Micro foundations of public sector management 2 (updated)

Update: Added discussion of the Holmstrom and Milgrom paper.

This is my second post on the Treasury working paper "Contemporary Microeconomic Foundations for the Structure and Management of the Public Sector" by Lewis Evans, Graeme Guthrie and Neil Quigley.

In chapter 3 the authors focus on the "incomplete contracts" or "property rights" approach to theory of the firm.

In section 3.2 Evans, Guthrie and Quigley write,

"Transaction-cost explanations for contractual incompleteness are unsatisfactory, because there is more incompleteness than can be accounted for by transaction costs (specifically, because there are many elements where contracting is not possible rather than just more costly than the alternative). Examples include situations where information is symmetric, but key contractible elements are not verifiable by either party. Even when transaction costs are zero, incomplete contracts may arise because parties cannot observe relevant economic variables, cannot verify those variables to a legal standard of proof, or prefer not to disclose information about themselves that would be required for a complete contract."

Now this I don't get. Aren't all cases of incompleteness driven by some form of transaction cost? If we think of transactions costs as the costs of market transactions then in a zero transaction costs world contract would be complete since such contracts would be cost-less to write. Coase has written,

"The solution to the puzzles that I took with me to America [Why are there firms?] was, as it turned out, very simple. All that was needed was to recognize that there were costs of carrying out market transactions and to incorporate them into the analysis, something which economists had failed to do. A firm had therefore a role to play in the economic system if it were possible for transactions to be organized within the firm at less cost than would be incurred if the same transactions were carried out through the market. The limit to the size of the firm would be set when the scope of its operations had expanded to the point at which the costs of organizing additional transactions within the firm exceeded the costs of carrying out the same transactions through the market or in another firm."

The idea that when

"information is symmetric, but key contractible elements are not verifiable by either party"

we get incomplete contracts seems odd. If information is known to the contracting parties, what does it not being verifiable to the parties mean? If the information is not verifiable to a third party, e.g. a court, then a contract can be incomplete, but this is a different thing from information being non-verifiable to the contracting parties. If information is symmetric in that it is unknown to all contracting parties, will a contract be incomplete? The answer to this depends on whether or not the information is verifiable to a third party. If it is then the contracting parties can contract on it by just getting the third party to verify the information. If the information is not verifiable to the third party then a contract will be incomplete. But the reason for the incompleteness is not because the information is unknown to the contracting parties but rather because it is non-verifiable to the third party.

The idea that,

"Even when transaction costs are zero, incomplete contracts may arise because parties cannot observe relevant economic variables, cannot verify those variables to a legal standard of proof, or prefer not to disclose information about themselves that would be required for a complete contract"

also seems odd. I'm not sure what they mean when they say that information is non-observable to the contracting parties. If this means a moral hazard/adverse selection type framework then contract are comprehensive and not incomplete. As Hart explains it,

"Although the optimal contract in a standard principal-agent model will not be first-best (since it cannot be conditioned directly on variables like effort that are observed by only one party), it will be 'comprehensive' in the sense that it will specify all parties' obligations in all future states of the world, to the fullest extent possible. As a result, there will never be a need for the parties to revise or renegotiate the contract as the future unfolds. The reason is that, if the parties ever changed or added a contract clause, this change or addition could have been anticipated and built into the original contract."

and

"One would also not expect to see any legal disputes in a comprehensive contracting world. The reason is that, since a comprehensive contract specifies everybody's obligations in every eventuality, the courts should simply enforce the contract as it stands in the event of a dispute."

Clearly such a contract is not incomplete. If Evans, Guthrie and Quigley mean that neither of the contracting parties can observe the variable then we are in case discussed above in; which the important point is the verifiability of the variable to a third party. If the contracting parties,

"cannot verify those variables to a legal standard of proof"

then contracts could be incomplete. Non verifiability of information to a third party such as a court is the standard argument as to why contracts are complete. But this argument can be countered by the Maskin and Tirole critique. Maskin and Tirole argue that information which is observable to the contracting parties can be made verifiable (to a third party) by the use of ingenious revelation mechanisms. The contracting parties write into their contract a game which when played gives the appropriate incentives for them to truthfully reveal their private information in equilibrium. This undermines the non-verifiability approach to incomplete contracts.

If some of the contracting parties,

"prefer not to disclose information about themselves that would be required for a complete contract"

then its hard to see that we are in a zero transaction costs world. Isn't not providing information the same as saying the costs of contracting on that information are infinite? This looks like a very large transaction cost!

Under section 3.3 Evans, Guthrie and Quigley write,

"The starting point for this approach to the theory of the firm is the incompleteness of contracts. Since humans are boundedly rational, not all issues of relevance to a contract can be anticipated at the time of writing the contract."

But Oliver Hart argues,

"In the last few years, a literature has developed on the theory of incomplete contracts, and on applications of this theory to the understanding of organizations, such as firms. In this paper, I will argue that, while transaction costs of various sorts are a crucial ingredient of this literature, bounded rationality in the sense that agents have limited cognitive, computational or comprehension skills is not."

Given that Evans, Guthrie and Quigley argue that incompleteness is important for contracts there is one question that they need to answer. As it is possible for the contracting parties to fill any gaps in their contract as they go along, Why is contractual incompleteness important? The reason is that renegotiation itself imposes costs. These cost can be both ex post, incurred at the time of renegotiation, or ex ante, incurred in anticipation of renegotiation.

In section 3.4 the point is made that,

"The incomplete contracting perspective embodied in this example represents a sharp break with the earlier transaction cost-based literature on the firm. Whereas incomplete contracts imply that inefficiencies arise because it was hard to foresee and contract about the uncertain future, earlier literature tended to take a “complete contracts” perspective in which imperfections arise as a result of moral hazard and asymmetric information."

I would read the "earlier literature" comment to refer to the transaction cost literature. But incomplete contracts are a central feature of the transaction cost approach. As Hart and Moore (2007) explain

"Transaction cost economics (see, e.g., Oliver Williamson (1975, 1985), Benjamin Klein et al. (1978)) argues that firms are important when contracts are incomplete, and parties make large relationshipspecific investments."

Section 3.5 of the paper looks at the link between transaction costs, incentive-based theories and incomplete contracts. When discussing incentive-based theories of the firm Evans, Guthrie and Quigley write,

Incentive-based theories of the firm have their foundation in the analysis of the incentive problem between a principal and an agent. This approach assumes that there are many tasks and many instruments associated with the agency problems in a firm, and asset ownership is merely one of the instruments. Papers in this paradigm consider two ways to structure the agency problem: (i) where the agent does not own the asset (is an employee) and therefore has incentives provided by being paid on measured performance, and (ii) where the agent does own the asset (is an independent contractor) and receives both a payment based on measured performance and the value of the asset after production occurs.

This approach to the theory of the firm has in effect focused on the claimed distinction between the low-powered incentives associated with employment, and the high-powered incentives associated with contracting. Employees require low-powered incentives because they are not distracted by the contractor’s incentives to increase the value of the assets used for production. More generally, joint optimisation over asset ownership and contract parameters determines whether to conduct activity within the firm or outside.

The incentive-system theory of the firm is therefore related to the incomplete contracts literature, both in its use of ownership as an instrument and in its ability to provide a unified account of the costs and benefits of integration.

Incentive theory is normally thought of as a comprehensive contracts based theory and much of the literature is of this form. Think of moral hazard models. Incentive theory of this type is probably best understood as a extension of the neoclassical theory of the firm that inquiries into the incentive conflicts that may hinder the firm from reaching its production possibility frontier. But not all incentive theory is of this kind. While its not exactly clear what set of papers is being referred to above. I assume that papers like Bengt Holmstrom and Paul Milgrom’s 1994 paper, "The Firm as an Incentive System" fall into this group.

Holmstrom and Milgrom here stress the importance of viewing the firm as "a system", specifically as a coherent set of complementary contractual arrangements which mitigate incentive conflicts. In their opinion, it is misleading to focus on any one single aspect of the coherent whole: the firm is characterized by the employee not owning the assets, by the employee being subject to a low-powered incentive scheme, and by the employee being subject to the authority of the employer. These “incentive instruments” are complementary: For example, in the presence of measurement costs, it is important that a person who does not own the assets which he uses is not subject to high-powered incentives, since he then is likely to care too little for the assets. Likewise, low-powered incentives make it important for the employer to be able to exercise authority over the use of the employee’s time, since the employee will lack the proper incentive to be productive. Due to this complementarity it is logical that independent contracting has the exact opposite constellation of instruments from the employment relationship.

The choice between the two different incentive systems depends importantly on the extent to which every dimension of a person’s contribution can be measured. When an important dimension is unmeasurable, it might be counterproductive to remunerate the person through a high-powered incentive scheme since the person is likely to allocate too little attention on the unmeasurable activity. Thus, according to Milgrom and Holmstrom lack of measurability is an important variable determining the size of the firm [...]. (Foss 2000)

An important point to note about this paper is that it is not only a principal-agent theory but also an incomplete-contracting theory. So the relationship between the two theories can be a very close one, the theories are not just related but can be usefully merged.

In the past I have argued that transaction cost and property rights theories are "orthogonal" to each other. In a discussion of the differences between the Grossman-Hart-Moore (GHM) theory of the firm and the transaction-cost approach, Williamson (2000, pp. 605–606) argues that the most important difference between them is that GHM introduce inefficiencies at the ex ante investment stage while the transaction-cost approach emphasises that ex post haggling and maladaptation drive inefficiencies. There are no ex post inefficiencies in GHM due to their assumption of common knowledge and ex post costless bargaining. Gibbons (2010, p. 283) explains it this way:

‘[t]he model in question is Grossman and Hart’s (1986), which explores an alternative to Williamson’s (2000, p. 605) emphasis that “maladaptation in the contract execution interval is the principal source of inefficiency.” Instead, in the Grossman-Hart model, there is zero maladaptation in the contract execution interval, and the sole inefficiency is in endogenous specific investments.

It is striking how different the logic of inefficient investment can be from the logic of inefficient haggling. In their pure forms envisioned here, the two can be seen as complements. For example, the lock-in necessary for Williamson’s focus on inefficient haggling could result from contractible specific investments chosen at efficient levels. But by assuming efficient bargaining and hence zero maladaptation in the contract execution interval, Grossman and Hart focused attention on non-contractible specific investments and hence discovered an important new determinant of the make-or-buy decision: in the Grossman-Hart model, an important benefit of non-integration is that both parties have incentives to invest; in Williamson’s argument, an important cost of non-integration is inefficient haggling. In short, the two theories are simply different’.

This emphasis on ex post haggling and maladaptation can be interpreted as reflecting a view thatinternal organisation is better at reconciling the conflicting interest of the parties to a transaction and facilitating adaptation to changing supply and demand conditions when such cost are high.

One point worth making is that the reference point approach (not much discussed in the Evans, Guthrie and Quigley paper) to the firm that has grown in very recent times out of the property rights approach can be seen as a move away from the ex ante GHM approach and back towards transaction cost thinking in so much as contracting is not perfectly contractible ex post.

Chapter 4 of the Evans, Guthrie and Quigley paper is on Real Options and Investment.

Cato Unbound

The September 2012 issue of Cato Unbound is on the Theory and Practice in the Austrian School.

Ludwig von Mises's Human Action is still the key summation of the Austrian school of economics. In it, Mises describes certain conclusions, those of praxeology, as having a special epistemological status: They are deductive conclusions that are not subject to falsification. In plain language, they cannot fail to be true: While the findings of history may always be subject to revision—if new evidence is discovered, say, or if old evidence is found to be unreliable—the conclusions of praxeology will always be valid.

This move has brought critics of Austrian economics to cry foul. Such critics are apt to see the Austrian school as a group of almost cartesian rationalists, deducing economic theorems that, while perhaps interesting in their own right, can by definition have no purchase in the real world of economic policy and the study of human events.

Professor Steven Horwitz begs to differ. In his lead essay he argues that logical deduction has a strictly limited role to play in economics, and that Austrian economists are indeed making important empirical contributions to the field. Further, he argues that the Austrian school stands to teach mainstream economics a good deal about how to conduct empirical observations and interpret them properly. To discuss with Horwitz, we have invited three other distinguished economists, each of whom has been influenced by the Austrian school — while ultimately settling elsewhere methodologically: Bryan Caplan, George A. Selgin, and Antony Davies.

Micro foundations of public sector management 1

The Treasury has a recent working paper out on Contemporary Microeconomic Foundations for the Structure and Management of the Public Sector by Lewis Evans, Graeme Guthrie and Neil Quigley. All three authors are at Victoria University of Wellington. The abstract reads:

The new public management of the 1980s was based in part on a range of important new insights about the role of transaction and agency costs arising from contractual incompleteness in defining the boundaries of the firm and the governance relationships within it. In this paper, we consider the literature of the last 25 years which extends our understanding of allocations of ownership rights and the boundaries of the firm as responses to contractual incompleteness. From this perspective, ownership represents an allocation of control rights to those with the potential to make the most important (value-enhancing) relationship-specific investments. We provide an outline of this modern approach to contractual incompleteness, illustrate its application to a range of issues in public and private ownership, investment, governance and decision-making, and provide suggestions about the impact that this approach might have on the scope, structure and management of the public sector in the 21st century.

I have done a quick read of the first three chapters of the paper. They do managed to get the references to the chapters of the paper wrong in the Introduction. When they refer to Chapter 2 they mean Chapter 3 and when they refer to Chapter 3 they mean Chapter 4 and so on.

In Chapter 2 they review the microeconomic foundations of the state-sector reform in New Zealand after 1984. The chapter looks at the economic theories that were important in the formulation and implementation of New Zealand's public management framework after 1984. The major influences from economics were the new institutional economics, principal-agent theory, transaction costs and information economics. At one point Evans, Guthrie and Quigley write,

Since the issue was first raised by Ronald Coase in the 1930s, academic economists have developed increasingly sophisticated theories of why firms exist, why some economic activity is organised within the market and some is organised within firms, and how the efficient boundaries of firms are determined.

Some economists would date the start of the modern theory of the firm from Knight (1921) rather than Coase (1937). Demsetz (1988: 244) goes so far as to state,

"[ ... ] it can be said without hesitation that Knight launched the modern theory of the firm in 1921".

I do sometimes wonder just how sophisticated even the modern theories of the firm really are. As Oliver Hart has written,

"[a]n outsider to the field of economics would probably take it for granted that economists have a highly developed theory of the firm. After all, firms are the engines of growth of modern capitalistic economies, and so economists must surely have fairly sophisticated views of how they behave. In fact, little could be further from the truth. Most formal models of the firm are extremely rudimentary, capable only of portraying hypothetical firms that bear little relation to the complex organizations we see in the world. Furthermore, theories that attempt to incorporate real world features of corporations, partnerships and the like often lack precision and rigor, and have therefore failed, by and large, to be accepted by the theoretical mainstream". (Hart 1989: 1757).

In 2008 Hart said of the 1989 quote

"[t]he language of 1989 is strong, and I'd probably tone it down a bit now. There's been a lot of work in the last twenty years, and some progress. However, we are still not at the point where we have good models of the internal organization of large firms".

In section 2.3 Evans, Guthrie and Quigley write,

"The Treasury (1987:37-39) set out a transaction-cost and incentive-based theory of the limitations of state ownership. It motivated the benefits of private ownership by drawing attention to the agency problems associated with information acquisition and performance management under state ownership given the complex objectives of state entities and the absence of market monitoring and competition."

The problem with the complete contracts approach to ownership was not shown until the late 1980s when the ownership neutrality theorems started to appear. These theorems give conditions, in particular complete contracts, under which private or public ownership of productive assets is irrelevant for the allocation of resources. As Hart (2003) sums it up,

"One of the insights of the recent literature on the firm is that, if the only imperfections are those arising from moral hazard or asymmetric information, organisational form - including ownership and firm boundaries - does not matter: an owner has no special power or rights since everything is specified in an initial contract (at least among the things that can ever be specified). In contrast, ownership does matter when contracts are incomplete: the owner of an asset or firm can then make all decisions concerning the asset or firm that are not included in an initial contract (the owner has 'residual control rights')."

In section 2.4 Evans, Guthrie and Quigley outline what they see as some of the unresolved issues with public management,

• The boundaries between the state and the private sector, including:
  • the case for public investment where the private sector is unwilling to invest, and
  • the allocation of ownership and service delivery between the private and public sectors.
• The place of competition in the public sector and, in particular:
  
  • the role of competition in promoting greater efficiency in the delivery of services and the management of assets within the public sector, and between the public and private sectors, and
  • the balance between competitive discovery of efficient solutions to operational and organisational problems, and single national approaches to investment and public-sector infrastructure.
• 
  The need for stronger individual and organisational incentives for performance, and more effective mechanisms for the measurement and monitoring of that performance. Gill and Hitchener (2010:498) argue that while the vertical structures of accountability created under the Public Finance Act and the State Sector Act were designed to allow greater scrutiny of performance of ministers, chief executives and their departments or agencies, in practice there is relatively little use of performance information by central agencies, other than as a measure of bottom-line performance when things go wrong, and that this has tended to reinforce rather than mitigate the “well known bureaucratic pathologies of public organisations, in particular risk-averse, rule-driven behaviour.”
• The effectiveness of the governance and management of the public sector as a whole, including the role of advisory and governance boards, the central monitoring agencies, and the challenge of producing more effective mechanisms for solving problems and developing innovative new approaches to policy where policy issues span the mandates of multiple teams and multiple government organisations. Scott et al (2010) point out that there have been consistent concerns about the ability of the public sector to deliver quality and innovative policy advice on the big issues that are of relevance to multiple departments and entities.

The rest of the paper looks at the recent academic literature to search for answers to these problems.

More on chapter 3 of the paper later.

Waldegrave and mixed strategies

In my online History of Game Theory I have an entry dated 1713 on the first use of a mixed strategy,

In a letter dated 13 November 1713 James Waldegrave provided the first, known, minimax mixed strategy solution to a two-person game. Waldegrave wrote the letter, about a two-person version of the card game le Her, to Pierre-Remond de Montmort who in turn wrote to Nicolas Bernoulli, including in his letter a discussion of the Waldegrave solution. Waldegrave's solution is a minimax mixed strategy equilibrium, but he made no extension of his result to other games, and expressed concern that a mixed strategy "does not seem to be in the usual rules of play" of games of chance.

The reference I gave for the belief that James was the author of the letter was to a work by Professor Harold Kuhn,

On Waldegrave see Kuhn, H. W. (1968), Preface to Waldegrave's Comments: Excerpt from Montmort's Letter to Nicholas Bernoulli, pp. 3-6 in Precursors in Mathematical Economics: An Anthology (Series of Reprints of Scarce Works on Political Economy, 19) (W. J. Baumol and S. M. Goldfeld, eds.), London: London School of Economics and Political Science and Waldegrave's Comments: Excerpt from Montmort's Letter to Nicholas Bernoulli, pp. 7-9 in Precursors in Mathematical Economics: An Anthology (Series of Reprints of Scarce Works on Political Economy, 19) (W. J. Baumol and S. M. Goldfeld, eds.), London: London School of Economics and Political Science, 1968.

But James was not the only Waldegrave who could have written the letter. Professor David Bellhouse published a paper in 2007 arguing that Charles, not James, Waldegrave was the author of the famous letter. Charles was an uncle to James.

This morning I received an email from Professor Kuhn alerting me to the fact that Professor Bellhouse has been continuing his research into which Waldegrave wrote the letter and now believes that it was neither James nor Charles but Charles's brother Francis. In light of this I have amended my history to show Francis as the likely author of the letter.

Professor Bellhouse is working on a new paper about Montmort, Bernoulli and Waldegrave. I look forward to seeing this in print so we can get the whole story.

Justifications for foreign aid

From the Economist

Where poor people live, it turns out, makes a big difference to justifications for foreign aid. Research by Andy Sumner of the University of Sussex’s Institute of Development Studies has found that four-fifths of those living on $2 a day or less live in middle-income countries (such as China and India). Most of these countries can afford to help poor people themselves—and usually do. India, for instance, as provides subsidised food for the poor through the Public Distribution System and temporary work for anyone who asks for it through a rural employment guarantee act. Of course, this fact says nothing about justifications for aid in general. The Indians may be spending their money wisely, they may not. But it does undercut one obvious justification for foreign aid, since if national governments can afford to send the needed help, what do foreigners have to offer?

My first question about this would be, What about Africa? What percentage of the really poor are in Africa? Many of the African government may be too dysfunctional to provide aid to their own people, here foreign aid could help.

Blogging on stadiums

Thanks to Close Up the economics of stadiums is back in the news. I'm not sure what planet Gerry Brownlee is on when it comes to economics but his defence of a Christchurch stadium wasn't great. He didn't have any answers to the points raised against stadiums in the Close Up video.

Sam Richardson from the Fair Play and Forward Passes blogs starred in the Close Up video but he has also blogged on the topic of stadiums a number of times: see his label Stadiums. Eric Crampton at the Offsetting Behaviour blog has also blogged on stadiums, see his label Stadiums. I have also blogged on the economics of stadiums, see my label Stadiums.

Bradley on Enron

Over at EconLib Robert L. Bradley Jr writes on Enron: The Perils of Interventionism. His conclusion is

Enron was essentially a political company, not a free-market one. Ken Lay's creation would be unknown to history were it not for the distorted incentives from the government side of the mixed economy.

For classical liberals, Enron is a case study in support of the separation of government and business. There is egregious rent-seeking, whereby the company worked to shape political intervention for economic advantage. There is bootleggers and Baptist politicking, whereby Enron teamed with nonprofit groups to win support for what was in the company's narrow self-interest.

There is the peril of half-slave, half-free. Partially deregulated markets (such as with electricity in California) created a devil's sand box for profit-making that otherwise would have been absent in a free-market order.

Although an Enron could not have been predicted, it is yet another example of the unintended consequences of interventionism in the field of energy, as well as from the politicized accounting and tax systems that governed all corporations.

And then there is the ultimate consequence from the dynamics of intervention. Historically, the failures of the mixed economy have been an excuse to further politicize the economy. Richard Epstein warned: "The greatest tragedy of the Enron debacle is not likely to be the consequences of the bankruptcy, but from the erroneous institutional reforms that will take hold if its causes are not well understood." The Sarbanes-Oxley Act (2002) and the Bipartisan Campaign Reform Act (2002), enacted with Enron in mind, proved him right.

Both the false narrative and the real story of Enron impart lessons for intellectuals and pundits alike. Sound theory makes complex history intelligible; bad theory blinds us to recognizing what is there for the taking. Enron fooled many people in its active life, and it continues to fool in death. A true understanding of "Exhibit A" deserves to enter into the mainstream of thought.

No the usual way the Enron story is presented.

EconTalk this week

Neil Barofsky, author of Bailout and the former Special Inspector General for the TARP program, talks with EconTalk host Russ Roberts about his book and the government bailouts by the Bush and Obama Administrations. Barofsky recounts what he learned about how Washington works and the incentives facing politicians and bureaucrats. His book and this interview are a workshop in public choice economics. Along the way he unravels some of the acronyms of the last few years including TARP, TALF, and HAMP. The conversation concludes with lessons learned by Barofsky and what might be done in the future to prevent the corruption and ineffectiveness of past bailouts.

Firms reorganise to grow

Lorenzo Caliendo, Ferdinando Monte and Esteban Rossi-Hansberg have a new column up at VoxEU.org on the subject Firms reorganise to grow (by hiring workers that know and earn less). The basic idea is that firms that reorganise production to grow account for almost 40% of the value added created in the manufacturing sector. They add layers of management, increase by 7% the average hours worked in the firm, and reduce the average wage at pre-existing layers of managers or workers by 11%.

The Caliendo, Monte and Rossi-Hansberg column presents new stylised facts about the way firms organise production and explains how recent advances in economic theory can help to understand these findings.

In recent research (Caliendo et al. 2012) we identify a number of robust empirical patterns on the organisation of firms as well as the changes in this organisation as firms grow. We find that:

• Firms that expand (or contract) significantly are exactly those involved in a reorganisation process;
• Firms that do not reorganise typically change very little.

One part of the literature on firms thinks of firms as hierarchies of knowledge. This idea of a division of knowledge within a firm was first recognised by Demsetz (1988) and formalised by Becker and Murphy (1992). What these works suggested was simply a new interpretation of the role of the firm. Given that there are limitations to what a worker can know, the competence that a firm has to possess to produce must be divided into manageable portions and allocated between the workers. The actions of the different groups of workers are then coordinated by the firm’s management. Thus workers who produce on the basis of knowledge they themselves do not possess, have their activities directed by someone who does possess (at least more of) the necessary knowledge. This gives a rationale for management. As there are asymmetries in information among workers, management is required to coordinate the activities of the different groups of employees. If the workers knew everything about the production process they could carry out production without coordination. In this way, direction is a substitute for education, that is, a substitute for the transfer of the knowledge itself.

Caliendo, Monte and Rossi-Hansberg make the point that it is useful to interpret the data  if we think of firms as hierarchies of knowledge.

• Production requires labour and knowledge.
• Knowledge is embedded in individuals and is costly to acquire.
• The organisational problem is then the result of the limited time of individuals.

This time constraint implies that it is not optimal to have only very knowledgeable employees, but to have many agents with basic knowledge and fewer experts that focus on exceptions. Subordinates save the time of knowledgeable expert by dealing with the simple problems. This is the essential role of organisations.

• Firms are hierarchical with a large base of workers, who know and are paid less, and with higher layers of management with more knowledgeable employees that earn more.

The next question worth asking is, Are firms different in their organisation? Caliendo, Monte and Rossi-Hansberg present new evidence on this point.

We use administrative data from the French manufacturing sector on the balance sheet of firms and the occupations of their workers from 2002 to 2007. To construct a picture of the organisation of firms our empirical analysis is guided by Caliendo and Rossi-Hansberg (2012). We can distinguish up to three layers of management (supervisors, senior staff and CEOs) above clerks and blue collars whom we refer to as production workers.

Firms do, in fact, differ in their organisation. On average firms have 1.5 layers of management above their production workers, many small firms have only production workers, and about as many large firms have all three of them (the maximum we can observe). Larger firms (i.e. firms that employ more workers and add more value) tend to have more layers of management. This fact makes perfect economic sense. If an artisan wants to produce more, he or she can of course hire other workers that perform exactly his or her tasks, but it is better just to hire apprentices, who know only the most common operations (and are therefore cheaper), and use his or her own time to deal with more infrequent matters. Organisations allow exactly this leveraging of the time of managers through the extensive use of a less able workforce. The data shows that firms are hierarchical, in the sense that higher layers of management tend to have fewer employees and pay them more than lower layers.

Now we get to the point of reorganising a firm. The question is, When do reorganisations occur?

Looking at all the firms with a given organisation type (i.e. with the same number of layers of management), we find that the larger the firm, the higher the likelihood that it will reorganise its production by adding one layer (symmetrically, the smaller firms are more likely to contract their production by dropping one). This fact also makes economic sense. Firms can respond to a given increase in the demand for their product with or without a reorganisation. In the latter case, they just expand their production base, i.e. they hire more workers. By doing so, however, a strain is put on the time of the managers above them, who now would have to deal with more people (and more problems). Hence, firms expanding this way must have more employees at each layer and must pay them more (in order for them to be more knowledgeable and ask less). Hence, the average wages at all layers must rise. Among all the firms with a given organisation, those which grow in this way are the small ones, since they employ fewer employees and so expanding the knowledge of all of them is cheaper. In contrast, if the firm is relatively large, it makes sense to add one layer of managers and reduce the knowledge of everyone below. In this case, firms grow by reorganising.

Another advantage of a more extensive division of labour was noted as far back as Charles Babbage. In his book “On the Economy of Machinery and Manufactures” Babbage observed that the greater the division of labour with workers knowing less about the overall production process reduced the less time required for learning any requisite skills. This results in a lessening of the period during which a new entrant to the workforce would be relatively unproductive and unremunerative. Because less knowledge and training was required to learn to undertake a single operation, as opposed to that required to undertake many different operations, a new employee would more quickly reach a situation where he generates a profit for his employer.

Caliendo, Monte and Rossi-Hansberg now ask, Why is growth through reorganisation different?

The data tells us that when firms reorganise, they have a larger number of employees than they used to in all layers, but the average wage at all pre-existing layers falls. Following the logic above this drop in average wages has a very clear economic rationale. The objective of the reorganisation is exactly to economise on the knowledge of all pre-existing layers. Apprentices are hired exactly because they know less than the master, and can deal with the most frequent and basic issues. So firms that expand by reorganising pay their workers less, because they prefer to employ less knowledgeable workers.

Caliendo, Monte and Rossi-Hansberg conclude that

While, in our data, only about 13% of the firms go through reorganisation episodes in a given year, these episodes account for almost 40% of the value added created in the manufacturing sector. These findings shed light on the process through which firms grow. Most of the existing literature documents a 'firm size – wage premium', whereas average wages are higher for larger firms; we show that this relation is just the result of the composition of many firms that grow little and raise wages, and a few firms that reorganise, grow a lot, pay the new top manager more, but reduce average wages in all pre-existing layers [...] Our analysis also explores the export behaviour of firms. Accessing a foreign market is a particularly important form of expansion for many firms, and we find that the same facts described above are reproduced for the subset of firms that grow and start exporting (or, of course, shrink and stop exporting). In particular, firms who start exporting are more likely to reorganise their activity than firms who keep operating only domestically, and new exporters who reorganise tend to reduce (rather than increase) average wages paid at all pre-existing layers.

The great ideas of the social sciences

At the ThinkMarkets blog Gene Callahan put forward a list of great ideas in social science:

* The state as the individual writ large (Plato)

* Man is a political/social animal (Aristotle)

* The city of God versus the city of man (Augustine)

* What is moral for the individual may not be for the ruler (Machiavelli)

* Invisible hand mechanisms (Hume, Smith, Ferguson)

* Class struggle (Marx, various liberal thinkers)

* The subconscious has a logic of its own (Freud)

* Malthusian population theory

* The labor theory of value (Ricardo, Marx)

* Marginalism (Menger, Jevons, Walras)

* Utilitarianism (Bentham, Mill, Mill)

* Contract theory of the state (Hobbes, Locke, Rousseau)

* Sapir-Worf hypothesis

* Socialist calculation problem (Mises, Hayek)

* The theory of comparative advantage (Mill, Ricardo)

* Game theory (von Neumann, Morgenstern, Schelling)

* Languages come in families (Jones, Young, Bopp)

* Theories of aggregate demand shortfall (Malthus, Sismondi, Keynes)

* History as an independent mode of thought (Dilthey, Croce, Collingwood, Oakeshott)

* Public choice theory (Buchanan, Tullock)

* Rational choice theory (who?)

* Equilibrium theorizing (who?)

I would add:

*Organisational theories explaining why a given organisational form gets used in a given situation (Coase)

Others?

Cutthroat v. cuddly capitalism

Why, ask Daron Acemoglu, James A. Robinson and Thierry Verdier, can't we all be more like Scandinavians? They have a new working paper out on the question Can't We All Be More Like Scandinavians? Asymmetric Growth and Institutions in an Interdependent World.

Acemoglu, Robinson and Verdier argue that many people perceive average welfare to be higher in Scandinavian societies than in the United States due to Scandinavian countries having more limited inequality and more comprehensive social welfare systems. This raises the question of Why doesn't the United States adopt Scandinavian-style institutions? Why isn't the U.S. more like the Scandinavians? More generally, in an interdependent world, would we expect all countries to adopt the same institutions? To provide theoretical answers to this question,  Acemoglu, Robinson and Verdier develop a simple model of economic growth in a world in which all countries benefit and potentially contribute to advances in the world technology frontier. A greater gap of incomes between successful and unsuccessful entrepreneurs (thus greater inequality) increases entrepreneurial effort and hence a country’s contribution to the world technology frontier. Under plausible assumptions, the world equilibrium is asymmetric: some countries will opt for a type of "cutthroat" capitalism that generates greater inequality and more innovation and will become the technology leaders, while others will free-ride on the cutthroat incentives of the leaders and choose a more cuddly form of capitalism. Paradoxically, Acemoglu, Robinson and Verdier are able to show that those with cuddly reward structures, though poorer, may have higher welfare than the cutthroat capitalists; but in the world equilibrium, it is not a best response for the cutthroat capitalists to switch to a more cuddly form of capitalism. They also show that domestic constraints from social democratic parties or unions may be beneficial for a country because they prevent cutthroat capitalism domestically, instead inducing other countries to play this role.

Stadiums and opportunity costs

John Spry, an economist with St. Thomas University in the Twin Cities, has written an opinion piece in the St. Paul Pioneer Press in which he takes issue with proposals to build a new stadium for the St. Paul Saints (an independent league baseball team) and to renovate the Target Center, the arena for the NBA’s Minnesota Timberwolves.

Spry make a number of points against these ideas, but one of the most important is

Finally, politicians erroneously claim that construction spending for these sports facilities will create jobs for Minnesotans. These claims ignore the basic economic concept of opportunity cost. Instead of building duplicative facilities, we could have either more productive public spending, such as improved courts or roads, or reduced taxes on private-sector investments.

Thinking about the opportunity cost of such proposals is important in any situation but it is doubly important for cities like Christchurch were there is so much that needs to be done.

(HT: The Sports Economist)

Interesting blog bits

1. Matt Nolan writes In defence of inflation targeting in NZ

   Why the RBNZ is a scapegoat for the failure of government

2. Steven Horwitz writes Ezra Klein Mistakes the Arsonist for a Firefighter

   In Friday’s Washington Post, Ezra Klein raises a number of criticisms of the gold standard using as his hook the call for a new Gold Commission that appears in a draft of the new Republican Party platform. Putting aside the question of party politics and what a new Commission might do, Klein’s arguments against the gold standard are not as strong as he thinks. I want to respond to three of them here, and in reverse order of importance.

3. John Cochrane on Gordon on Growth

   Bob Gordon is making a big splash with a new paper, Is US Growth Over?

4. Francisco Ceballos, Tatiana Didier and Sergio Schmukler on Different facets of financial globalisation

   A lot has been said about the pros and cons of financial globalisation. But what exactly is ‘financial globalisation’? This column argues that we can’t be clear about the pros and cons of financial globalisation unless we are clear on what it actually is.

5. Chris Dillow writes on Bad Incentives in Politics

   Why do politicians not solve social problems? One reason, of course, is that such problems are intractable. But there's another reason - politicians sometimes lack the incentive to do so because politicians need to keep their enemies alive just as parasites need to keep their hosts alive.

6. Russ Roberts on Competition

   In this conversation with Roger Noll, we talked about how much more purposive and less relaxed sports are for kids these days. There are travel teams. Coaching is much more intense and serious. Training and conditioning is much more intense and serious. All of it starts young. Roger and I chalked this up to the increased amount of money coursing through the sports pipeline. That money makes professional sports more competitive which in turn makes the stakes higher for college sports (which has its own cash pipeline) which in turn make high school and middle school more intense.

7. Donald J. Boudreaux on Inconceivable Complexity

   Nevertheless, too many people, including politicians, continue to believe that because they can observe a handful of bulky facts about the economy, they can thereby know enough to intervene into that economy in ways that will improve its operation. That belief, though, is hubris. It’s very much like believing that you’ll fly if you simply strap on a pair of wings and commence to flapping madly.

What is it about Labour and economics?

Another example of Labour getting basic economics wrong. Thanks to a message at the Homepaddock blog my attention to drawn to this comment on the upcoming partial sale of Mighty River Power:

Labour's state-owned assets spokesman, Clayton Cosgrove, seized on the result as evidence the company was in no fit state for sale.

"Mighty River's profits have almost halved. That will have a real impact on their share price if the Government rushes ahead with the sale. Listing a struggling company in a market like this is economics for dummies."

But the current level of profits of the company doesn't determine what people will pay for (part of) the company. The sale price will be determined by the expected future profits of the firm. Even if this years profits are down, what matters to investors are future profits. If investors think the future is likely to be good they will pay more for the firm no matter what the current level of profits are. Investors are forward looking, not backward looking as is the case with Clayton Cosgrove.

There are, I would argue, good reasons for not liking the partial sell-off of SOEs but Cosgrove's argument isn't among them.

Incentives matter: organ donation file

A new NBER working paper looks at the incentives for organ donation and bone-marrow donations. The paper, Removing Financial Barriers to Organ and Bone Marrow Donation: The Effect of Leave and Tax Legislation in the U.S., is by Nicola Lacetera, Mario Macis and Sarah S. Stith. The abstract reads,

In an attempt to alleviate the shortfall in organs and bone marrow available for transplants, many U.S. states passed legislation providing leave to organ and bone marrow donors and/or tax benefits for live and deceased organ and bone marrow donations and to employers of donors. We exploit cross-state variation in the timing and passage of such legislation to analyze its impact on organ donations by living and deceased persons, on measures of the quality of the organs transplanted, and on the number of bone marrow donations. We find that these provisions did not have a significant impact on the quantity of organs donated. The leave legislation, however, did have a positive impact on bone marrow donations. We also find some evidence of a positive impact on the quality of organ transplants, measured by post-transplant survival rates. Our results suggest that these types of legislation work for moderately invasive procedures such as bone marrow donation, but may be too low for organ donation, which is riskier and more burdensome to the donor.

So getting the incentives right matters for donation rates and what "right" means depends on what is being donated.

One instrument can't achieve two goals

From Don Brash

The Reserve Bank has got only one instrument, and that's monetary policy. You can't deliver two objectives with one instrument, and David Parker at least should have the brains to know that. Apparently not.

In short the RB can't control both inflation and the exchange rate.

The idea that some economic quantities can be classified as targets and others as instruments goes back to the 1950s and is due to the Dutch Nobel Prize winning economist Jan Tinbergen. He argued that targets are those macroeconomic variables the policy maker wishes to influence, whereas instruments are the variables that the policy maker can control directly. The important point that Tinbergen made, but David Parker has missed, is that achieving the desired values of a certain number of targets requires the policy maker to control an equal number of instruments.

Caplan v. Dickens on poverty and welfare (updated)

Bill Dickens and Bryan Caplan argue about poverty and welfare. Just read it all: start here then go here and then go here. The debate is obvious about the U.S. welfare system but but many of the issues carry over to New Zealand.

Update: Bryan responds to Bill's essay at Reply to Bill Dickens on Poverty: Part 1. David Henderson also has some Thoughts on Dickens.

EconTalk this week

Roger Noll of Stanford University talks with EconTalk host Russ Roberts about the economics of sports. Noll discusses the economic effects of stadium subsidies, the labour market for athletes, the business side of univeristy sports, competitive balance in sports leagues, safety in sports, performance-enhancing drugs, and how the role of sports in the lives of children has changed.

The interview begins with a discussion of the financial impact of sports stadiums. Noll makes the point that for a stadium to just break even it has to be used around 250-300 nights a year! This is something to keep in mind when you hear local councils arguing that their city should have a new sports stadium. Ask yourself, Will it be used 300 days a year?

The above comments refer to multiple-use stadiums. As for single use stadiums, rugby/cricket here in New Zealand, baseball/football in the U.S., Noll says,

Baseball and football stadiums, however--there aren't any that have been substantially subsidized where the local community has received anything remotely resembling a reasonable return on investment. They are financial black holes.

Preaching to the unconverted

The good news of the day is that there is now an economics blog on Sciblogs. It's called The Dismal Science and will pull posts from New Zealand economics blogs such as Fair Play and Forward Passes (Sam Richardson), Groping Towards Bethlehem (Bill Kaye-Blake), Offsetting Behaviour (Eric Crampton and Seamus Hogan) and The Visible Hand in Economics (Matt Nolan, James Zucollo and co-bloggers).

Eric Crampton explains there are still a few problems workings of the new blog:

We're still working out some back end issues to let me efficiently curate the different inbound feeds. When everything is working right, I'll see a morning dashboard with a list of new posts up at the source blogs that their authors deemed worthy, then schedule them for appearance at Dismal. I'd also like to be able to pull classic posts from our combined back archives when topics like capital gains taxes or stadiums become timely. Peter Griffin, the Editor at SciBlogs, is seeing what we can do to set up the system's back end.

But the problems will be sorted quickly, so keep an eye on The Dismal Science to add to your daily fix of economics blogging!

Growth and wages

I have made the point in the past that economic growth leads to wage growth. Paul Krugman makes the point when he writes,

Economic history offers no example of a country that experienced long-term productivity growth without a roughly equal rise in real wages. In the 1950s, when European productivity was typically less than half of U.S. productivity, so were European wages; today average compensation measured in dollars is about the same. As Japan climbed the productivity ladder over the past 30 years, its wages also rose, from 10% to 110% of the U.S. level. South Korea's wages have also risen dramatically over time. ("Does Third World growth hurt First World Prosperity?" Harvard Business Review 72 n4, July-August 1994: 113-21.)

Now James Otteson shows that Adam Smith was ahead of us on this issue, as he was on so many things.

It is not the actual greatness of national wealth, but its continual increase, which occasions a rise in the wages of labour. It is not, accordingly, in the richest countries, but in the most thriving, or in those which are growing rich the fastest, that the wages of labour are highest. [...] But though North America is not yet so rich as England, it is much more thriving, and advancing with much greater rapidity to the further acquisition of riches. ("An Inquiry into the Nature and Causes of the Wealth of Nations" I.viii.22-23)