (3) the employer has authority over the employee.

Holmstrom and Milgrom (1991) make two observations. First, they note that there are a number of ways that an employee can spend their time, many of which can be of value to an employer. But if these multiple activities compete for the worker’s attention, then the incentives offered for each of the activities must be comparable. Otherwise, the employee will put most effort into those things that are most well compensated and put less effort into the others activities. The second observation relates to the provision of strong incentives to a risk-averse employee. Providing strong financial incentives is costly because it loads extra risk into the worker’s pay. In addition, the cost is greater the more difficult it is to measure performance. This means that, other things being equal, tasks where performance is hard to measure should not be given as intense incentives as ones that are more accurately observed. But having low-powered incentives means that the employer needs to be able to exercise authority over the use of the employee’s time, since the employee will not have the proper incentives to be productive.

This logic suggests that, conversely, an independent contractor should face the opposite combination of instruments. The choice between having an employee or using an independent contractor depends on the ability of the principal to measure each dimension of the agent’s contribution. Thus, in the Holmstrom and Milgrom approach, measurability of performance is one important determinant of the boundaries of the firm. In addition their approach incorporates the importance of the allocation of property rights to the physical assets in determining incentives via determination of bargaining positions as is the case with the Williamson and Grossman-Hart-Moore approaches.

Hart enters our story with the  'firm as an ownership unit' approach to the firm. This approach is more commonly called the property rights theory or incomplete contracts theory of the firm. Early contributions to this approach include Grossman and Hart (1986,1987), Hart and Moore (1990) and Hart (1995).

The central idea in the property rights approach is that as contracts are incomplete the allocation of control rights affects the incentives that people face, and thus their behaviour and the allocation of resources.This theory defines ownership of an asset as the possession of the residual control rights
over that asset. A firm is defined as a collection of jointly-owned (non-human) assets. This means, for example, that the distinction between an independent contractor and an employee turns on who owns the non-human assets with which the agent works. An independent contractor owns his own 'tools' while an employee does not.

But, how and why does ownership matter? The answer is that in a world of incomplete contracts, ownership (i.e. having residual control rights) can serve as a source of power. Given that incomplete contracts contain gaps (or ambiguities) the question arises of who gets to make decisions in these non-contracted for situations? For the property rights theory, it is the owner. This matters since if there are two separate firms, A and B say, then the management of each firm can make decisions for their firm in the uncontracted for situations. If, on the other hand, A was to take over B then A’s management could make decisions for both A and B in the uncontracted for cases. To see the implications of this imagine that B supplies A with an input for A’s production process. If A and B are separate firms then B’s management could threaten to withdraw both its assets and its own labour if the firms cannot, say, agree on the terms for an increase in the supply of the input. If A owns B then B can only threaten to withhold its labour. The latter threat is normally weaker than the former. Such differences in power will effect the distribution of surplus generated by the relationship between A and B. If the firms are separate, then A may have to pay a lot to induce B to supply the increased level of inputs whereas if A owns B, then it can enforce the supply at a much lower cost since B’s management has a reduced threat, and thus, bargaining power.

Determining the boundaries of the firm requires us to balance the advantages of integration against its disadvantages. The benefit of integration is that the acquiring firm’s, A above, incentives to make relationship-specific investments is stronger because it now has greater residual control rights and thus can command a larger share of the ex post surplus created by such investments.The disadvantage of integration is that the incentives of the acquired firm, B, to make relationship-specific investments is reduced since they now have fewer residual controls rights and thus are able to capture less of the ex post surplus that their investments creates. To put this in employee/independent contractor terms, the optimal size of a firm trades off the fact that hiring an employee means hiring someone who lacks optimal incentives since they risk being held up by the firm because they can be fired, and thereby separated from the assets they need to be productive, versus using an independent contractor who could hold-up the firm by threatening to quit the relationship and taking his assets with him.

An implication of this is that if a non-contractible, specific to a particular set of assets, investment is undertaken then a non-owner risks being held-up by the owner. Thus,the property rights theory would say that whoever makes the most important, non-contractible,asset-specific investment should be the owner of the asset.and a larger share of the ex post surplus created by such investments.

Another approach in which Hart is a major contributor is the 'the reference point approach' to the firm.

Hart (2008) presents a simple reference points model and applies it to the theory of the firm. What is presented below is a slightly modified version of Hart's model. I hope that you can tell the difference between the zero's and the theta's below. Hart assumes that a seller, S, can provide a good, costing 10, to a buyer, B, who is willing to pay 20. Let us assume that we are talking about a public lecture on some aspect of microeconomics which B is organising and which B wants S to give. A successful lecture is worth 20 to B and it costs 10 for S to give the lecture.

At this stage Hart ignores the fact that B could engage other economists or that S could give lectures elsewhere. While trade could proceed smoothly, it is also possible that it will not. We will assume that B and S each have some discretion over the ‘quality’ of performance. For example, S could give a witty, lively, entertaining lecture or a very boring one. B on the other hand could treat S well, give her a nice dinner and pay quickly, or treat her badly.

In the language of Hart and Moore (2008) each party is able to provide basic (perfunctory) or exemplary (consummate) performance. It is further assumed that only the basic (perfunctory) level of performance can be legally enforced: exemplary (consummate) performance is entirely discretionary. It is assumed that each party is more or less indifferent between providing each level of performance − exemplary performance costs only a little more than basic or may even be slightly more pleasurable − and will provide exemplary performance if they feel they are being 'well treated' but not if they feel they are being 'badly treated'. Cutting back on exemplary performance is called ‘shading’. Such behaviour cannot be observed or punished by an outsider. Shading hurts the other party.

Hart emphasises that each party will feel 'well treated' if they receive what they think they are entitled to; that a contract between the parties is a reference point for perceived entitlements; and that should there be no reference point, then entitlements can diverge, wildly in some cases.

To return to the example above. First, we will add a time line. The time line tells us that B and S will write a contract some months before the lecture is given, at date 0, rather than at the last minute, date 1. One reason for this is that each party has more options earlier on. In fact it is assumed that there is a competitive market for sellers, at date 0.

Assume, further, that although B and S sign a contract at date 0, they leave the question of how much B will pay S open until the night before the lecture, date 1. This may seem a bad idea, and later it will be shown that it is. If no price is specified, then any p between 10 and 20 is possible. What might each party feel entitled to?

Hart and Moore (2008) take the view that entitlements can diverge. S may feel that the whole success of the talk will be due to her giving it and thus she feels entitled to p = 20. On the other hand B may have a somewhat different view of S’s abilities and likely contribution and thus feel that S is worth much less, say, p = 10.

Even though they disagree as to what p should be, they are rational enough to arrive at a compromise, say p = 15. According to Hart and Moore (2008) each party will feel short-changed and therefore aggrieved. Since B is aggrieved by 5, (15-10), B shades to the point where S’s payoff falls by 5θ, where θ is the constant of proportionality. And since S is also aggrieved by 5, (20-15), S shades to the point where the payoff for B falls by 5θ.

The end result of this is that if S and B leave the determination of the price until the night before the lecture, there will be a deadweight loss of 10θ due to the shading activities of each party. This reduces the value of the relationship between S and B from 10 to 10−10θ = 10(1−θ).

Next Hart asks the question: Can anything be done to avoid this deadweight loss? His answer is yes. But first note an answer that doesn’t do the job. Ex post Coasian bargaining at date 1 doesn’t work. The reason is that shading is not contractible and thus an agreement not to shade is not enforceable. Or to put this another way, if B offers to pay S more to reduce her shading, say B offers to pay p = 16 to S rather than 15, then this will indeed reduce S’s shading, from 5θ to 4θ, since S will now feel less aggrieved, but it will also increase B’s shading from 5θ to 6θ, since he now feels more aggrieved. Total deadweight loss does not change, it remains at 10θ. However there is a simple solution; the parties just put the price in the contract at date 0. Since it has been assumed that the market for lectures is competitive at date 0, B will be able to hire S for a price p = 10. With this price specified in the contract, there is nothing for B and S to disagree about at date 1. The fact that B and S may disagree about the contribution that S makes to the success of the lecture no longer matters. B and S have agreed that B will pay S 10, and neither B nor S will be disappointed or aggrieved when that happens. Importantly, agreeing in advance, at date 0, to a payment of 10 eliminates ex post argument and aggrievement, and thus both parties will be willing to provide exemplary performance. Here we have the first best being achieved and zero deadweight losses as a result. This does raise an obvious question: What changes between dates 0 and 1? Why does a date 0 contract that fixes p avoid aggrievement, whereas a date 1 contract that fixes p does not? The crucial point here is the role of the ex ante market at date 0. This market gives an objective measure of what B and S bring to the relationship. Given the assumption of a competitive date 0 market, there are many sellers willing to supply at p = 10 and thus S accepts that she cannot expect to receive more than 10, while B understands that he can’t expect to pay less, as no one would be willing to give the lecture for less. Thus, neither party is aggrieved by p = 10. This gives us a model of the contractual relationship between B and S, but, as Hart explains, we need one further ingredient to create a theory of the firm.

Now let us add a little more realism by assuming that not all of the details of the lecture can be anticipated at date 0. To keep things simple we will assume that two different lectures can be given.

Lecture 1 - say, a theory of the firm lecture - is the same as above, with a value of 20 and costs of 10. Lecture 2 - say, a microeconometrics lecture - yields value of 14 and costs of 8. Note that lecture 1 is more efficient in that it generates a greater surplus - 10 v's 6. Assume that the lectures can not be specified in the date 0 contract, since thinking about econometrics is sooooo boring that no one can stay awake long enough to write the contract! At date 1, however, the choice between them becomes clear.

Now we have to compare two organisational forms: an employment contract and an independent contractor. First, let B and S fix the price of the good at date 0, at say 10, and let B and S agree at date 0 that S will be an independent contractor. This is, in other words, a market exchange between two separate economics agents. Independent contractor means here that S gets to pick which lecture to give.

Hart then asks, What will S do? Given that the price has been fixed by the date 0 contract, S will pick lecture 2, since it is cheaper for her. But note this is inefficient. B will be aggrieved because S didn’t choose lecture 1, which B feels entitled to; B is short-changed by 6 (20-14), and he will therefore shade enough to reduce S’s payoff by 6θ. Total surplus in this case will be 6 − 6θ.

The second organisation form to be considered is an employment contract. B and S agree at date 0 that S is an employee of B. This we take to mean that S will work for B at a fixed wage, again assume 10. B, being the employer, has the right to decide on which lecture is to be given. As the wage is fixed B will choose lecture 1, as this gives him the greater value. This is efficient. S will be aggrieved since lecture 2 wan’t chosen, but S’s aggrievement is only 2. This induces S to shade by enough to reduce B’s payoff by 2θ. Total surplus is therefore 10 − 2θ.

Under the conditions specified, the employment contract is better. This is true for two related reasons. First, the lecture matters more to B than to S. B will lose 20 − 14 = 6 if his favoured lecture is not chosen while S only loses 10 − 8 = 2 if her favoured lecture is not chosen. This means it is efficient for B to choose the lecture. Second, and related, S’s aggrievement is low since she doesn’t care very much.

Hart now changes the numbers. Keep lecture 1 as it is, but change lecture 2 so while it still yields 14, it now costs only 2. Lecture 2 is now the more efficient (12 v’s 10). Under employment, lecture 1 will be chosen, yielding a total surplus of 10−8θ. If S is an independent contractor, lecture 2 will be chosen resulting in a total surplus of 12 − 6θ.

What this suggests is that employment is good if the lecture matters more to B than to S, while independent contracting is good if the lecture matters more to S than to B.
Hart goes on to say,

“[o]ne point worth emphasizing is that in neither of the above examples is the following contract optimal: to leave the choice of price and method until date 1, i.e. to rely on unconstrained Coasian bargaining. This would always yield the efficient method, but the aggrievement costs would be high. In [Table not shown] the parties would agree on method 1; however, since there are 10 dollars of surplus to argue over, shading costs equal 10θ: net surplus = 10(1 − θ), which is less than that obtained under the employment contract. In [Table 171.1] there are 12 dollars of surplus to argue over and net surplus = 12(1 − θ), which is less than that obtained under independent contracting.” (Hart 2008: 409).

Clearly the examples above are toy ones, but Hart argues they contain the basic ingredients of a theory of the firm in that they consider the choice between carrying out a transaction in the market, using an independent contractor, and 'inside the firm', via an employment contract. This was the trade-off at the heart of Coase (1937).

The basic ingredients of the reference point approach to contracts have been applied to the theory of the firm more fully in papers by Hart and Moore (2007), Hart (2009) and Hart and Holmstrom (2010) - yes they get together!. For more on these papers see Walker (2013).

Refs.:

• Coase, Ronald Harry (1937). ‘The Nature of the Firm’, Economica, n.s. 4(16) November: 386–405.
• Grossman, Sanford J. and Oliver D. Hart (1986). ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy, 94(4): 691–719.
• Grossman, Sanford J. and Oliver D. Hart (1987). ‘Vertical Integration and the Distribution of Property Rights’. In Assaf Razin and Efraim Sadka (eds.), Economic Policy in Theory and Practice (504–48), London: Macmillan Press.
• Hart, Oliver D. (1995). Firms, Contracts, and Financial Structure, Oxford: Oxford University Press.
• Hart, Oliver D. (2008). ‘Economica Coase Lecture: Reference Points and the Theory of the Firm’, Economica, 75(299) August: 404–11.
• Hart, Oliver D. (2009). ‘Hold-up, Asset Ownership, and Reference Points’, Quarterly Journal of Economics, 124(1) February: 267–300.
• Hart, Oliver D. and Bengt Holmström (2010). ‘A Theory of Firm Scope’, Quarterly Journal of Economics, 125(2) May: 483–513.
• Hart, Oliver D. and John Moore (1990). ‘Property Rights and the Nature of the Firm’, Journal of Political Economy, 98(6): 1119–58.
• Hart, Oliver D. and John Moore (2007). ‘Incomplete Contracts and Ownership: Some New Thoughts, American Economic Review, 97(2) May: 182–6.
• Hart, Oliver D. and John Moore (2008). ‘Contracts as Reference Points’ Quarterly Journal of Economics, 123(1) February: 1–48.
• Holmstrom, Bengt (1982). ‘Moral Hazard in Teams’, Bell Journal of Economics, 13(2) Autumn: 324–40.
• Holmstom, Bengt (1999). ‘The Firm as a Subeconomy’, Journal of Law, Economics, and Organization, 15(1) April: 74-102
• Holmstrom, Bengt and Paul Milgrom (1991). ‘Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design’, Journal of Law, Economics, & Organization, 7(Special Issue): 24–52.
• Holmstrom, Bengt and Paul Milgrom (1994). ‘The Firm as an Incentive System’, American Economic Review, 84(4) September: 972–91.
• Holmstrom, Bengt and Jean Tirole (1991). ‘Transfer Pricing and Organizational Form’, Journal of Law, Economics, and Organization, 7(2) Fall: 201-28.
• Walker, Paul (2013). ‘The ‘Reference Point’ Approach to the Theory of the Firm: An Introduction’, Journal of Economic Surveys, 27(4) September: 670–95.
• Walker, Paul (2015). 'Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective'. Journal of Economic Surveys, v29 no2, April: 317-38

Views on the 2016 Nobel Prize in economics

Just a few links giving different views on the prize.

The Conversable Economist: Oliver Hart and Bengt Holmström: The 2016 Nobel Prize in Economics

A Fine Theorem: NOBEL PRIZE 2016 PART I: BENGT HOLMSTROM
A Fine Theorem: NOBEL PRIZE 2016 PART II: OLIVER HART

Coordination Problem: And the Nobel Goes To ... Oliver Hart and Bengt Holmstrom

Mises Wire: The 2016 Nobel Prize: Incentives, Property Rights, and Ownership

Marginal Revolution: Private Prisons and Incentive Design: Critiquing Oliver Hart
Marginal Revolution: The Performance Pay Nobel
Marginal Revolution: Bengt Holmström, Nobel Laureate
Marginal Revolution: Oliver Hart, Nobel Laureate

Free exchange: Oliver Hart and Bengt Holmstrom win the Nobel prize for economic sciences

Money Watch: Why this Nobel prize for economics is so well deserved

2016 Nobel Prize in economics

The  Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel  2016  was awarded jointly to  Oliver Hart  and  Bengt Holmström  "for their contributions to contract theory"

Press Release: The long and the short of contracts
Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.

Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions. This year’s laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.

In the late 1970s, Bengt Holmström demonstrated how a principal (e.g., a company’s shareholders) should design an optimal contract for an agent (the company’s CEO), whose action is partly unobserved by the principal. Holmström’s informativeness principle stated precisely how this contract should link the agent’s pay to performance-relevant information. Using the basic principal-agent model, he showed how the optimal contract carefully weighs risks against incentives. In later work, Holmström generalised these results to more realistic settings, namely: when employees are not only rewarded with pay, but also with potential promotion; when agents expend effort on many tasks, while principals observe only some dimensions of performance; and when individual members of a team can free-ride on the efforts of others.

In the mid-1980s, Oliver Hart made fundamental contributions to a new branch of contract theory that deals with the important case of incomplete contracts. Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights: which party to the contract should be entitled to make decisions in which circumstances? Hart’s findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law. His research provides us with new theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and when institutions such as schools or prisons ought to be privately or publicly owned.

Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.

Popular Science Background

Scientific Background.

A great award, contract theory is important in so many areas of economics now. For me, of course, its importance is in the theory of the firm. Both the work of Hart and Holmstrom has played a major role in the modern theory of the firm. In addition to the Ronald Coase (Nobel 1991) and Oliver Williamson (Nobel 2009) these guys are two of the biggest players in the field. Holmstrom's work has been in the area of the moral hazard in teams approach to the firm while Hart was one of the major developers of the incomplete contracts (or property rights) and reference point approaches to the firm.

Piketty’s rising share of capital income and the US housing market

VoxEU.org has a new column by Gianni La Cava available on the above topic

Thomas Piketty argues that the rising share of income accruing to housing is a key feature of the changing US income distribution. La Cava's column examines the determinants of this phenomenon. The rise occurred due to an increasing share of income accruing to owner-occupiers through imputed rent, it is concentrated in states that are constrained in terms of new housing supply, and it is closely associated with the long-run decline in real interest rates and inflation.

A key observation in Thomas Piketty’s Capital in the Twenty-First Century [...] is that the share of aggregate income accruing to capital in the US has been rising steadily in recent decades [...]. The growing disparity between the income going to wage earners and capital owners has led to calls for government intervention. But for such interventions to be effective, it is important to ask who the capital owners are.

Recent research has shown that the long-run rise in the net capital income share is mainly due to the housing sector [...]. This phenomenon is not specific to the US but has been evident in almost every advanced economy. This suggests that it is not entrepreneurs and venture capitalists that are taking an increasing share of the economy, but land owners.

So are we seeing the rise of a new `landed gentry’? And, if we are, what might explain it? Several research papers [...], print articles [...] and blogs [...] have hypothesised that the long-run increase in the housing income share is due to factors such as lower interest rates, higher mortgage debt, and constraints on home building, due to either geographic constraints or land zoning restrictions. But there is comparatively scarce empirical evidence to confirm these hypotheses.

In a new paper, I examine the determinants of the rise in the US housing capital income share over recent decades (La Cava 2016). I build upon the foundations set by Piketty and Zucman (2014), but rather than focusing on trends at the national level, I dig deeper and decompose the US national accounts data by different types of housing (e.g. owner-occupied and tenant-occupied) and, even more importantly, by US state. To the best of my knowledge, my paper is the first to explore the determinants of the secular rise in the housing share of the economy by exploiting both cross-sectional and time-series variation in factors such as housing prices, interest rates and housing supply constraints.

In the US national accounts, income accruing to the housing sector is measured as ‘net housing capital income’, or simply, net rental income (i.e. gross rents less housing costs, such as depreciation and property taxes). This measure includes rental income going to both owner-occupiers (imputed rent) and landlords (market rent). The very detailed nature of the Bureau of Economic Analysis’ regional economic accounts allows for similar estimates of housing capital income to be constructed for each US state spanning several decades.

This investigation reveals three things about the rise in the US housing capital income share in recent decades. First, it has occurred due to an increasing share of income accruing to owner-occupiers through imputed rent. Second, it is concentrated in states that are constrained in terms of new housing supply. Finally, it is closely associated with the long-run decline in real interest rates and inflation..

Point 2 here is interesting in light of the housing issues in New Zealand, especially in Auckland.

Refs.:

• La Cava, G (2016), `Housing Prices, Mortgage Interest Rates and the Rising Share of Capital Income in the United States’, Reserve Bank of Australia Research Discussion Paper, No 2016-04. Also published as BIS Working Papers No 572, Bank for International Settlements.
• Piketty, T, and G Zucman (2014), “Capital is Back: Wealth-Income Ratios in Rich Countries 1700–2010”, The Quarterly Journal of Economics, 129 (3), 1255–1310.

Incentives matter: Adam Smith and teaching file

James R. Otteson reminds us of this point made by Adam Smith on incentives and teaching:

"In other universities the teacher is prohibited from receiving any honorary or fee from his pupils, and his salary constitutes the whole of the revenue which he derives from his office. His interest is, in this case, set as directly in opposition to his duty as it is possible to set it. It is the interest of every man to live as much at his ease as he can; and if his emoluments are to be precisely the same, whether he does, or does not perform some very laborious duty, it is certainly his interest, at least as interest is vulgarly understood, either to neglect it altogether, or, if he is subject to some authority which will not suffer him to do this, to perform it in as careless and slovenly a manner as that authority will permit. If he is naturally active and a lover of labour, it is his interest to employ that activity in any way, from which he can derive some advantage, rather than in the performance of his duty, from which he can derive none."

--Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), V.i.f.7.

15% off!

I've just noticed that currently the price of the greatest book ever written has dropped by 15% at Routledge.

So order now for Christmas and save!

Al Roth: game theory and market design

From the NBER comes this video of Al Roth giving an Introduction to Matching Markets and Market Design.



Al Roth: Game Theory and Market Design from NBER on Vimeo.

Multinational firms and tax havens

A new column by Anna Gumpert, James Hines and Monika Schnitzerat at VoxEU.org looks at the investment activities of multinational firms in tax havens. They argue that multinational firms may invest in tax havens to avoid taxation in non-haven countries, but other motives, such as business opportunities in these countries, may also drive such investment.

The Gumpert, Hines and Schnitzerat research uses data on German firms to investigate the motives for tax haven investment. Tax avoidance does appear to be a motive, particularly for manufacturing firms. Policies that raise the costs of reallocating profits maybe be effective in attenuating firms’ use of tax havens.

The column ends by arguing that

While the tax haven investments of some multinational firms attract considerable public attention, many multinational firms do not have affiliates in tax havens. Our evidence is consistent with tax avoidance as a motive for tax haven investments, in particular for manufacturing firms. At the same time, the size of a multinational firm’s operations and business opportunities in tax havens also induce multinational firms to invest in tax havens. As higher costs of reallocating profits attenuate firms’ tax haven use in response to higher taxation, policy measures that raise the costs of income reallocation may be effective at discouraging tax haven investment, as long as they do not induce firms to shift real activities to tax havens.

Of course there does seem a much simpler way of stopping the use of tax havens, lower the company tax rate in non-haven countries.

The cost of protectionism to the poor

The Economist magazine writes,

A study by Pablo Fajgelbaum of the University of California, Los Angeles, and Amit Khandelwal, of Columbia University, suggests that in an average country, people on high incomes would lose 28% of their purchasing power if borders were closed to trade. But the poorest 10% of consumers would lose 63% of their spending power, because they buy relatively more imported goods. The authors find a bias of trade in favour of poorer people in all 40 countries in their study, which included 13 developing countries.

In short, free trade has been good for the poor.