"The Standard" on Iraq and oil

Over at "The Standard" they have a "Guest post" on the US lead invasion of Iraq. It in "Guest post" writes,

It was always about the oil, and the currency in which oil is traded.

If its about oil then its an economically illiterate way to get oil-which may explain why "The Standard" thinks its about oil, you would have to be economically illiterate to think its about oil. Bryan Caplan has written

The left-wing take on this argument is that it's bad to spend blood for oil; the right-wing take is that it's good (or at least necessary) to spend blood for oil, and we should just face facts. In a recent piece in Public Choice, however, I argue that - whatever else you think about U.S. foreign policy in the Middle East - it's an economically illiterate way to get oil.

and

The popular anti-war slogan "no blood for oil" assumes that blood actually buys oil and appeals to our conscience not to pay the price. I've got a better slogan: "No oil for blood." You could spill an ocean of blood without making it cheaper to fill up your gas tank.

Think about it this way, its just the theory of the firm writ large. Invasion amounts to a form of vertical integration, a very hostile takeover. That is, one "firm", the US, wants to vertically integrate with another "firm", Iraq, who is a supplier of an input for US production, oil. The question is does integration make sense? In a world of incomplete contracts we know integration makes economic sense when there is a possibility of a hold-up problem due to the relationship specific nature of investments. Given that oil is an more or less homogeneous good and there are a number of different supplies it is not clear what relationship specific investments have to be made and thus its not clear what the danger of hold-up is. Or to put it another way, our two firms should merge if they have highly complementary assets and not merge if they have independent asserts. Given there are a number of other supplies of oil its not obvious that oil from Iraq is highly complementary to US assets. If you think of this as a "make" - invade Iraq - or "buy" - purchase on the open market - decision, its not clear why a "make" decision is optimal.

EconTalk this week

Novelist Mark Helprin talks with EconTalk host Russ Roberts about copyright and the ideas in his book, Digital Barbarism. Helprin argues for an extension rather than a reduction in the length of time that authors have control over their work. He also argues that technology is often not attuned to human needs and physical constraints, claiming that tranquility is elusive in modern times. He sees the movement against copyright and intellectual property generally as part of an educational and social trend toward collective rather than individual work.

Boudreaux on globalisation

Donald J. Boudreaux has a short essay up at the Fraser Institute on Globalisation. He opens by saying,

Globalization is the spread of human cooperation across the globe. If not hindered by government restraints, this cooperation spreads naturally and without much attention to political boundaries. Geographic and cultural differences, along with differences in currencies and other social institutions, sometimes slow the spread of cross-border economic cooperation. But the single largest obstacle to the spread of human cooperation across political borders is politics—in particular, the difficult-to-resist pressure on each government to protect local producers from the competition of external producers.

The advantages of buying global are many,

Suppose, for example, that shirts can be made in one of two ways. The first is by hand. It costs a shirt maker using this method—regardless of how many shirts he produces—$250 to produce each shirt. Working full-time producing shirts by hand, the shirt-maker can produce 10 shirts each month. The second way to produce shirts is in a highly mechanized factory. If the factory runs at a peak capacity of a million shirts monthly, each shirt costs $5 to make. But because building and equipping the factory requires a huge initial investment, operating the factory at less-than-full capacity causes the cost of each shirt to rise. The reason for this increase is that producing fewer shirts denies the shirt-maker the opportunity to spread the investment cost over maximum output. The smaller the factory’s output, the higher the cost of each shirt.

Which method of production would a shirt-maker use? The answer depends on the size of his market. If a shirt-maker expected to serve a market of millions of people, he would use the factory method. But if he expected to serve a market of only a few dozen potential customers, he would produce shirts by hand. If each shirt-maker had access only to small markets, the price of shirts would be higher than it would if shirt-makers had access to larger markets.

So, if you want expensive shirts, or most other things, buy local. This example outline one important justification for free trade: by expanding markets beyond political boundaries, firms can take better advantage of economies of scale which results in consumers to enjoying lower prices.

But wait! There's more,

Another advantage of specialization is that it allows consumers to enjoy the fruits of resources and talents located far away. Canadians can enjoy pineapple grown in Hawaii while Hawaiians can enjoy maple syrup produced in Canada; the French enjoy financial expertise concentrated in the City of London while Londoners enjoy wines from Burgundy and Bordeaux. Although other factors are always in play, a region’s geographical characteristics—for example, its weather, topology, and mineral deposits—and the special talents of its work force determine which goods and services can be produced in that region at the lowest cost—or, as economists say, “at a comparative advantage.” The freer the trade, the more likely it is that regions will specialize in producing the goods and services they can produce most efficiently, and then import those things that are produced most efficiently elsewhere.

Free trade gives consumers the opportunity to buy goods and services from the best producers in the world. If shirts could be best produced domestically, then free trade would help to keep those producers profitably in business. Alternatively, if shirts could be best produced abroad, domestic consumers would only have ready access to those shirts through trade. Thus, free trade would encourage inefficient domestic shirt makers to use their talents for the maximum benefit of consumers by switching out of shirt-making and into other productive activities. By directing resources around the world into those tasks that each resource does best, free trade arranges the world’s resources so that they produce the greatest possible output while giving consumers maximum access to this output.

Another point to keep in mind is that free, globalised markets reduce the number of workers required to produce most types of output and thus make possible the production of goods and services that would otherwise be too costly to produce. Large globalised markets help to raise living standards by freeing workers to seek higher value jobs and by making labour-saving products and services more affordable.

A Mengerian theory of the firm.

In an interesting article in Studies in Emergent Order, Aidan Walsh offers up A Mengerian theory of the origins of the business firm. The analogy is to Menger's theory on how money came into being. Walsh writes,

How could an ‘invisible hand explanation’ (Nozick 1974: 19; Haller 2000) allow us to conjecture a theory of the origins of the business firm? Again, we should approach the problem step by step. However, the problem is more complex, and the solution less visible, than the bilateral problem solved by money.

Step 1. The market order.

We have seen above that a market order arises spontaneously. As we have also seen, it arises naturally, spontaneously, because individuals follow certain common rules of behaviour. The larger this market order becomes, the more people that it involves, generally, the greater prosperity involved. Therefore, there is always the general tendency for a market to grow in size until, as we have now, one market encompassing nearly all of humanity.

Step 2. The problem.

But there is a problem resulting from this extended market order. Hayek argued that in the extended market order that the common rules of behaviour must become ‘attenuated’, that is they must be thinned out as compared to the rules of a small tribe where, for example, everyone is known to everyone else and everyone owes intricate duties to everyone else:

‘This application of the same rules of just conduct to the relations to all other men is rightly regarded as one of the great achievements of a liberal society. What is usually not understood is that this extension of the same rules to the relations to all other men (beyond the most intimate group such as the family and personal friends) requires an attenuation of at least some of the rules which are enforced in the relations to other members of the smaller group. If the legal duties towards strangers or foreigners are to be the same as those towards the neighbours or inhabitants of the same village or town, the latter duties will have to be reduced to such as can also be applied to the stranger. No doubt men will always wish to belong also to smaller groups and be willing to assume greater obligations towards self-chosen friends or companions… A system of rules intended for an Open Society and, at least in principle, meant to be applicable to all others, must have a somewhat smaller content than one to be applied in a small group.’ (Hayek 1976: 88ff)

It is not central to this discussion whether the rules of the Open or Great Society are more attenuated than in a small tribe (although, it is submitted that this is true), more important is the fact that the rules are common to all. This fact alone creates a problem. Individuals solve problems by following the rules. Different cultures have different rules and so will be guided in different ways: ‘Since different values legitimate different objectives, and different objectives generate different kinds of problem[s], societies with different cultures will tend to focus on distinctive types of problem solving. “Learning by doing” is an important aspect of problem solving and so learning effects will give each culture a distinctive type of problem-solving expertise.’ (Casson 1995: 89) It may be that an extended market order creates a problem. If everyone in a market order follows the same rules, then there may only be a limited number of ways that any problem may be solved, only a limited range of options may appear to be open, open options may appear to be closed and so on. (Heiner 1983; Witt 1998, 1999; see also Loasby 2007)

Step 3A. The solution.

‘This difficulty would have been insurmountable, and would have seriously impeded progress in the division of labour, and above all in the production of goods for future sale, if there had not been … a way out.’ (Menger 2007: 258) This way out may have been for an entrepreneur to see or realise that individuals are capable of following different rules in different ‘settings’; by noticing say the behaviour of a company of soldiers or a community of religious.

The entrepreneur has a ‘notion’ (Witt 1999), that, for example, pins can be produced more cheaply his or her ‘way’ than the methods in the larger market order. So the entrepreneur, who ‘must be a natural leader of men’, (Marshall quoted in Streissler 1990: 58) like a general, a Wallenstein (Roscher quoted in Streissler 1990: 58), ‘a cognitive leader’ (Witt 1999, 2000, Ioannides 2003a) convinces others that his or her ‘way’ is a good way to produce pins. Of course, this ‘way’ requires that all the individuals involved follow rules of behaviour that are different, to a greater or lesser extent, to the rules in the larger market order. Furthermore, the entrepreneur may not articulate his ‘way’ in terms of rules or in terms of rule-following behaviour. He or she may clearly envisage a ‘process’ or, more likely, the goal may be still quite vague, and he or she may just tell the other individuals to ‘do what I say’ or ‘follow what I do’.

Step 3B: The solution.

Simultaneously with Step 3A, other individuals make choices and act; they have their goals, but realise that they can, also, only achieve them indirectly. These individuals realise that, in the long or the short term, their self-interest is served best if they do not sell their services, directly, into the larger market order. Instead, he or she realises that if they participate, if they commit, to the sometimes new but always changing order, outside of the market, in a firm that they may obtain benefits that they might not obtain in the larger market order and bring themselves closer to their personal goals. In fact, an entrepreneurial notion may fail because no person may believe that their personal goals can be best achieved directly or indirectly through committing to a particular entrepreneur’s firm. (Witt 1999)

One reason an individual may wish to become an employee is that it allows that individual the opportunity to convert what might otherwise not be an economic good into an economic good. (The individual is, of course, unconscious of this directly but is conscious of the higher remuneration available in a firm, particularly early in a career, and the individual also, as Hayek pointed out, may have a preference for assuming greater obligations towards certain self-chosen companions.) That good, that might otherwise not be an economic good, is the ability of humans to follow complex and usually tacit rules and the ability to follow different rules in different ‘settings’. We are all entrepreneurs in selling our labour; it is natural that individuals would seek, even if unconsciously, a return on all their assets, including the ability to follow complex, tacit, rules of behaviour and the ability to follow different rules in different settings.

Step 4: A further refinement of the solution.

Over time, under the powerful influence of custom, establishing firms, becoming an employer or an employee become well-established behaviours. Thus firms become common in the economy. The skills to manage and control employees in firms become more widespread – skills like double-entry bookkeeping or even reading and writing. In addition, often the habits and practices that are required of employees in a firm become widespread in the larger market order; for example, punctuality.

Step 5: The influence of the state.

There may be one final step in the origin of the firm: within the boundaries of a state, the legal order usually has an influence on the character of the firm which, though small, cannot be denied. ‘A firm’ – it is submitted is an order created by the rule following behaviour of individuals (rules different to the rules in the larger market order) to achieve some purpose, however vague. Firms are, by this definition, larger than the cognitive abilities of any one individual to create, survey or control. The legal personality of the firm may have somewhat blinded observers; Sautet is right and the ‘firm can be seen as a pulling together of entrepreneurial activity by a central entrepreneur… the essence of the firm, in that context, is coordination rather than ownership.’ (Sautet 2000: 134)

However, there is no doubt that the legislative acts of a state can improve the character of firms in many ways and can improve the chances that firms will be created and that the individuals in them will prosper. However, this does not mean that one can go too far in looking for a role of the state in the origin of the firm: firms are not an invention of the state. But the state can have a role, when the firm has already emerged as an economic institution. For example, individuals may be more inclined to establish a firm when there is limited liability and individuals may be more inclined to become employees of a legal fiction than of a particular individual.

More from Kevin Murphy

More from the interview of Kevin Murphy in the The Federal Reserve Bank of Minneapolis's magazine, The Region, June 2009.

IMPLICATIONS FOR DRUG POLICY

Region: What are the implications of rational addiction theory for public policy on currently illegal drugs—that is, enforcing prohibition versus legalization and taxation?

Murphy: There we started out from the point of view of how does an economist think about a prohibition? The way I think about prohibition, why does prohibition on drugs curtail drug consumption? Well, the primary way is it makes drugs more expensive. It raises the street price of drugs from what they would be if people could freely bring them into the country and freely distribute them. It raises the price by making them less available. If I want to get drugs, I can’t just go down to the supermarket or the drugstore and buy my drugs. I’ve got to go to a neighborhood, maybe it’s dangerous. I also have to worry about the strength and quality of the drugs. Am I going to get drugs that are tainted?

All those things make drugs more expensive than they would otherwise be. And what do we know about demand for any commodity, whether it’s drugs or haircuts or strawberries? You make them more expensive, people consume less. So our view of the world is that, basically the way drug policy works in the United States at least, is it tries to make drugs more expensive, less attractive, and cause people to consume less. In economic terms, it pushes us back up the demand curve. And rough estimates say we’ve quadrupled the cost of drugs relative to what they would be in a world without this interdiction.

If you quadruple the price of something, people are going to buy less of it. But, unfortunately, the way we bring about that quadrupling of price is by increasing the cost of supplying drugs. The amount of money people are spending on drugs is actually higher than it would be if the price were lower, because the demand for drugs is not very elastic.

Region: You’ve shifted the supply curve, and moved up the demand curve.

Murphy: Exactly. So think about a simple world where the elasticity of demand is about a half. You quadruple the price of drugs, and the quantity of drugs is cut in half. So you’ve got four times the price, half the quantity. You’ve doubled expenditures. People are spending twice as much and consuming half as much.

Well, where did that added expenditure go? It goes to the drug dealers. It doesn’t go to the government; it doesn’t stay with the consumers. It goes to drug dealers. And that revenue actually finances the supply of drugs and finances the drug lords who supply drugs to the United States. So what we’ve really done in this case is financed the people who are on the other side of the War on Drugs. So, the War on Drugs, in our view, has been kind of doomed by its basic economics. That is, the harder you fight the war, the higher you push up the price. The higher the price, the higher the revenue of suppliers; the higher the price, the greater the incentive to supply drugs to the United States.

Now, what are the costs to the suppliers? Well, they have to avoid detection. They fight over turf for drug territories. They pay people off. They may go to prison. All those costs are pretty much bad things. They use violence to enforce their contracts and the like. Not a good outcome.

But when you put people in prison, you have to consider not only does it cost society in the form of people in prison who could otherwise be gainfully employed, but it also costs us money to put them there. So for every dollar of cost we impose on the drug suppliers, we spend at least a dollar of our own money on top of it to keep them there. If we normalize what we would have spent in a free market on drugs at $100, consumers are now spending $200 on half the quantity of drugs and then spending another $100 on top of that to put all those people in jail. So we’re paying three times as much for half as much output. From an economic point of view, that’s more than a little bit counterproductive.

Usually you think, if I’m going to produce less output at least it should cost me less.

Region: So, rational addiction but irrational ...

Murphy: Irrational policy, right. So, what’s the answer? If you want to reduce consumption, raise the price. What’s the natural way to raise the price of something? Tax it.

Region: That is, something you want to discourage.

Murphy: Something you want to discourage, exactly. We want to discourage smoking, so we tax cigarettes. If we want to discourage greenhouse gases, we’ll tax carbon emissions. Whatever it is, if you want to discourage it, tax it. The advantage of that is, you get the same reduction in output; the cost of production rather than going up, goes down. It costs less to produce half as much output as it does to produce the full amount of output. And the extra money that would have been wasted is now going to the government in the form of tax revenues, which would allow us to reduce other taxes, or do other things.

So, a system where we make drugs legal and tax them makes a lot of economic sense relative to the current system. People say, wait a minute, we can’t make drugs legal. Don’t drugs cause all these horrible problems?

The problem is, most of the things that people point to when they talk about the horrible things generated by drugs are actually the horrible things generated by the War on Drugs. The violence and the corruption we have, and the corruption in foreign governments—that’s because drugs are illegal. If drugs were legal, we wouldn’t have a violence problem. We wouldn’t have tons of people in prison. Those people are there not because drugs did anything but because we made these things illegal. People still wanted them, and when people still want something that’s illegal, we have a black market. And if we imprison people who engage in a black market, we’re going to increase the size of the prison population and make all the associated expenditures.

We see that in the recent War on Drugs. We saw that with prohibition in the 1920s. It’s an old phenomenon. You may enact a prohibition, but it doesn’t get rid of demand. People still want the commodity. You’ve just forced production to occur in the black market, and when demand is inelastic—and that’s what’s key—when people are going to still demand it even as you push the price up, the black market is very inefficient, because you’re raising costs and expenditure at the same time.

The important point from this?

So, the War on Drugs, in our view, has been kind of doomed by its basic economics. That is, the harder you fight the war, the higher you push up the price. The higher the price, the higher the revenue of suppliers; the higher the price, the greater the incentive to supply drugs to the United States.

Now if we could only get those in government and law enforcement to understand this bit of basic economics.

Interview with Kevin Murphy

From The Federal Reserve Bank of Minneapolis's magazine, The Region, June 2009.

Kevin Murphy on rational addiction:

ADDICTION

Region: With Gary Becker, you developed a theory of “rational addiction.” Could you give us a description of what seems, on its surface, a very counterintuitive concept?

Murphy: OK. Let’s take that rational addiction framework. I guess I’ll tie together—and I think this is what’s important really—the predictions of the theory along with the mechanics of the theory.

We laid out in our analysis how someone would behave who was a perfectly rational individual faced with the notion that if he starts, say, smoking cigarettes, that that will have an effect on his desire to smoke cigarettes in the future—that is, our perfectly rational individual realizes that smoking today raises his demand for smoking in the future. And he takes that into account in his decision-making.

He also takes account of the impact of smoking today on other things in the future, like his future health—smoking today means he’s more likely to get lung cancer or cardiovascular disease.

That theory has some pretty simple implications. One is, if I learn today that smoking is going to harm me in the future, then I will smoke less—that is, people will respond to information about the future.

People will also respond to future prices. If they think cigarettes are going to be more expensive in the future, developing a taste for cigarettes is a more expensive habit, and they will have an incentive to avoid building up a smoking habit.

A major implication that we tried to test in the data was, do anticipated increases in the future price of cigarettes impact smoking today? And what we found when we went to the data was yes, there’s a pretty strong pattern saying that anticipated future changes in the price of cigarettes actually show up as less smoking today.

Now, what’s interesting is you can compare that with what we call a naïve or myopic model. In a myopic model, people don’t look forward and, therefore, they only decide whether to smoke based on the current price of cigarettes. They don’t care about the future price. And the data actually reject that simple myopic model in favor of the rational addiction framework.

So I think the empirical evidence that we found was consistent with the rational addiction model. It was that evidence that convinced us, more than anything, that we were on to something. We wrote down the theory because we wanted to understand, what does the theory have to say? We then took it to the data to say, well, do the data bear out this theory or do they bear out a more traditional theory, that addicts are somehow completely irrational? And we found that the data say, well, people seem to respond at least somewhat in the direction of being rational.

You don’t want to overstate it though. Our data don’t say people are completely rational. It looks like they’re mostly rational is the way I would interpret our data.

Region: Bounded?

Murphy: Well, I don’t know if it’s the same as bounded rationality, but they take account of future prices but not quite as much as the theory would say they should. The myopic theory says there should be a zero. Let’s say as a normalization, the rational addiction framework says you’d get a one; you actually kind of get a number like 0.7 or 0.75. So it’s closer to the rational model than the myopic model, but it’s not a 100 percent victory. It’s a 75 percent victory for the rational model. So it comes out to be a useful model for understanding behavior, but not a perfect model.

Subsequently, others have gone out and modified the model and tried to make it consistent with bounded rationality and hyperbolic discounting and all kinds of other things, so I think there’s been a lot of work that’s built on our model, that tries to help explain that last 25 percent that we missed. But I take it as saying that, look, the model is a very useful model for thinking about the world.

And I don’t think it’s that surprising to people. One of the things that comes into people’s minds when they smoke is, they think about the future, they think about should I really be smoking, it’s bad for me. Most people who quit smoking don’t quit smoking because they don’t enjoy it. Right? There’s nobody out there who said, you know, I quit smoking because I didn’t enjoy smoking. You ever meet anybody who said, I quit because I didn’t enjoy it?

No, people say, I quit because I worried about my health, worried about my children, it costs too much. But very few people stop smoking because they don’t enjoy it. And that tells you immediately that there’s an element of rationality to their decision-making. Maybe not as much as there should be, in some people’s minds, but there’s certainly an element of rationality in the smoker’s mind.

If you ask people who don’t smoke why they don’t smoke, there’s an element of rationality too. They say, well, I don’t want to smoke because I don’t want to get addicted and I don’t want the bad health consequences. So I don’t find it surprising that a model that says that people look forward has some predictive power. I think a lot more people would smoke if they didn’t worry about the future.

This bit is interesting,

Most people who quit smoking don’t quit smoking because they don’t enjoy it. Right? There’s nobody out there who said, you know, I quit smoking because I didn’t enjoy smoking. You ever meet anybody who said, I quit because I didn’t enjoy it?

So people get benefits from smoking, they actually enjoy doing it. But what about alcohol? Any benefits from drinking alcohol? May be we should commission a report to find out.

The Adam Smith Annual Lecture by Deepak Lal

The Great Crash of 2008: Are governments or markets to blame?

Deepak Lal is the James S. Coleman Professor of International Development Studies at the University of California at Los Angeles, Professor Emeritus of political economy at University College London, President of the Mont Pelerin Society and a Senior Fellow of Adam Smith Institute.

He was a member of the Indian Foreign Service (1963-66) and has served as a consultant to the Indian Planning Commission, the World Bank, the Organization for Economic Cooperation and Development, various UN agencies, South Korea, and Sri Lanka. From 1984 to 1987 he was research administrator at the World Bank.

Lal is the author of a number of books, including The Poverty of Development Economics; The Hindu Equilibrium; Against Dirigisme; The Political Economy of Poverty, Equity and Growth; Unintended Consequences: The Impact of Factor Endowments, Culture, and Politics on Long-Run Economic Performance; and Reviving the Invisible Hand: The Case for Classical Liberalism in the 21st Century.

Treasury on BERL (Updated x3)

As Eric Crampton has noted over at Offsetting Behaviour, Treasury has weighed in on the BERL report into the social costs of alcohol and drugs and they don't seem too pleased with either the BERL report or the use of it by the Law Commission. See the NBR article here.

On the Burgess and Crampton response to BERL, the Deputy Secretary of the Treasury Peter Bushnell says,

“I think the points they’re making are sound about adding the costs of production into the cost of it, and not counting any benefits. In a market if you’re selling something that people are prepared to pay for, then they’ve at least got that much benefit, otherwise they wouldn’t have bought the stuff. So if you exclude the benefits then you’re clearly only looking at one side of the story.”

“I can see the point being made in the article – it looks pretty shonky” said Dr Bushnell. “I think the fact that some work’s done that academic review says is pretty shonky is a problem by itself.

BK Drinkwater translates this into English as,

"We don't know what those dudes at BERL were smoking when they wrote this, but we're upset they've been holding out on us. If they just hand over the drugs, we at least can promise not to push fuzzy-headed economics and public policy while using them."

Bushnell goes on to say,

[...] the onus should be on the Law Commission to be rigorous Dr Bushnell said.

“Geoffrey’s reputation is reduced [if] he’s putting weight on something that actually doesn’t stack up. So the Law Commission ought to ... build in processes that give adequate QA and so on.

“What we’re saying is it’s your reputation that’s at risk here. It doesn’t reflect well on the Law Commission if it ... backs [work], that doesn’t have a sound basis.”

The interesting thing here is that this is a very strong statement coming from a very senior member of the Treasury. It is unusual to see such statements. Treasury can not be happy.

The NBR also says

Sir Geoffrey was overseas when contacted by NBR, and has declined to comment on the matter thus far.

Is he running for cover? It will be interesting to see what he says, if anything, on the matter when he returns from overseas.

Update: See Money quotes from Peter Bushnell from Offsetting Behaviour.

Update 2: Not PC notes that Treasury gives BERL’s alcohol report another smack . PC says

Meanwhile, BERL are still yet to comment on Treasury’s bollocking of their work. At this point, the last word from “BERL Chief Economist Ganesh Nana” is that “BERL stands by its report.” If that’s still the case, I’d suggest you start discounting everything they say.

Stephen Franks has made a similar point,

BERL must convincingly answer the criticims (or preferably other economists for them) if their future work is to have credence.

I think both PC and Franks are right, thus far this alcohol report has done great damage to BERL's reputation.

Update 3: Kiwiblog notes Treasury on BERL report.

Putting teachers in detention ... at a cost.

This from Alex Tabarrok at Marginal Revolution:

Hundreds of New York City public school teachers accused of offenses ranging from insubordination to sexual misconduct are being paid their full salaries to sit around all day playing Scrabble, surfing the Internet or just staring at the wall, if that's what they want to do.

Because their union contract makes it extremely difficult to fire them, the teachers have been banished by the school system to its "rubber rooms" — off-campus office space where they wait months, even years, for their disciplinary hearings.

The 700 or so teachers can practice yoga, work on their novels, paint portraits of their colleagues — pretty much anything but school work....Because the teachers collect their full salaries of $70,000 or more, the city Department of Education estimates the practice costs the taxpayers $65 million a year.

Exit barriers are in effect entry barriers. Why would you employ anyone as a teacher if it is this difficult to get rid of them if they turnout not to be up to it? The employment process must be hell since you just can't take a chance on picking the wrong teacher.

Austrian economics and the theory of the firm

Peter Klein maintains an online bibliography of articles and books dealing with applications of Austrian economics to the theory of the firm. Unfortuately he hasn't been able to update the bibliography on a consistent basis.

He has a bleg, please send him, pklein at missouri dot edu, any suggested additions and corrections (ideally with URLs). Self-nominations are welcome!

Economics in One Lesson

If you just happen to have a spare 3 hours, 28 minutes and 45 seconds, why not watch this YouTube video from the Mises Institute on the wonderful book Economics in One Lesson by Henry Hazlitt.

1. Walter Block - The Lesson
2. Thomas DiLorenzo - The Broken Window @ 15:58
3. Jeffrey Herbener - Public Works Means Taxes @ 24:30
4. Tom Woods - Credit Diverts Production @ 42:02
5. Robert Murphy - The Curse of Machinery @ 56:53
6. Walter Block - Disbanding Troops and Bureaucrats @ 1:12:36
7. Mark Thornton - Who's Protected By Tariffs? @ 1:29:51
8. Peter Klein - "Parity" Prices @ 1:47:26
9. Guido Hulsmann - How The Price System Works @ 2:09:36
10. George Reisman - Minimum Wage Laws @ 2:37:11
11. Joseph Salerno - The Function of Profits @ 2:53:17
12. Roger Garrison - The Assault on Saving @ 3:13:53

How to pay executives? part 2

With regard to the previous posting How to pay executives?, this comes from the Economist article The Jack Welch MBA,

One extremely popular class would be “Maximising Your CEO Pay”. This columnist once heard Mr Welch tell a chief executives’ boot-camp that the key was to have the compensation committee chaired by someone older and richer than you, who would not be threatened by the idea of your getting rich too. Under no circumstances, he said (the very thought clearly evoking feelings of disgust), should the committee be chaired by “anyone from the public sector or a professor”.

I guess that means Professors Edmans and Gabaix are out then.

And there is the Dogbert approach to CEO pay.

How to pay executives?

In their book "Pay Without Performance: The Unfulfilled Promise of Executive Compensation", Lucian Bebchuk and Jesse Fried argue that executive compensation is set by managers themselves to maximise their own pay, rather than by boards looking after the interests of shareholders. Some commentators have gone so far as to argue that executives’ pay schemes were major contributors to the financial crisis, encouraging them to take on too much risk and manage their company for short-term profit.

In a column at VoxEU.org Alex Edmans and Xavier Gabaix propose a solution to address the economic issues that are at heart of the current crisis to prevent future value destruction. Edmans and Gabaix argue that existing payment schemes have two major problems,

First, stock and options typically have short vesting periods, allowing executives to “cash out” early. For example, Angelo Mozilo, the former CEO of Countrywide Financial, made $129 million from stock sales in the twelve months prior to the start of the subprime crisis. This encourages managers to pump up the short-term stock price at the expense of long-run value – for instance by originating risky loans, scrapping investment projects, or manipulating earnings – because they can liquidate their holdings before the long-run damage appears. Long-term incentives must be provided for the manager to maximise long-term value, which we call the “long-horizon principle.”

Second, current schemes fail to keep pace with a firm’s changing conditions. If a company’s stock price plummets, stock options are close to worthless and have little incentive effect – precisely at the time when managerial effort is particularly critical. This problem may still exist even if the executive has only shares and no options. Consider a CEO who is paid $4 million in cash and $6 million in stock. If the share price halves, his stock is now worth $3 million. Exerting effort to improve firm value by 1% now increases his pay by only $30,000 rather than $60,000 and may provide insufficient motivation. To maintain incentives, the CEO must be forced to hold more shares after firm value declines. Our research has shown that, to motivate a manager, a given percentage increase in firm value (say 10%) must generate a sufficiently high percentage increase in pay (say 6%). In the above example, this is achieved by ensuring that, at all times, 60% of the manager’s pay is stock. We call this the “constant percentage principle.” The appropriate proportion will vary across firms depending on their industry and life cycle, but we estimate 60% as a ballpark number for the average firm.

The "long-horizon principle" and the "constant percentage principle" can be achieved by giving the executive a scheme Edmans and Gabaix call an "Incentive Account". Their scheme

[...] contains two critical features – rebalancing to address the constant percentage principle and gradual vesting to satisfy the long-horizon principle. Each year, the manager’s annual pay is escrowed in a portfolio to which he has no immediate access. In the above example, 60% of the portfolio is invested in the firm’s stock and the remainder in cash. As time passes and the firm’s value changes, this portfolio is rebalanced monthly so that 60% of the account remains invested in stock at all times. In our example, after the stock price halves, the Incentive Account is now worth $7 million ($4 million cash and $3 million of stock). This requires the CEO to hold $4.2 million of equity, which is achieved by using $1.2 million of cash to buy stock. This satisfies the “constant percentage principle” and maintains the manager’s incentives after firm value has declined. Importantly, the additional stock is accompanied by a reduction in cash – it is not given for free. This addresses a major concern with repricing stock options after the share price falls – the CEO is rewarded for failure.

Each month, a fixed fraction of the Incentive Account vests and is paid to the executive. Even when the manager leaves, he does not receive the entire value of the Incentive Account immediately. Instead, it continues to vest gradually; full vesting will occur only after several years. By then, most manipulation or hidden risk will have become public information and affected the stock price and thus the account’s value. Since the manager has significant wealth tied in the firm even after his departure, he has fewer incentives to manipulate earnings in the short term.

While the Incentive Account may seem a marked departure from current practices, it can be approximately implemented using standard compensation instruments without setting up a special account. In each period, the board pays the CEO a mix of deferred (cash) compensation and restricted stock. If performance is poor, the next period the CEO’s salary is paid exclusively in restricted stock; upon strong performance, it is paid exclusively in deferred cash.

Edmans and Gabaix note that ideas of gradual vesting is not without its costs. When compared to short-term vesting, it imposes more risk on the executive and they may argue for a higher salary as compensation for this risk. But the benefits of a high-powered incentive scheme are much greater than its costs. Edmans and Gabaix point out that even if an optimal contract induces the CEO to increase firm value by only an additional 1%, this is $100 million when applied to a $10 billion firm. Such an increase in value vastly exceeds any required compensation for any additional risk being borne by the executive. For a given vesting period and target incentive level, Edmans and Gabaix can demonstrate mathematically that Incentive Accounts are always less costly than other common schemes such as stock options, restricted stock, clawbacks, and bonus-malus banks.

Is behavioural economics doomed?

This is the question David K. Levine asks in his 2009 Max Weber Lecture. Levine sets the scene by noting,

Certainly behavioral economics is all the rage these days. The casual reader might have the impression that the rational homo economicus has died a sad death and the economics profession has moved on to recognize the true irrationality of humankind. Nothing could be further from the truth.

He continues,

The modern paradigmatic man (or more often these days woman) in modern economics is that of a decision-maker beset on all sides by uncertainty. Our central interest is in how successful we are in coming to grips with that uncertainty. My goal in this lecture is to detail not the theory as it exists in the minds of critics who are unfamiliar with it, but as it exists in the minds of working economists. The theory is far more successful than is widely imagined – but is not without weaknesses that behavioral economics has the potential to remedy.

Levine goes on to point out that while laboratory experiments have shown up a number of anomalies with the standard theory, it should not be overlooked that the theory works remarkably well in the laboratory.

One of the most widespread empirical tools in modern behavioral economics is the laboratory experiment in which people – many times college undergraduates, but often other groups from diverse ethnic backgrounds – are brought together to interact in artificially created social situations to study how they reach decisions individually or in groups. Many anomalies with theory have been discovered in the laboratory – and rightfully these are given emphasis among practitioners, as we are most interested in strengthening the weaknesses in our theories. However, the basic fact should not be lost that the theory works remarkably well in the laboratory.

Levine goes on to discuss areas where the theory works, such as voting, and areas where it doesn't, such as ultimatum bargaining. He then discusses learning and self-confirming equilibrium.

Learning and incomplete learning – whether or not we regard this as “behavioral” economics – are an important part of mainstream economics and have been for quite some time. An important aspect of learning is the distinction between active learning and passive learning. We learn passively by observing the consequences of what we do simply by being there. However we cannot learn the consequences of things we do not do, so unless we actively experiment by trying different things, we may remain in ignorance.

As I indicated, the notion of self-confirming equilibrium from Fudenberg and Levine [1993] captures this idea. A simple example adapted from Sargent, Williams and Zhao [2006a] by Fudenberg and Levine [2009] shows how this plays a role in mainstream economic thought. Consider a simple economic game between a government and a typical or representative consumer. First, the government chooses high or low inflation. Then in the next stage consumers choose high or low unemployment. Consumer always prefer low unemployment, while the government (say) gets 2 for low unemployment plus a bonus of 1 if inflation is low. If we apply “full” rationality (subgame perfection), we may reason that the consumer will always choose low unemployment. The government recognizing this will always choose low inflation. Suppose, however, that the government believes incorrectly that low inflation leads to high unemployment – a belief that was widespread at one time. Then they will keep inflation high – and by doing so never learn that their beliefs about low inflation are false. This is what is called a self-confirming equilibrium. Beliefs are correct about those things that are observed – high inflation – but not those that are not observed – low inflation.

Next Levine explains that while behavioural economics points to many paradoxes and problems with mainstream economics, their own models and claims are often not subject to a great deal of scrutiny. He then examines some popular behavioural theories and discusses the relationship between psychology versus economics. He notes,

Much of behavioral economics arises from the fact that people have an emotional irrational side that is not well-captured by mainstream economic models. By way of contrast, psychologists have long been fascinated with this side of humankind, and have many models and ideas on the subject. Not surprisingly much of behavioral economics attempts to import the ideas and models developed by psychologists.

[...]

The key difference between psychologists and economists is that psychologists are interested in individual behavior while economists are interested in explaining the results of groups of people interacting. Psychologists also are focused on human dysfunction – much of the goal of psychology (the bulk of psychologists are in clinical practices) is to help people become more functional. In fact, most people are quite functional most of the time. Hence the focus of economists on people who are “rational.” Certain kinds of events – panics, for example – that are of interest to economist no doubt will benefit from understanding human dysfunctionality. But the balancing of portfolios by mutual fund managers, for example, is not such an obvious candidate. Indeed one of the themes of this essay is that in the experimental lab the simplest model of human behavior – selfish rationality with imperfect learning – does an outstanding job of explaining the bulk of behavior.

In summary Levine has this to say,

A useful summing up is by considering the main theme of this lecture: that behavioral economics can contribute to strengthening existing economic theory, but, at least in its current incarnation, offers no realistic prospect of replacing it. Certain types of “behavioral” models are already important in mainstream economics: these include models of learning; of habit formation; and of the related phenomenon of consumer lockin. Behavioral criticisms that ignore the great increase in the scope and accuracy of mainstream theory brought about by these innovations miss the mark entirely. In the other direction are what I would describe as not part of mainstream economics, but rather works in progress that may one day become part of mainstream economics. The ideas of ambiguity aversion, and the related instrumental notion that some of the people we interact with may be dishonest is relatively new and still controversial. The use of models of level-k thinking to explain one-time play in situations where players have little experience works well in the laboratory, but is still unproven as a method of analyzing important economic problems. The theory of menu choice and self-control likewise has still not been proven widely useful. The theory of interpersonal (or social) preferences is no doubt needed to explain many things – but so far no persuasive and generally useful model has emerged.

Read the whole thing, its worthwhile.

EconTalk this week

Michael Munger, of Duke University, talks with EconTalk host Russ Roberts about franchising, particularly car dealerships. Munger highlights how the dealers used state regulations to protect their profits and how bankruptcy appears to be unraveling that strategy. The main themes of the conversation are the incentives in the franchising relationship and the evolution of the auto industry in the United States over the last forty years.

It's the economy, stupid

When governments lose power it is often blamed, at least in part, on the state of the economy. The standard story would be that when the economy is doing badly a government is more likely to lose power. Of course a bad economy may just be bad luck, say unfortunate external conditions, rather than mismanagement by the incumbent government. Can voter tell the difference and do they vote differently when they can?

Andrew Leigh look at this question in a paper, "Does the World Economy Swing National Elections?", in the Oxford Bulletin of Economics and Statistics, Vol. 72, No. 2. The abstract reads,

Do voters reward national leaders who are more competent economic managers, or merely those who happen to be in power when the world economy booms? Using data from 268 democratic elections held between 1978 and 1999, I compare the effect of world growth (luck) and national growth relative to world growth (competence). Both matter, but the effect of luck is larger than the effect of competence. Voters are more likely to reward competence in countries that are richer and better educated; and there is some suggestive evidence that media penetration rates affect the returns to luck and competence.

The paper provides evidence that voters commit systematic attribution errors when casting their ballots – tending to oust their national leaders when the world economy slumps and retain them when it booms. Across a wide range of countries, voters appear to behave only quasi-rationally. Is anyone really surprised by that? Note that any given individual voter has little incentive to try to distinguish a lucky government from a skilful one since we all know that elections are almost never decided by a single vote, and so each voter would be right to conclude that her vote is highly unlikely to make a difference.

What factors are associated with voters rewarding competence and luck? In countries with a richer and better educated population, voters are better able to parse out competence from luck in deciding whether to re-elect their national leaders. Leigh also find suggestive evidence that the media affects the returns to luck and competence, though these effects seem to differ across media types. Countries with high newspaper circulation have voters better able to distinguish luck from skill. Radio does not help, and television makes things worse. Well, given the standard of economic reporting on New Zealand television that last result doesn't exactly surprise me.

Privatisation and freedom

At the IEA blog John Meadowcroft writes

Advocates of privatisation have often paid insufficient attention to one of the most important reasons why scholars like Friedman and Hayek argued in favour of privatisation: that people are the best judges of how to spend their own money and, moreover, that they have a right to spend their own money as they wish. Privatisation must not be separated from the broader libertarian project of making government smaller and giving people control of their own lives - which includes their own money.

[...]

Those who believe in freedom should therefore not uncritically praise privatisation. It should be supported solely as a means to the end of increasing individual freedom by giving people back more of their own money to spend. Where privatisation becomes a backdoor way of expanding the role of the state and thereby reducing people’s freedom this should be exposed and criticised.

This extends the argument for privatisation beyond that of the purely economic into a general political argument for freedom. It also reminds us not to be uncritical of some of the other arguments made in support of privatisation.

Learning by doing?

People are assumed to learn from experience. But may be not in the case of local politicians and bureaucrats,

GREEN BAY - For the second year in a row, a bicycle sharing program in downtown Green Bay is seeing some problems. The bikes, meant for public use, are disappearing.

The city began its green bike program two weeks ago. 25 bikes were put on the streets and almost all of them are gone. The same thing happened last year.

Private delivery of public services

In this audio from VoxEU.org, Paul Grout of the Centre for Market and Public Organisation (University of Bristol) talks to Romesh Vaitilingam about his report, Private Delivery of Public Services, which surveys the theory and evidence on three models of private sector involvement in the delivery of public services: privatisation; public-private partnerships; and not-for-profit organisations.

Interesting blog bits

1. Brad Taylor on Bootleggers and Baptists: Normatively Ambiguous. Lobbying gives you outcomes which are very good for the industry (at least, good for existing players), but very bad for consumers.
2. Liberty Scott on Local government cargo cult - Hawke's Bay Airport. The airport should be privatised, the government should flog off its ownership so that a private owner can put in some directors with some business acumen, and the councils should be required to sell off their shares.
3. BK Drinkwater on Geddis On Citizen-Initiated Referenda. Referenda, good or bad?
4. Robin Hanson on Why Signals Are Shallow. We all want to affiliate with high status people, but since status is about common distant perceptions of quality, we often care more about what distant observers would think about our associates than about how we privately evaluate them.
5. Robert L. Scheuttinger and Eamonn F. Butler on Price Fixing in Ancient Rome. It failed.
6. Helmut Reisen on Shifting wealth: Is the US dollar Empire falling? If history is any guide, the Chinese renminbi will soon be due to overtake the US dollar, just as the dollar replaced the pound sterling last century. But will the renminbi be ready for reserve currency status? This article discusses the issues at hand and explains why some experts would prefer the IMF’s Special Drawing Rights as the next global reserve currency.
7. Homepaddock on Milk too expensive or people too poor? Price controls are simply a tax on production and if they were imposed on farmers they’d stop supplying the domestic market in favour of exporting or change from dairying to something more profitable.