The broken window fallacy

The (inverse) broken window fallacy from The Onion:

BREAKING: Terror Attack Failure Costs Detroit 10,000 Construction Jobs

(HT: Coordination Problem)

Nations don't trade with each other; individuals do

Mark J. Perry makes a good point at his blog Carpe Diem: Nations Don't Trade With Each Other; Individuals Do. Perry opens by quoting the Washington Post

WASHINGTON (Reuters) -- The United States imported $2.74 billion of "oil country tubular goods" from China in 2008, more than triple the previous year, as a surge in oil prices led to increased demand for the oil well tubing and casing.

Perry then writes,

The statement above perpetuates a common misconception about international trade that clouds clear thinking about the topic. Technically, the United States did NOT import $2.74 billion of steel pipe from China, at least not as a "country." It was dozens, if not hundreds, of American-owned companies that voluntarily placed hundreds, if not thousands, of individual purchase orders in 2008 to purchase Chinese steel from dozens, if not hundreds, of steel-producing companies in China who filled the orders totalling $2.72 billion, and shipped the steel.

The reason this is important is,

Starting with the fallacy that countries, not individuals, engage in international trade, it's then much harder to realize that it's individual American companies and consumers who are penalized, taxed and disadvantaged by trade protection. By understanding that only individuals ultimately trade, it's then much easier to see that trade barriers typically protect a concentrated, small but well-organized group of inefficient domestic producers from more efficient foreign competition, while imposing huge and significant costs on other Americans - domestic companies that buy imported inputs and ultimately millions of U.S. consumers.

Remember it is companies that are trading, it's companies that have to pay the taxes (tariffs) to our own government. In the case of New Zealand tariffs on, say, Chinese goods the tariffs (that is, taxes) are being imposed not on the Chinese government or even the Chinese manufacturers, but on New Zealand companies who now are taxed for buying goods from China, and then those taxes are ultimately passed along to the individual New Zealanders who purchase the Chinese goods directly or purchase other consumer products that use the Chinese goods as inputs.

EconTalk this week

In a couple of posting recently, see here and here, I have mentioned the Smoot-Hawley Act. Now Thomas Rustici of George Mason University and author of Lessons from the Great Depression talks with EconTalk host Russ Roberts about the impact of the Smoot-Hawley Act on the economy. The standard view is that the decrease in trade that followed Smoot-Hawley was not big enough to be a significant contributor to the Great Depression. Rustici argues that this Keynesian approach that looks at aggregate spending misses a crucial mechanism for understanding the impact of Smoot-Hawley. Rustici focuses on the impact of Smoot Hawley on bank closings and the money supply. Smoot-Hawley launched an international trade war that reduced world trade dramatically. This had large concentrated regional effects in the United States and around the world in areas that depended on trade. Those were the areas where the first banks collapsed, contracting the money supply via the fractional reserve banking system. Rustici argues that the Keynesian indictment of the price system ignores the policy failures that destroyed the institutions that make the price system work.

Why it matters who leads research universities

Amanda Goodall has a interesting column at VoxEU.org on the topic of Why it matters who leads research universities. Goodall argues that the top European research universities underperform compared to their American counterparts. The evidence is summarised with policy recommendations by van der Ploeg and Veugelers (2008a,b). These authors raise the need for improved governance, in particular that governments should give universities greater autonomy to manage their own affairs. Leadership is an important part of governance, and again, in Goodall's view, Europe lags. US universities choose different types of leaders; indeed, as she argues, the achievement of America’s top institutions today may be explained partially by the legacy of outstanding scholars who have led them.

Goodall writes,

The top research universities in the world are overwhelmingly located in the US (Jacobs and van der Ploeg 2006; Goodall 2006). US institutions also house most Nobel Prize winners. A further difference between the US and Europe is that many of America’s great universities are also led by their best researchers.

Goodall then asks,

Could it be that having a distinguished scholar as leader improves the performance of universities?

She goes on,

Using the Shanghai Jiao Tong global league table, Figure 2 shows the average lifetime citations (normalised for discipline) of each president by the position of their university in the ranking. The 100 universities are grouped into quintiles (the ‘1-20’ group refers to the top of the Shanghai Jiao Tong table, where 1 is Harvard). As can be seen there is a clear monotonic decline – the higher the university is placed in the global ranking, the higher are the lifetime citations of its leader (Goodall 2006, 2009b). In other words, better universities appear to hire better scholars to lead them.

The important question is, Which way does the causation flow? Goodall writes,

Can the correlation be explained simply by assortative matching or reverse causality? For example, Harvard and Stanford become great and hence can attract and afford presidents who are outstanding scholars. The longitudinal part of my research suggests otherwise (Goodall 2009a,b). I follow a panel of 55 UK research universities in three Research Assessment Exercises. (The British government’s Research Assessment Exercises use peer review to assess each university’s research output and then allocates funding according to quality and quantity.) Using regression equations and controlling for confounding variables such as size of institution, my results show that those universities led, a number of years earlier, by good scholars go on to perform better in the RAE. Figure 3 presents the results in a simple cross-sectional bar diagram that correlates universities’ later performance in the Research Assessment Exercises with vice chancellors’ lifetime citations – normalised for discipline – some years earlier. The focus here is on the leaders of those universities that made the greatest gains, and the smallest gains, in the Research Assessment Exercises between 1992 and 2001. The universities that improved the most were overwhelmingly led by better researchers.

From all of this comes an obvious question, Why might top scholars improve university performance? Goodall discusses four reasons,

First, a president (vice chancellor, rector, principal) who is a distinguished scholar will have a better understanding of the core business of a university, that of research and teaching. This is key to the idea (promoted in Goodall 2009) of “expert leadership”, that in organisations where the core business relies on expert knowledge – for example, law and accounting firms, in R&D, management consultancies, and architecture practices – the leader must first be an outstanding expert in the relevant area of business. This particularly challenges the ideas of managerialism that would appear to promote management skills above expert knowledge. Arguably, top scholars, engineers or lawyers must also have management and leadership skills, and in my dataset of 400, almost all the leaders had progressed through managerial hierarchies in their institutions prior to the top job.

A second explanation raised by interviewees, one that again relates to expert knowledge, is that a scholar-leader will likely demand higher academic standards. Arguably, it is leaders who should set the standards in any organisation. This message is articulated by a dean in one of my interviews, “leaders are the final arbiters of quality. Therefore it is right to expect the standard bearer to first bear the standard”. A number of UK vice chancellors said that it was easier to encourage others to submit articles to top journals for the Research Assessment Exercise if they had done so themselves.

Top scholars send out important signals to a number of audiences, according to interviewees. They signal a university’s priorities, act as a beacon when hiring other outstanding academics, and are attractive to students and donors. Finally, it was suggested that scholars are more credible leaders. A president who is a researcher will gain greater respect from academic colleagues and appear more legitimate. Legitimacy extends a leader’s power and influence.

The last section of Goodall's column asks an interesting question, at least to me: How do economists fare as leaders?

Many years ago, humanists dominated as university heads. Today they have largely been replaced by scientists and social scientists, among whom economists are a rising force. One of the most successful, and arguably most influential, presidents of the 20th Century was the distinguished labour economist Clark Kerr, former Chancellor of Berkeley and the founding president of the University of California, who is often credited with its success. Indeed, labour economists are the largest group within the discipline, possibly because empirical work is more helpful in these roles than theory. Two retired economists recognised as having made an important contribution are William Bowen, former president of Princeton and the Mellon Foundation, and Henry Rosovsky, who was an influential dean of the Faculty of Arts and Sciences at Harvard, although he stopped short of becoming a president.

Lawrence Summers was one of the most distinguished scholars at the head of the Top-100 universities in the ranking mentioned above. When I present this work in seminars, the former Harvard president is often mentioned – “he was a top scholar who failed”. But my response to this question is that Summers spent many years in Washington DC prior to becoming Harvard’s president, and unquestionably the world of politics is played differently to that of academe. Summers may have been out of touch with the norms and values of the academy. In my interviews at Harvard, many reported that Summers, despite being controversial and short-lived, had developed a powerful intellectual vision for the institution and been a good fundraiser, although it is fair to say he may not have been a good manager of people.

The longest tenured Ivy League president, Richard Levin at Yale, is also an economist. At Bocconi University in Milan, one of Italy’s top institutions, Guido Tabellini has become rector. Tabellini is a highly cited economist, as is Kim Clark, former dean of Harvard Business School, now president of Brigham Young University. George Bain, another labour economist, is credited with raising the research performance of Queens University in Belfast, and before that he was both dean of Warwick Business School and London Business School. A number of business school deans are economists – Glenn Hubbard at Columbia, Rich Lyons at Berkeley’s Haas, Laura Tyson formerly at London Business School, and David Begg at Imperial. It has been difficult for business school deans to make the jump to university president. But the tide may be turning, and if so, more economists, preferably top economists, will likely take the helm at universities.

Question to self: Should I point all of this out to the non-academic economist VC of this university? Hmmmmmm

References:

• Goodall AH. (2006), “Should research universities be led by top researchers, and are they?” Journal of Documentation, 62: 388-411.
• Goodall AH. (2009a), “Highly cited leaders and the performance of research universities” Research Policy, 38: 1079-1092.
• Goodall AH. (2009b), Socrates in the boardroom: Why research universities should be led by top scholars. Princeton University Press.
• Jacobs, B. and F. van der Ploeg (2006), “Guide to reform of higher education: A European perspective”, Economic Policy, 47, 535-592.
• van der Ploeg, F. and R. Veugelers (2008a), “Towards evidence-based reform of European universities”, CESifo Economic Studies, 52, 3, 2-22.
• van der Ploeg, F. and R. Veugelers (2008b), “Towards evidence-based reform of European universities”, VoxEU.org, 27 September.

How not to run an economy

The following report comes via stuff.co.nz,

Nestle SA, the world's biggest food and drink company, says it has temporarily closed its production site in the Zimbabwe capital because employee security is no longer guaranteed.

Nestle's factory in Harare on Saturday received an unannounced visit from Zimbabwean government officials and authorities who forced it to unload a truck of milk, the company said.

Police questioned two local managers and released them without charges the same day, Nestle said in a statement.

"Since under such circumstances normal operations and the safety of employees are no longer guaranteed, Nestle decided to temporarily shut down the factory,'' it said.

Nestle announced in October that it stopped buying milk from eight farms, including one that appears to belong to the family of President Robert Mugabe.

The company had temporarily bought milk from these farms because the government was unable to buy it and the country's dairy industry risked to collapse.

When the government in October resumed purchasing milk from the eight farms, Nestle said it would end the temporary purchases.

But since then Nestle has faced pressure to continue buying milk from these farms, a demand it has refused.

How temporary is temporary? What incentives does this give Nestle, and other companies in Zimbabwe? Obviously the supply of Nestle's products in Zimbabwe must be affected, as will the income of the employees of the firm. Anyone what to take a bet on what will happen to private foreign investment in Zimbabwe? If there is anywhere in the world that needs foreign investment, Zimbabwe would be it. This kind of action isn't the way to attract it. Arbitrary government action of this type only increases regime uncertainty at a time when Zimbabwe can lest afford it. Long-term private investment must be reduced because what remains of investors' confidence in the durability of private property rights is further eroded.

Blowing smoke at a ban

In the New York Times Douglas Quenqua writes on Blowing Smoke at a Ban. He says

Six years after New York City passed a ban on smoking in bars and restaurants, it is easier than ever to find smokers partying indoors like it’s 1999, or at least 2002. In November, Eater.com called it “the worst kept secret in New York nightlife” that “smoking is now allowed in numerous nightspots, specifically just about any and every lounge and club with a doorman and a rope.” A few weeks later, GuestofaGuest.com, a blog about New York clubs and bars, posted a “smoker’s guide to N.Y.C. nightlife.”

“Everyone looks the other way,” said Billy Gray, 25, a reporter for Guest of a Guest, who says that he knows precisely which high-end bars and lounges, most of them in the meatpacking district or Lower East Side, will let him smoke inside. Far from deterring smoking indoors, the ban simply adds an allure to it, said Mr. Gray, a half-pack-a-day smoker.

“It’s more of an illicit thrill now,” he said. “Like when you were a teenager and snuck a beer in your parents’ basement.”

Does prohibition ever work? Is there a single example of where it has achieved its ends? Alcohol? Drugs? Smoking? The economics of such bans mean they will not work. At best prohibition just forces up the price of whatever is being banned which makes it that much more profitable to supply. Hence, where there is a demand there is a supply.

Why not just let the owners of bars and restaurants decide whether or not to allow smoking. They can put a notice on their front door saying smoking is or is not allowed and thus consumers can then decide to enter or not given that information. Simple.

As for employees, they to can decide whether or not to work in a smoking or non-smoking establishment. It would just be another factor to take into account when deciding to take a job or not.

Dave Barry on 2009

From the Washington Post comes Lowlights of a Downer Year: Dave Barry on the money, madness and misery of 2009

It was also a year of Change, especially in Washington, where the tired old hacks of yesteryear finally yielded the reins of power to a group of fresh, young, idealistic, new-idea outsiders such as Nancy Pelosi. As a result, Washington, rejecting "business as usual," finally stopped trying to solve every problem by throwing billions of taxpayer dollars at it, and instead started trying to solve every problem by throwing trillions of taxpayer dollars at it.

Quote of the day

"You might be an economist if you refuse to sell your children because they might be worth more later."

Yoram Bauman

Just for the record, Eric Crampton, of Offsetting Behaviour fame, hasn't tried to sell his son Ira .... yet.

Interesting blog bits

1. Tom Odula on Pirate cash suspected cause of Kenya property boom. Property prices in Nairobi are soaring, and Somali pirates are getting the blame. The hike in real estate prices in the Kenyan capital has prompted a public outcry and a government investigation this month into property owned by foreigners. The investigation follows allegations that millions of dollars in ransom money paid to Somali pirates are being invested in Kenya, Somalia's southern neighbor and East Africa's largest economy.
2. Peter Goodman on U.S. Loan Effort Is Seen as Adding to Housing Woes. The Obama administration’s $75 billion program to protect homeowners from foreclosure has been widely pronounced a disappointment, and some economists and real estate experts now contend it has done more harm than good.
3. Justin Lahart on Secrets of the Economist's Trade: First, Purchase a Piggy Bank. Economists are often cheapskates.
4. Eric Crampton on Wishful thinking. Ayn Rand may not be as "in" as some people think.
5. Bryan Caplan on Baby-Selling: When Is Wrong to Sell? When Is It Right to Ban? An example of a repugnant market.
6. Glen Whitman on New Paternalism on the Slippery Slopes, Part 7: The Inevitable Misinterpretation of New Paternalist Arguments.
7. Noam Scheiber on Upper Mismanagement. Why can't Americans make things? Two words: business school. And I would guess its not just a problem in the US.
8. Tyler Cowen on Fruitful Decade for Many in the World. It may not feel that way right now, but the last 10 years may go down in world history as a big success.

Ronald Coase - 2003 Coase Lecture

The topic of the lecture is The Present and Future of Law and Economics and it was given at the University of Chicago Law School on Tuesday, April 1, 2003.

Regulation and Sarbanes-Oxley

On the question of why we get regulation Oliver Hart has a paper which looks at the Sarbanes-Oxley Act (SOX) in the US. Hart argues that rather than being based on sound principles, regulation often seems to be a consequence of the public’s need for action in response to a crisis, and that this was the case with Sarbanes-Oxley Act. Hart writes,

What does explain SOX then? Probably the best explanation is that the pressure on politicians to act—from the public, interest groups, and the politicians themselves—was so great that nonintervention was not an option. To quote Coates [2007, p. 91]: “In a democracy in which most voters own stock either directly or indirectly through their pension and retirement funds, government was certain to react. The only question was the shape the reaction would take.” The good news is that the intervention does not seem to have been a disaster; in fact, it may even have been a mild success (see, e.g., Coates [2007], Leuz [2007], Hochberg, Sapienza, and Vissing-Jørgensen [2009]). At the same time, as Ball [2009] points out, we still do not know definitively whether the 1933 to 1934 Securities Acts were a good thing 75 years after the event! Thus, we will not have the final word on SOX for a while.

So its the old, "we must do something and this is something, so lets do it" (no matter how bad the something may be) approach to government action. Interestingly he also argues that the recent financial meltdown provides another example of the same phenomenon.

Efficient regulation

An obvious point about the world is that there is a hell of a lot of regulation out there. Why? Regulation of economic activity is ubiquitous around the world, there must be a reason for it. In a new paper Harvard economist Andrei Shleifer looks for this reason.

To a student of traditional Pigouvian (1938) welfare economics, such an extent of government regulation makes perfect sense. Markets fail, a Pigouvian would say, because of externalities, asymmetric information, and lack of competition, and governments need to regulate them to counter these failures. Regulation is ubiquitous because market failures are.

Such a view however has come under attack since, at least, Coase (1960).

This tradition holds that competition is merciless in driving firms toward efficiency, that markets exhibit tremendous ingenuity in dealing with potential failures, that contracts enforced by courts get around most externalities, and that even when for some reason contracts do not take care of all harmful conduct, tort law addresses most of the rest. The space left for efficient regulation is then very limited. From the efficiency perspective, the ubiquity of regulation is puzzling.

But the problem may be deeper than even Coase suggests.

In fact, it is even more puzzling than Coasian logic would suggest. In Coase’s view, contracts are a substitute for regulation. If potential externalities can be contracted around, no regulation is necessary. Yet, contrary to this prediction, we see extensive government regulation of contracts themselves. [...] The fact that contracting itself is so heavily regulated severely undermines both the Pigouvian and the Coasian theories of regulation.

For the Pigouvian tradition

The Pigouvian theory is undermined because market failures or information asymmetries do not seem to be necessary for regulation, yet those are seen by the theory as the prerequisites for government intervention.

As for the Coaseian

The Coasian position is undermined because free contracts are expected to remedy market failures and eliminate the need for regulation, yet regulation often intervenes in and restricts contracts themselves, including contracts with no third party effects.

Thus we see that the puzzle of ubiquitous regulation remains.

In reaction to this many economists would argue that regulation is driven not by efficiency but by politics.

Under the most prominent version of this theory, proposed by Stigler (1971), industries or other interest groups organize and capture the regulators to raise prices, restrict entry, or otherwise benefit the incumbents. Alternatively, regulation is just a popular response to an economic crisis, introduced under public pressure whenever market outcomes are seen as undesirable, regardless of whether there are more efficient solutions.

But there are problems here to.

[...] the political theories are not entirely persuasive, as they fail to come to grips with the fairly obvious facts [...] that regulation is ubiquitous in the richest, most democratic countries, with most benign governments, and seems to support the highest quality of life. Extensive regulation seems to be embraced in nearly all corners of these societies, which seems inconsistent with the view that regulation is inefficient.

So what is Shleifer's response to all of this?

In this paper, I revisit the case for efficient regulation. My basic point is simple. The case against regulation relies on well-functioning courts. Courts are needed both to enforce contracts and to provide remedy for torts, and hence are central to the basic private mechanisms for curing market failures. In so far as courts resolve disputes cheaply, predictably, and impartially, the efficiency case for regulation is difficult to make in most areas. Efficient regulation would be an exception, not the rule. But when litigation is expensive, unpredictable, or biased, the efficiency case for regulation opens up. Contracts accomplish less when their interpretation is unpredictable and their enforcement is expensive. Liability rules would not address market failures if compensation of the victims is vulnerable to the vagaries of courts. In short, the case for efficient regulation rests on the failures of courts.

So regulation is caused not by market failure or government failure but by court failure.

Arnold Kling raises a question,

The question that occurs to me is why regulation is supplied by government rather than by the private sector. If workplace safety regulation is more efficient than a system that relies on competition and contracts enforced by courts, then an entrepreneur could offer to set up a workplace safety standards body and earn fees from market participants for certifying compliance.

He argues that what Shleifer's paper fails to do is explain what determines the choice between private and government regulation. Kling goes on to say,

What I suspect is that government regulation emerges when some firms want to restrict entry from other firms. Regulations that restrict entry are likely to be harder to enforce when they come from the private sector, because the unwanted entrant has little incentive to comply. Only with government coercion can entry-restricting regulations be enforced.

To induce taxpayers to fund any sort of regulation, a broad public interest must be asserted. However, of the universe of regulations that might be given a public interest justification, the ones that will be enacted will be those that serve to protect incumbent firms from new entrants.

This seems a good point to me.

References:

• Coase, Ronald H. 1960. “The Problem of Social Cost.” Journal of Law and Economics 3: 1-44
• Pigou, Arthur C. 1938. The Economics of Welfare. 4th ed. London: Macmillan and Co.
• Stigler, George J. 1971. “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science 2(1): 3-21.

Top ten pro-liberty books of the decade

As we enter a new year we have cause to reflect on the fact that there are too many areas of our lives in which the future looks more bleak for individual liberty than they did a year ago. To counter this we need to find ways to bring the classical liberal message to a wider audience. One method is via books that promote this message. To help in this, the Atlas Foundation has come up with a list of the Top Ten Pro-Liberty Books of the Decade. They asked 22 classical liberal thinkers which were the most important books published this past decade that advance the cause of liberty. The results are now in.

#10 The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics (2001) by William Easterly

#9 Elements of Justice (2006) by David Schmidtz

#8 The White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good (2006) by William Easterly

#7 From Mutual Aid to the Welfare State (2000) by David T. Beito

#6 In Defense of Global Capitalism (2003) by Johan Norberg

#5 The Bourgeois Virtues (2007) by Dierdre McCloskey

#4 Justice And Its Surroundings (2002) by Anthony de Jasay

#3 The Myth of the Rational Voter: Why Democracies Choose Bad Policies (2008) by Bryan Caplan

#2 Radicals for Capitalism: A Freewheeling History of the Modern American Libertarian Movement by (2008) by Brian Doherty

#1 Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (2001) by Hernando de Soto

More detail on each book can be found at the webpage. Its good to see Bill Easterly on the list ... twice. And also to see Bryan Caplan in at number 3. About the number one book the Atlas Foundation writes,

Aware that developed countries did not start wealthy, and weren’t assisted by foreign aid, the De Soto coordinated a series of empirical investigations to identify what prevents the Third World from reaching the same level of development as the First. He discovered that institutional costs imposed by governments all over the world are the main obstacles to reducing poverty. Real estate is the most emblematic case. The fact that states do not recognize the property rights of millions of people to the homes they effectively own prevents them from capitalizing on goods that sum billions of dollars. Free exchange and initiative has made poverty more of an exception than a rule in the developed world, and it is the lack of freedom that imprisons millions of people in a condition of poverty. No book of this decade demonstrates this better than The Mystery of Capital.

The list would make for a good summer of reading.

As for books not on the list, Damon W. Root at Reason makes the case for David Bernstein’s "Only One Place of Redress: African Americans, Labor Regulations, & the Courts from Reconstruction to the New Deal". He writes

Obviously any such list will have its omissions, but I’d like to nominate one additional book that deserves real attention: legal historian David Bernstein’s excellent Only One Place of Redress: African Americans, Labor Regulations, & the Courts from Reconstruction to the New Deal. Bernstein meticulously documents the ways that Progressive and New Deal economic regulations, including labor laws, occupational licensing laws, and prevailing wage laws, directly harmed African Americans. In contrast, on those occasions when state and federal courts actively protected economic liberty against this state abuse, blacks were among the prime beneficiaries, a process that the New Deal takeover of the Supreme Court brought to a disastrous end.

Knowledge & ownership

At the Stumbling and Mumbling blog Chris Dillow raises the interesting issue of Knowledge & ownership. He writes,

The thing is, part of the case for worker ownership is that it is a means of using dispersed, fragmentary knowledge. Workers sometimes (often?) know better than bosses how to cut waste or improve efficiency. Giving them ownership might therefore be a means of improving efficiency.
There are two principles here we should make explicit.
First, ownership should, ideally, flow to where there is knowledge. Not all ownership forms achieve this. For example, customer ownership did not stop Equitable Life collapsing, in part because customers didn’t really know what the hell it was doing. Similarly, shareholders’ failure to stop banks going bust wasn’t just a problem of collective action - it was that they didn’t know what banks were doing.
Second, ownership must entail real power.

Dillow is right in that workers may well have more information that bosses about the actual workings of a firm. But does this mean they need to be given ownership? In some cases the answer would be yes. We see worker ownership in the form of partnerships in areas where knowledge is important, lawyers and doctors being two obvious examples. But can the idea be applied more widely or are labour-owned firms likely to remain small partnership like institutions? Consider the paper Brynjolfsson (1994).

The Brynjolfsson (1994) model considers an entrepreneur who has some expertise needed to run a firm. No value can be created without both the knowledge asset of the entrepreneur and the physical assets of the firm. He assumes that no comprehensive contract can be written between the entrepreneur and the firm. If the entrepreneur does not own the firm, then if he makes an investment in effort and creates value, he can be subject to hold-up by the other party since he needs the firm’s physical assets. If the entrepreneur owns the firm then clearly the hold-up problem ceases to exist. The most obvious interpretation of Brynjolfsson model is as a model of a labour-owned firm. Brynjolfsson argues that it is optimal to give the entrepreneur ownership of the physical assets of the firm since he has information that is essential to its productivity. This result is obviously just an application of Hart and Moore’s proposition that an agent who is ‘indispensable’ to an asset should own it. Here, firms are owned by the indispensable human capital, or more normally by a small section of the human capital, e.g. a partnership.

Labour-owned firms are therefore one way to form a human capital-intensive firm but the shortcomings of such organisations are obvious: lack of access to capital, inadequate risk pooling, investment problems, older workers wanting a shorter pay-back period than younger workers, are membership rights tradable and if so under what conditions, new members would have to purchase ‘equity’ in the business from retiring ones, borrowing to cover such a purchase could be a problem for younger would-be members, etc.

Brynjolfsson (1994, p. 1654) also sees advantages in firms being small when information is important in production. In his view, smaller firms have an advantage in providing incentives both because it is easier to separate out the contributions made by each individual, and thus to reward each individual accordingly, and because it is more likely that agents in small firms have a stronger incentive to make non-contractible contributions. Small firms therefore have an advantage over larger ones in situations in which it is important to provide incentives for the application of information in ways that cannot be easily foreseen and incorporated into a contract. Brynjolfsson (1994, footnote 12) goes further by noting that the stronger, output-based incentives for the noncontractible actions in smaller firms will not only induce higher effort overall, but, in multidimensional models, also induce less effort on actions that do not enhance output. Note that what we mainly see in terms of labour-owned firms are small firms. Outside of some of the accounting firms, partnerships and other worker-owned firms are generally small.

But even if knowledge is important to production, firms can change in response to this without a change in ownership. Rajan and Zingales (2003, p. 87) argue that we are in fact seeing a new ‘kinder, gentler firm’. This is in response to the increase in the importance of human capital, along with increased competition and access to finance, all of which have increased the worker’s importance and improved the outside options for workers, thereby changing the balance of power within firms. Rajan and Zingales (2003, p. 87) also argue that the biggest challenge for the owners and management today is to manage in an environment of much reduced authority. Today, authority has to be gained by persuading workers that the workplace is an attractive one and one that they would hate to lose. To do this, management has to ensure that work is enriching, that responsibilities are handed down, and that rich bonds develop not only among workers but also between workers and management.

Another example is Cowen and Parker (1997) who make a similar point about the changes to organisational structures that the new economy is bringing about. For them:

Information as a factor of production is making old functional structures and methods of organisation and planning redundant in many areas of business. The successful use of knowledge involves not only its generation, but also its mobilisation and integration, requiring a change in the way it is handled and processed. (Cowen and Parker, 1997, p. 12)

Organisational change, according to Cowen and Parker, is the consequence of the increasing need to make use of market principles within the firm and the growing importance of human capital. They note that as far as a firm’s labour force is concerned, the emphasis has now shifted towards encouraging knowledge acquisition, skills and adaptability since these are seen as critical in maintaining a competitive advantage. (Cowen and Parker, 1997, p. 32). Firms are obliged to rely more on market-based mechanisms as the most efficient way of processing and transmitting information and giving the firm the flexibility but also the focus it requires. Companies are decentralising their management systems as a way of coping with the uncertainty and pace of change in their markets. The aim is to ensure that those with the required knowledge and right incentives are the ones making the decisions and taking responsibility for the outcomes. Cowen and Parker (1997, pp. 25–8) emphasise how advances in ICTs underlie the capacity to combine the advantages of this organisational flexibility with mass production.

The point of all this is that the efficient use of (tacit) knowledge may not require a change in ownership. This is for two related reasons: 1) worker ownership may require the firm to be small, large worker-owned firm may create more problems than they solve. You do have to ask why are they so rare. 2) there are other ways to deal with (tacit) knowledge within a firm which don't require changes in ownership.

References:

• BRYNJOLFSSON, E. (1994). Information assets, technology, and organization. Management Science, 40, 12, pp. 1645–62.
• COWEN, T. and PARKER, D. (1997). Markets in the Firm: A Market-Process Approach to Management. London: Institute of Economic Affairs.
• RAJAN, R. G. and ZINGALES, L. (2003). Saving Capitalism From the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity. New York: Crown Business.

Schumpeterian creative destruction

It would appear that the forces of Schumpeterian creative destruction have been around for thousands and thousands of years ...

(HT: Carpe Diem)

Protectionism is doing to ourselves in peacetime what our enemies to do us in wartime

This graph comes from Mark J. Perry's blog Carpe Diem.

The graph shows the volume of U.S. exports of goods and services, in inflation-adjusted dollars, annually from 1929 to 1945. The effects of protectionism - the Smoot-Hawley Tariff Act of 1930 - are roughly the same as the effects of war - World War 2. Trade protection amounts to making economic war on yourself.

Mechanism design in a nutshell

Or at least Daniel McFadden's view of mechanism design in a nutshell.

The above diagram is Figure 1 from The human side of mechanism design: a tribute to Leo Hurwicz and Jean-Jacque Laffont , by Daniel McFadden, Review of Economic Design, Volume 13, Numbers 1-2 / April, 2009, pp. 77-100.

Market design in New Zealand

Via Al Roth's great (US) blog Market Design, I leant about a New Zealand example of market design. A kidney exchange has got going in New Zealand. Some information from Kidney Health New Zealand

New Zealand Paired Kidney Exchange Scheme – Information Sheet June 2009

1. Introduction

1. This information sheet is designed to provide basic information regarding the NZ Paired Kidney Exchange (PKE) Scheme.
2. Detailed information regarding kidney transplantation and live donor nephrectomy (kidney removal) will be supplied to you by your transplant co-ordinator. You should make sure that you have received this information and that you understand the operations and any medicines that you will need to take. The exact protocols for transplant and nephrectomy vary slightly between the 3 NZ transplant units.
3. Any questions should first be directed to your local transplant co-ordinator or renal specialist, if they are unable to assist then you should contact the Medical Director of the NZ Kidney Allocation Scheme – Dr Ian Dittmer. Your co-ordinator will be able to put you in contact.

2. Purpose

1. Kidney transplant is usually the best treatment for people with end stage kidney disease, however waiting times for a deceased donor kidney transplant are very long.
2. Live kidney donation has therefore become one of the treatment routes of choice. Unfortunately some donor / recipient (D/R) pairs cannot proceed because of
        i .  A positive crossmatch caused by anti-HLA antibodies
        ii.  Incompatible blood groups
3. The PKE scheme is designed to allow D/R pairs who are unable to proceed to transplant as described above an opportunity to do so.
4. The simplest example of how this might work is
   i. Donor X – blood group A, recipient X blood group B.
   ii. Donor Y – blood group B, recipient Y blood group A.
   iii. These two pairs cannot proceed normally but with PKE donor Y can give a kidney to recipient X, and donor X to recipient Y
   iv. Importantly these 2 transplants can proceed without any extra immunosuppressive medication.

3. How the PKE scheme works

1. D/R pairs who wish to participate in the scheme will have their Blood Group and Tissue Typing details entered into a database. This information will be held in the NZ Blood Service Tissue Typing Lab in Auckland.
2. Prior to being formally entered the D/R pair will need to have
   i. Been accepted both as suitable for transplantation and for donation. The NZ transplant subcommittee has agreed to guidelines for assessing this.
   ii. Completed all their work-up for these procedures.
   iii. Given written consent to enter the PKE scheme.
3. At least every 2 months a search will be made of those enrolled in the scheme to see if there are any possible paired exchanges.
   i. Priority will be given to those waiting on the National Kidney allocation scheme the longest.
   ii. There will be a small extra priority given to children as in the deceased donor scheme.
4. Where a possible PKE match is found then both pairs will be notified and planning begun for the transplants if both pairs still wish to participate.

Crossmatches will be performed to confirm that both transplant procedures are safe to perform.

4. How the transplants will be performed

1. The donor nephrectomies will be performed at the same time
2. The transplants will be performed as soon after the nephrectomy as is practically possible – these may not be at the same time exactly but any difference will not be enough to have an effect on transplant function
3. The operations may not all be performed at the same transplant centre, in fact they will often be performed in different centres.
   i. Where a kidney needs to be transported this will be co-ordinated by Organ Donation NZ

5. Other important information

1. You will not be given any information regarding the D/R pair who you are exchanging kidneys with
   i. All D/R pairs will be medically acceptable for the procedures
   ii. The kidney you will receive has been assessed as having good function
   iii. The recipient that will receive your kidney has been assessed as having a good chance of successful transplantation
   1. if there is any variation from this you would be informed
2. The success of the transplant is not guaranteed
   i. outcomes should be the same as normal live donor transplants and unfortunately this means that 1 in 20 of the transplants will fail in the first 12 months
   ii. in the unfortunate situation where a transplant fails without ever functioning then the recipient of that transplant will keep all their waiting time points
3. PKE transplants may be difficult to arrange
   i. We will try very hard to make sure that everything proceeds smoothly
   ii. We will try to ensure that the date you have been given for the transplant is kept to, but cannot guarantee this even the evening before the transplant
   
4. There is no guarantee that we will find you a suitable D/R pair for you to participate in a PKE with
   i. We expect however that we will be able to perform at least 2 PKEs each year – a significant increase in the number of live donor transplants performed.
   ii. We hope for more
   iii. We will try to provide regular updates as to the number of D/R pairs in the scheme

A transatlantic free trade area?

An interesting idea to start the new year off with. Razeen Sally wants us to consider the idea,

It is perhaps time to revive the idea of a transatlantic free trade area (TAFTA). This is the gist of two papers, one by ECIPE’s Fredrik Erixon and Gernot Pehnelt (http://www.ecipe.org/publications/ecipe-working-papers/a-new-trade-agenda-for-transatlantic-economic-cooperation/PDF ), the other by GEM-Sciences Po’s Patrick Messerlin and Erik van der Marel (http://www.gem.sciences-po.fr/content/publications/pdf/Messerlin-VanderMarel_services07062009.pdf ). A TAFTA initiative was floated in the 1990s, only to sink; and the Transatlantic Economic Council (TEC), established at the initiative of Chancellor Merkel to tackle regulatory barriers, has got bogged down in micro-detail and hardly made progress. Sure, political obstacles are great, but it is worth stepping back to coolly assess costs and benefits, and then decide whether to go ahead with a new initiative.

Sally's assessment of the Bush and Obama administrations on trade policy,

Trade policy has deteriorated in the United States since the Obama administration took over. The Bush administration, for all its faults, did not do a bad job on this front. Its major achievement was to contain protectionism at home, especially against China. President Obama, on the other hand, while no clear-cut protectionist, has ambivalent views on the subject and is not an instinctive free-trader. He has powerful protectionist forces inside his tent – among Congressional Democrats, the AFL-CIO, and at his Cabinet table (notably the Labour Secretary, Hilda Solis). His record to date shows a delicate balancing act, giving way to domestic protectionist forces at one moment, but cushioning their impact and maintaining open markets the next moment. But his overall approach is defensive; and trade policy is crowded out by his domestic priorities. That leaves sweet-sounding multilateralist rhetoric, but without substance. It is soft-serve ice-cream multilateralism, worthy of a Norwegian peace prize.

His conclusion:

To conclude: This is not a good time for EU and US trade policy. Both are defensive in a global economic climate that has gone from benign to turbulent. That also poses a threat to bilateral economic relations. TAFTA is worth another look, this time as a two-stage initiative: first to eliminate tariffs, and then to tackle the harder stuff.

The rest of Sally's article is available here.

The fascist economy

At the Fraser Institute economics professor Steven Horwitz has a brief essay on Fascism. On the topic of the economics of fascism Horwitz writes,

What emerged as the fascist economic system then was a combination of the socialist rejection of capitalism and the nationalist rejection of internationalist socialism. It’s not coincidental that “Nazi” was short for National Socialist German Workers Party. The very name suggests that the fascists started from a socialist premise (including the emphasis on being a “workers” party), but added the “nationalist” (and specifically “German”) twist.

Rather than have full-blown socialism as we saw in the early years of the Soviet Union, the fascists generally preferred hybrid forms that often maintained the appearance of elements of capitalism but with a much larger role for the state in allocating resources. A look at the Nazi Party platform of 1920 shows the very strong influence of socialism in the economic planks, including objections to the earning of interest, the desire to nationalize industries, the confiscation of profits, and land reform. Not all of these were put into place when Hitler gained power, but the Nazis’ antipathy toward capitalism is quite clear, even as they often co-opted big business into their power structure in during their reign. The trappings of private ownership were often preserved, but the Nazis used the power of the state to try to ensure that private ownership was used as a means toward the national ends that they defined.

The Italian model was similar in its broad outlines, though different in its execution. The Italians were more clear than the Germans about the way in which market competition was destructive of national goals. They didn’t see Russian socialism as a solution for the reasons noted above. Instead, they argued for industry-level partnerships among labor, capital, and the political class. The idea was that by working collectively, these cartel-like organizations could resolve questions of what to produce, what price to charge, what wage to pay, and the like all without the need for cut-throat competition among firms or workers, or the use of strike threats between workers and capitalists. By putting national interests first, these collectives could plan out production industry by industry and ensure a cooperative peace among Italians. So, once again, the system kept some of the trappings of capitalism, such as nominally private ownership, but set them in a system where collective planning of a limited, and nationalistic, sort was the overarching structure.

Both of these systems are probably most accurately called “corporatism.” In such a system, we get these sorts of private-public collaborations in which private ownership is combined with state control and privileges for labor, and where all are expected to serve some larger national goal. It looks like private ownership, which is often the source of the claim that fascism is a form of capitalism, but the degree of distrust of the unplanned order of free markets and the de facto power that falls into the hands of the state to set goals both point to it as being more accurately a form of socialism or planning.

Avraham Barkai writes in his book "Nazi Economics: Ideology, Theory, and Policy", Oxford: Berg Publishers Ltd., 1990.

In an off-the-record talk with a newspaper editor in 1931, Hitler defined the basic principle of his economic project: "What matters is to emphasize the fundamental idea in my party's economic program clearly-the idea of authority. I want the authority; I want everyone to keep the property he has acquired for himself according to the principle: benefit to the community precedes benefit to the individual ["Gemeinnutz geht vor Eigennutz"]. But the state should retain supervision and each property owner should consider himself appointed by the state. It is his duty not to use his property against the interests of others among his people. This is the crucial matter. The Third Reich will always retain its right to control the owners of property." Here we have all the basic assumptions that later determined the Nazis' economic plans and their actual policy: virulent antiliberalism, subjection of the economy to the primacy of political and social goals as defined by the national leadership, and state control over all economic activities. [p.26-7]

So you could do anything you liked with your own property, just as along as it was exactly what the state wanted you to do with it.