The ownership of firms

Who owns a firm and why? Investor-owned firms are the most common form of ownership for large-scale enterprises in most of the world, but in a market economy there are a number of other forms of ownership which are commonly utilised. We see, in many sectors of the economy, producer cooperative, customer cooperatives, nonprofit firms and mutual enterprises. Why? What determines who owns a firm?

This is a question addressed by Hansmann (1988, 1996, 2013). To understand Hansmann's theory of firm ownership we first need two definitions. Hansmann defines a firm's owners to be those persons who have two formal rights: the right to control the firm and the right to appropriate the firm's profits. That is, owners have control and income rights over the firm(1). Compare this to the property rights approach to the firm which see a firm's owners as those who have just control rights over the firm. Note also that this definition means some firms do not have owners. In nonprofit firms the control rights are separated from the income rights, no one can receive the residual earnings, meaning such firms are ownerless. A second useful definition is that of a firm's "patrons". Patrons are those persons who transact with the firm either as purchases of the firm's outputs or as suppliers of factors of production to the firm.

Significantly nearly all large firms are owned by persons who are also patrons.

"In principle, a firm could be owned by someone who is not a patron. Such a firm's capital needs would be met entirely by borrowing; its other factors of production would likewise be purchased on the market, and its products would be sold on the market. The owner(s) would simply have the right to control the firm and to appropriate its (positive or negative) residual earnings. Such firms are rare, however" (Hansmann 1988: 272).

But

"[i]f a firm were entirely owned by persons who were not among the firm's patrons, then all the firm's transactions involving inputs and outputs would take the form of market contracting. Although feasible in principle, in practice this is likely to be quite inefficient. Market contracting can be costly, especially in the presence of one or more of those conditions loosely termed ``market failure"-for example, where there is an absence of effective competition, or where one of the parties is at a substantial informational disadvantage. [\dots] For the present we need simply note that, where these costs are high, they can often be reduced by having the purchaser own the seller or vice versa. When both the purchaser and the seller are under common ownership, the incentive for one party to exploit the other by taking advantage of market imperfections is reduced or eliminated. Assigning ownership of a firm to one or another class of the firm's patrons can thus often reduce the costs of transacting with those patrons-costs that would otherwise be borne by the firm or its patrons. To assign ownership to someone who is not among the firm's patrons would waste the opportunity to use ownership to reduce these costs" (Hansmann 1996: 20).

There are two basic types of relationship between firms and patrons, a "market contract" or "ownership". Under a market contract the patron interacts with the firm only through a contract and is not an owner. Under ownership the patron is also an owner of the firm.

This raises an obvious question of what are the costs of contracting and of ownership? We will briefly survey the most significant types of costs that arise with market contracting and ownership.

The costs of contracting include market power, "lock-in", asymmetric information and the risks of long-term contracting.

In some situations a firm can have market power with respect to some of its patrons. The affected group of patrons have an incentive to own the firm to avoid price exploitation. For example, if the firm has monopoly power with respect to its customers, the customers could takeover and reorganise the firm as a consumer cooperative. Or if the firm has monopsony power with regard to its suppliers, the suppliers could create a producer cooperative as a way to avoid receiving the monopsony price (Hansmann 1996: 24-5).

Monopolistic exploitation can occur after a person has been dealing with the firm for sometime, even if at the beginning of the relationship there was competition for which firm the patron would contract with. Such ``lock-in" can occur if the patron has to make transaction-specific investments, which have little or no value outside of the relationship, and the contract between the firm and the patron is incomplete so that not all important aspects of future transactions can be specified in an ex-ante contract. This leaves the patron open to ex-post exploitation by the firm. Assigning ownership to the effected patrons mitigates the effects of such lock-in. This can be, for example, one reason for worker ownership of firms where firm-specific investment is required by the workers (Hansmann 1996: 25-6).

Asymmetric information can increase contracting costs via both moral hazard and adverse selection. If, for example, a firm knows more about the quality of its products than consumers know, then the firm may offer lower quality products than it says it will. This is the "lemons" problem (adverse selection) made famous by Akerlof (1970). In such situations consumer ownership has the advantage that it reduces the incentive for the firm to exploit its informational advantage. Consumers will not exploit themselves. Another example would be where workers know more about their effort levels than the firm knows. This gives rise to moral hazard issues. Worker ownership could act to reduce the incentive for workers to act opportunistically, since as owners the workers suffer more if effort levels are low. They also are likely to be better at monitoring each others level of effort. Asymmetric information can also give rise to strategic bargaining. A firm's management has private information about the firm and the firm's patrons have private information about their preferences and opportunities. If the patrons do not own the firm then each group has little incentive to reveal their information. Each group can use their private information strategically when bargaining with the other and thus increase the costs of negotiation. Patrons ownership reduces strategic behaviour since it decreases the incentive to hide information or to take advantage of information the other party lacks (Hansmann 1996: 27-9).

When patrons can not credibly communicate their preferences the costs associated with contracting increase. Not knowing patrons true preferences the firm's management may not be able to determine the least-cost combination of contractual terms that satisfies the firm's patrons. In addition patrons have an incentive to misrepresent their preferences to their strategic advantage. Ownership by patrons reduces the conflict of interest between patrons and owners and thus makes communication easier (Hansmann 1996: 30).

It is often the case that firms have to treat all patrons in a given class the same even when individual patrons in that class have different preferences. In such a case market contracting may result in an inefficient compromise being made among the patrons' differing preferences. This is because market contracting satisfies the preferences of the marginal patron whereas efficiency generally requires the choosing of conditions that satisfy the preferences of the average patron(2), and the marginal and average preferences can be very different. When patrons own the firms and a voting rule - in particular the majority rule - is used to make decisions then the results tends to favour the median patron rather than the marginal. The median will not in general be the average, but it will likely be closer than the marginal. Thus patron ownership has an advantage in decision making when patrons preferences differ (Hansmann 1996: 30-1).

Long-term contracting comes with its own problems. One such issue is that transaction-specific investment can leave one of the parties exposed to opportunistic behaviour by the other. Another is how can the parties allocate specific risks between them. Yet another issue is how can the parties mitigate the problems of adverse selection that occur in insurance and related markets (Hansmann 1996: 27).

Next Hansmann considers the costs of ownership, which involve risk bearing, principal agent problems and collective decision making.

One group of patrons may be able to better bear the risks associated with owning the firm than others. They may, for example, be better able to diversify their investments. Assigning ownership to this group can bring important economies. This is a common argument for having investors as the owners of a firm. However, Hansmann argues that investors are not the only low-cost risk bearers and that the evidence suggests that the importance of risk bearing as a reason for investor-ownership is overstated (Hansmann 1996: 44-5).

Hansmann (1996: 35-8) divides agency costs onto two board groups, costs of monitoring the firm's managers and the cost of opportunism by the managers given they can not be perfectly monitored. For effective monitoring of the managers, patrons must: 1. inform themselves about the operations of the firm and 2. communicate among themselves to exchange information and made decisions and enforce those decisions upon the managers. Each of these activities is costly but the costs will vary among the different groups of patrons. Patrons who transact with the firm frequency, for important transactions, over a long period of time will, most likely, be better informed about the firm. The ease of organising patrons for collective action will also affect the costs of monitoring. Thus patrons who are physically closer to one another and the firm will have lower costs. The size of the group of patrons will also affect monitoring costs. Given the public good nature of monitoring the larger is the group, the smaller is any individual's share of potential gains from monitoring, and thus the smaller is the incentive to monitor. Therefore when the group of patrons is large it can be prohibitively expensive for the owners to undertake effective monitoring.

"In itself, this [costly monitoring] argues for smallest group of owners possible--preferably a single owner. The fact that, despite this, a large firm often has a very large class of owners therefore suggests that either or both of two things must be true. First, the costs of market contracting would be much higher under any alternative assignment of ownership. Second, the costs of managerial opportunism are modest even though the firm's owners cannot actively supervise the managers" (Hansmann 1996: 36-7).

Managerial opportunism can be thought of as being divided into two groups: self-dealing ("putting their hand in the till") and deliberate managerial inefficiency. There are a number of sanction on self-dealing that do not require collective action by the firm's owners. There are moral, contractual, tort and criminal actions that can be taken against a transgressing manager which, for the most part, limit self-dealing activities. While self-dealing may be limited, this does not mean that managers always work hard and make the best commercial decisions. Managers may not always be acting in the best interests of the owners. But Hansmann argues that for the types of people who win the winner-takes-all management type contest and make it to the top of the management hierarchy pride and moral suasion provides important motivation. Also the need for the firm to prosper so that a manager's career can be enhanced provides additional incentive for effort. But Hansmann, more controversially, argues that the potential gains from better monitoring are often exaggerated. There is one area in which Hansmann does think managers may be able to act against the interests of owners, excessive retention of earnings. Retentions provide managers with a buffer against adverse times, enhance the survival of the firm and increase the size of the firm the manager controls. But retentions are costly to owners if the rate of return on retentions is lower than that on outside investments or if retentions can not be recovered by the current owners. This is seen in some mutuals and cooperatives.

Hansmann explains that in most firms collective decision making is enacted via some form of voting scheme. But when the interests of owners are diverse such schemes involve costs. Such costs fall into two general groups: costs from inefficient decisions and costs of the decision making process, see Hansmann (1996: 39-44).

As has already been noted majority voting leads to the outcome which is preferred by the median voter while efficiency requires the outcome preferred by the average voter. Where these two preferences differ it can lead to inefficient decisions. Also the decision making process can become dominated by the majority even when the costs of the agreed outcome are greater than the benefits. Hansmann gives the example of a broken lift in a hypothetical four-story cooperative apartment building. If residents on the first two floor don't use the lift and outnumber those on the top two floors then a vote would result in the cheapest method of repair being chosen rather than the quickest, despite the fact that any money saved could be less than the pecuniary and nonpecuniary costs borne by the top floor residents. Alternatively the decision process could be dominated by a motivated, better informed, if unrepresentative minority resulting, again, in an inefficient outcome. All that is needed for a costly outcome is for the dominant decision makers' self interest to be given greater weight than the interests of others.

The process of collective choice can be costly in and of itself. Time and resources must be invested to obtain information about the firm and other patron's preferences as well as in attending meetings and carrying out other activities required to reach and enforce decisions. The possibility of voting cycles increase as differences in preferences among patrons increase. This can be costly if it results in continued alterations to a firm's policies. Such cycles also give power to whomever gets to set the voting agenda. Setting the agenda strategically can help the setter get the outcome they want. Strategic behaviour by owners will also increase costs via the costs of hiding or finding information or making and breaking coalitions.

But the costs of collective decision making need not be large even when the owners of the firm have heterogeneous interests as long as there is a simple criteria for harmonising those interests. If there is not then reaching agreement can be long and costly. Think of a worker owned firm where the workers differ in the work they do. Reaching agreement on the division of earnings may be straightforward as long as it is easy to account for the net benefits to the firm of each owner's efforts. If, on the other hand, it is difficult to measure every owner's net benefits then agreement may be difficult to reach.

The process of collective decision making may bring benefits to participants as well as costs. Hansmann identifies three such benefits. First, individuals may enjoy the experience of participating in decision making as a social activity in and of itself. Second, it can be argued with regard to worker ownership that workers gain psychological satisfaction from being in control, that is, from participating directly in decision making. Third, again with regard to worker ownership, participation in the firm's decision making process is useful training for participation in the democratic processes of society in general. Hansmann does note however that while such benefits are real the evidence suggests that they do not outweigh the costs of collective decision making.

The takeaway message from Hansmann is that

"[t]he preceding survey points to several reasons for the dominance of investor-owned firms in market economies. One is that contracting costs for capital are often relatively high as compared with contracting costs for other inputs--including labor--and for most products. A second reason is that, however poorly situated investors may be to exercise effective control, there is seldom any other group of patrons who are in a better position to assert control. Where either of these conditions fails, other forms of ownership arise. Thus, when there are serious imperfections in the firm's product or factor markets, the firm is often organized as a consumer or producer cooperative or as a nonprofit. Similarly, when some group of patrons other than suppliers of capital is in a good position to exercise collective control, consumer or producer cooperatives often arise even when the patrons in question are faced with only modest problems of market failure. This suggests either that the effectiveness of the oversight exercised by shareholders--even with the assistance of the market for corporate control--is distinctly limited or that other factors may be more important in constraining managerial opportunism.

In determining whether the costs of ownership are manageable for a given class of patrons, homogeneity of interest appears to be an especially important consideration. In particular, it is evidently a significant factor in the widespread success of the modern investor-owned business corporation, and it may be among the best explanations for the relative paucity of worker­ owned firms, which otherwise have some significant efficiency advantages" (Hansmann 1988: 301-2).

Footnotes:

1. While having both sets of right controlled by the same people is not necessary it is the most common form of allocation. For efficiency reason you would expect that both sets of rights would be held together. Put simply control rights give you the ability to do things while income rights give you the incentive to do things. Having them controlled by the same people lowers the cost of achieving an efficient outcome.
2. In a footnote Hansmann makes reference to Spence (1975) as an explanation for this result. See Krouse (1990: section 6.1) for a simple exposition of Spence's result. There is a result from public choice theory that says for a public good the Pareto efficient quantity of the good is the same as the medians' voters demand only if the median voter is also the average voter. So when the median and average differ the result is inefficient.

References:

• Akerlof, George A. (1970). 'The Market for 'Lemons': Quality Uncertainty and the Market Mechanism', Quarterly Journal of Economics 84(3) August: 488-500.
• Hansmann, Henry (1988). 'Ownership of the Firm', Journal of Law, Economics, & Organization, 4(2) Autumn: 267-304.
• Hansmann, Henry (1996). The Ownership of Enterprise, Cambridge, Mass: Harvard University Press.
• Hansmann, Henry (2013) 'Ownership and Organizational Form'. In Robert Gibbons and John Roberts (eds.), The Handbook of Organizational Economics (pp. 891-917), Princeton: Princeton University Press.

Joseph Stalin: Waiting For Hitler

Peter Robinson at Uncommon Knowledge of the Hoover Institution interviews Stephen Kotkin about his book Joseph Stalin: Waiting For Hitler.

“If you're interested in power, [if] you're interested in how power is accumulated and exercised, and what the consequences are, the subject of Stalin is just unbelievably deep, it's bottomless.” – Stephen Kotkin

In part two, Stephen Kotkin, author of Stalin: Waiting for Hitler, 1929–1941, discusses the relationship between Joseph Stalin and Adolf Hitler leading up to and throughout World War II. Kotkin describes what motivated Stalin to make the Molotov-Ribbentrop Pact with Hitler and the consequences of his decision.

Kotkin dives into the history of the USSR and its relationship with Germany during WWII, analyzing the two leaders' decisions, strategies, and thought processes. He explains Stalin's and Hitler’s motivations to enter into the Molotov-Ribbentrop Pact even without the support of their respective regimes. Stalin’s goal was to defeat the West and he saw the pact as an opportunity to do so by driving a wedge between Germany and the capitalist West. Kotkin analyzes Stalin’s decisions leading up to the Nazi invasion of the Soviet Union and the disinformation Germany was feeding soviet spies to prevent Stalin from moving against Hitler first.

Why does Joseph Stalin matter?

Peter Robinson at Uncommon Knowledge of the Hoover Institution interviews Stephen Kotkin about Joseph Stalin and collectivisation and the great terror.

“Joseph Stalin, Soviet dictator, creator of great power, and destroyer of tens of millions of lives …” Thus begins this episode of Uncommon Knowledge, which dives into the biography of Joseph Stalin. This episode’s guest, Stephen Kotkin, author of "Stalin: Waiting for Hitler, 1929-1941", examines the political career of Joseph Stalin in the years leading up to World War II, his domination over the Soviet Union, and the terror he inspired by the Great Purge from 1936–38.

“Why does Joseph Stalin matter?” is a key question for Kotkin, as he explains the history of the Soviet Union and Stalin's enduring impact on his country and the world. Kotkin argues that Stalin is the “gold standard for dictatorships” in regard to the amount of power he managed to obtain and wield throughout his lifetime. Stalin stands out because not only was he able to build a massive amount of military power, he managed to stay in power for three decades, much longer than any comparable dictator.

Kotkin and Robinson discuss collectivization and communism and how Stalin’s regime believed it had to eradicate capitalism within the USSR even in regions where capitalism was bringing economic success to the peasants, with the potential of destabilizing the regime. This led to the Great Purge, a campaign of political repression that resulted in the exile and execution of millions of people.

Competition and firm productivity

Using data on Portuguese firms this new working paper looks at the relationship between competition and firm productivity. And, not too surprisingly, finds a positive relationship between competition and both total factor productivity and labour productivity.

Competition and Firm Productivity: Evidence from Portugal

Pedro Carvalho

Abstract:
This paper presents empirical evidence on the impact of competition on firm productivity for the Portuguese economy. To that effect, firm-level panel data comprising information between 2010 and 2015 gathered from the Integrated Business Accounts System (Portuguese acronym: SCIE) is used. The database enables the construction of economic and financial indicators, which allow for isolating the impact of competition on firm-level productivity. We find a positive relationship between competition and both total factor productivity and labor productivity. This relationship is found to be robust to different specifications and in accordance with the results in the literature obtained for other countries.

Henry Hansmann on codetermination

Codetermination is the practice of workers of a firm being able to vote for representatives on the board of directors in an enterprise. It has been getting a bit of press lately, in the US at least, thanks to a new bill from Senator Elizabeth Warren. When thinking about whether codetermination is a good thing or not it's useful to ask who should own a company and why. In his article 'Ownership of the Firm' Henry Hansmann makes a simple but important point about a firm's owners,

"In determining whether the costs of ownership are manageable for a given class of patrons, homogeneity of interest appears to be an especially important consideration. In particular, it is evidently a significant factor in the widespread success of the modern investor-owned business corporation, and it may be among the best explanations for the relative paucity of worker­owned firms, which otherwise have some significant efficiency advantages" (Hansmann 1988: 301-2).

Heterogeneity of interests can increase the firm's costs of decision making substantially. Codetermination seems to be the very opposite of 'homogeneity of interest' in that it deliberately sets out to increase the 'heterogeneity of interest'.

When discussing the German experience with codetermination in his book "The Ownership of Enterprise" Hansmann writes,

"[...] the worker representatives on the board represent constituencies with diverse interests. The legally mandated system for selecting worker representatives reinforces this, because it requires that there be at least one representative from each of three classes of workers: wage earners, salaried employees, and managerial employees" (Hansmann 1996: 111)

Hansmann goes on the say

"From all that has been said above, one would not expect that this system of representation would be highly viable as a means of governing the firm. Given the apparent difficulty of making collective self-governance workable for employees alone when the labor force is heterogeneous, it would be surprising if a firm's electoral mechanisms, including voting for and within the board of directors, could effectively be employed not only to resolve conflicts among different groups of employees but also to deal with the more serious conflicts of interest between labor and capital" (Hansmann 1996: 111)

Hansmann then notes

"The German expereince does not clearly belie that expectation" (Hansmann 1996: 111).

Hansmann then raises an important point about codetermination,

"[...] codetermination has been imposed upon German firms by force of law; no similar system seems to have been adopted by any significant number of firms either inside or outside of Germany in the absence of compulsion" (Hansmann 1996: 111).

You have to ask, if codetermination is so good for the firm why isn't it adopted voluntarily?

Refs.:

• Hansmann, Henry (1988). 'Ownership of the Firm', Journal of Law, Economics, and Organization, 4(2) Autumn: 267-304.
• Hansmann, Henry (1996). The Ownership of Enterprise, Cambridge, Mass: Harvard University Press.

An interview of Ross Emmett

From the Smith and Marx Walk into a Bar: A History of Economics Podcast comes this interview of Ross Emmett by Scott Scheall.

In this wide-ranging episode, co-host Scott Scheall interviews Ross Emmett, Professor of Political Economy and Director of the Center for the Study of Economic Liberty at Arizona State University. Discussion topics include Ross's work on Frank Knight and the circle of economists around Knight at the University of Chicago, Robert Malthus's contributions to economics, and Ross's friendship with the influential historian of economic thought Warren Samuels.

Horizontal integration can be good for you

It has long been recognised that vertical integration can enhance efficiency. It can deal with hold-up problems etc. But horizontal integration has been looked at with much more suspicion.

The conventional view is that anticompetitive mergers increase industry concentration and hence increase market power, harm competition ex post, and therefore need to be carefully reviewed and possibly restricted by regulators. Hence, regulators, such as the Antitrust Division of the Department of Justice or the Federal Trade Commission, have the mandate to prevent situations that “excessively” transfer welfare from consumers to firms via buildups of dominant positions or firms with disproportionate market power, including mergers perceived to be anticompetitive.

Are these policies effective or desirable? We take a dynamic approach and find the answer to be No in both cases.

This quote is from a posting at the Pro-Market blog by Dirk Hackbarth and Bart Taub in which they ask Can Horizontal Mergers Actually Boost Competition?

To reach these conclusions we built a dynamic, noisy collusion model that captures firms’ optimal output strategies prior to a merger. [...] We thus focus only on the desire of firms to collude prior to merging or potentially to merge if collusion fails.

The conventional view fails to account for dynamics. Firms in our dynamic model are forward-looking, aware that they are in a dynamic cartel-like situation, but are unable to directly observe the actions of the rival firm, which would enable them to enforce the cartel. The inability of each firm to observe the other firm’s output reflects the real world: regulators punish firms that directly track and coordinate with each other’s actions for market power purposes.

Hackbarth and Taub go on to explain,

The conventional view fails to account for dynamics. Firms in our dynamic model are forward-looking, aware that they are in a dynamic cartel-like situation, but are unable to directly observe the actions of the rival firm, which would enable them to enforce the cartel. The inability of each firm to observe the other firm’s output reflects the real world: regulators punish firms that directly track and coordinate with each other’s actions for market power purposes.

Because they are blocked from observing each other directly, firms are unable to punish their rival for directly perceived deviations from collusion–that is, for producing too much in order to realize temporarily higher profits at the expense of the other firm. The inability to directly observe and punish deviations therefore requires a tacit collusion arrangement, in which firms attempt to observe each other indirectly–via prices. This indirect observation is imperfect, however, because prices are affected by random influences, in addition to the effects of the firms’ output choices.

Because of the random influences a firm can mistakenly appear to produce too much output. Under the tacit collusion arrangement this triggers a punishment in which the rival firm increases output, thus driving down prices and so harming the deviating firm: there is a price war, resulting in low profits for both firms. It is the fear of this price war that sustains the tacit collusion arrangement in the long run.

The potential to merge weakens those punishments, because it prematurely terminates them under terms that are an improvement over the price war for the firm that is being punished. Instead of the price war, the deviating firm gets a share in the monopoly that the firms form when they merge. Because the potential for punishment is concomitantly reduced, the trepidation about aggressively producing output in contravention of the interests of the cartel arrangement is reduced: there is more competition, resulting in more output and lower prices. Our conclusion is thus the exact opposite of the conventional view that mergers are harmful for society: making mergers more difficult (i.e., costlier for the firms) is actually harmful to society, because it strengthens the ability of firms to punish each other and enforce the cartel.

In addition to this fundamental result, we also show that pre-merger collusion is dynamically stable: episodes of collusion are long-lasting, and price wars are unusual and brief. Because mergers occur in the face of an incipient price war, mergers are therefore rare–pre-merger collusion is the normal state of the firms.

and

Although the monopoly gains stemming from merging harm consumers in the long run, the enhancement of pre-merger competition benefits consumers in the short-run and those benefits dominate the losses to consumers from the later formation of the post-merger monopoly. This is because discounted expected losses from post-merger increases in market power are small if mergers are rare [empirically they are] and hence the contemporaneously pro-competitive effect of the potential for mergers exceeds those losses if firms spend most of their time in pre-merger competition. This gives further impetus to a regulatory policy that is therefore a bit counterintuitive: reduce barriers and costs of merging in order to harness the pro-competitive effects of mergers.

In short, Hackbarth and Taub show, somewhat counter-intuitively, that regulators can increase consumer welfare by facilitating mergers by lowering frictions, such as barriers, costs, and expenses formally or informally placed by merger regulation such as merger guidelines of the Commerce Commission, the US Department of Justice or the European Commission.

Now just wait for the sound of heads exploding at the Commerce Commission!

An interview with Vernon Smith

From the IEA comes this interview of Professor Vernon Smith by Kate Andrews.

Professor Smith gives his analysis of current economic trends in the US and throughout Europe, including his take on Donald Trump's tariffs and obstacles to free trade.

Bruce Caldwell on F.A. Hayek, economic history, and his life's work

From the Hayek Program Podcast comes this audio in which Peter Boettke interviews Bruce Caldwell on the life and work of F.A. Hayek.

On this episode of the Hayek Program Podcast, Hayek Program Director Peter Boettke speaks with Professor Bruce Caldwell about his current projects, including an exciting new biography of F.A. Hayek himself. Caldwell talks of his experience and inspirations in directing the Center for the History of Political Economy at Duke University, the significance of his chosen life's work, and the history of the ideas found within it.

The latest Big Mac Index

From The Economist magazine comes their latest iteration of the Big Mac Index:

On the raw data version, shown above, the New Zealand dollar is 23.2 per cent under-valved.

If we adjust the index to account for GDP per person we see that the New Zealand dollar is 9.9 per cent under-valved.

Unemployment and domestic violence

Dan Anderberg spends a couple of mintues talking about his research on the link between unemployment and domestic violence.

Talk on Adam Smith by Jesse Norman

At a time when economics and politics are both increasingly polarized between left and right, this book, Adam Smith: What He Thought, and Why it Matters, which Jesse Norman will discuss at this event, returns to intellectual first principles to recreate the lost centre of public debate. It offers a Smithian analysis of contemporary markets, predatory capitalism and the 2008 financial crash; it addresses crucial issues of inequality, human dignity and exploitation; and it provides a compelling explanation of why Smith is central to any attempt to defend and renew the market system.

A brief note for @LewSOS

This note is a brief explanation for comments I made in an interesting twitter exchange with @LewSOS.

To start lets us define a socialist economy. I will follow those, on both sides, involved in the socialist calculation debate and define socialism as the state ownership of the means of production. Nothing strange in this.

This raises the question of what is ownership? Here I follow Grossman and Hart (1986) in defining ownership in terms of control rights. You "own" an asset insofar as you have control rights over that asset. As Grossman and Hart put it

We define a firm to consist of those assets that it owns or over which it has control; we do not distinguish between ownership and control and virtually define ownership as the power to exercise control.

This terminology seems consistent with standard usage. For example, Oliver Wendell Homes (1881) writes,

But what are the rights of ownership? They are substantially the same as those incident to possession. Within the limits of policy, the owner is allowed to exercise his natural powers over the subject-matter uninterfered with, and is more or less protected in excluding other people from such interference. The owner is allowed to exclude all, and is accountable to no one but him.

Clearly, in fact by definition, under socialism the state has residual control rights. Who then had control rights under the Nazi government? In particular, did private individuals have control rights over "their" assets? Adam Tooze in his book “The Wages of Destruction: The Making and Breaking of the Nazi Economy” (well worth reading, all 800 pages of it!!) makes a number of comments with regard to state involvement in the economy and control over business: to take a few examples,

Now capitalism's deepest crisis left German business powerless to resist a state interventionism that came not from the left but the right

and

The first years of Hitler's regime saw the imposition of a series of controls on German business that were unprecedented in peacetime history.

and

As we have already seen, the New Plan, which effectively regulated the access of each and every German firm to foreign raw materials, created a substantial new bureaucracy, which controlled the vital functions of a large slice of German industry.

and

Managing this burdensome system of controls was the primary function of a new framework of compulsory business organizations imposed by Schacht between the autumn of 1934 and the spring of 1935. In each sector, the existing multiplicity of voluntary associations was fused together into a hierarchy of Reich Groups (for industry, banking, insurance, and so on), Business Groups (Wirtschaftsgruppen, for mining, steel, engineering and so on) and Branch Groups (Fachgruppen, for anthracite as opposed to lignite mining, and so on). Every German firm was required to enrol. Each subdivision in each Business Group was headed by its own Fuehrer. These men were nominated by the existing associations, vetted by the Reich Group and appointed by Schacht. The primary role of the Business Groups was to act as a channel between individual firms and the Reich Ministry of Economic Affairs. Decrees came down from the Ministry via the Business group. Complaints, suggestions and information travelled upwards from the firms, via the Business Groups to Berlin. The organization was tireless in the production of publications, guidelines and recommendations for the best practice. On the basis of emergency decrees first issued during the latter stages of World War I, the Business Groups were also empowered to collect compulsory reports from their members, establishing an unprecedented system of industrial statistics. After 1936 they were authorized to penetrate even further into the internal workings of their members, with the introduction of standardized book-keeping systems.

and

So far-reaching were the regime's interventions in the German economy - starting with exchange controls and ending with the rationing of all key raw materials and the forced conscription of civilian workers in peacetime - that one is tempted to make comparisons with Stalin's Soviet Union.

and

[...] though there clearly was a dramatic assertion of state power over business after 1933, naked coercion was applied selectively [...]

What this points to is a high level of state control over business. While control over business was widespread, ownership was not taken over by the state in the manner of the Soviet Union. In Germany “ownership” formally remained in the hands of private individuals. But while it is true that "formal" ownership remained with private individuals, a question has to be asked as to what happened to "real" ownership. As Aghion and Tirole (1997) point out for the case of organisations, there is a difference between formal authority (the right to decide) and real authority (the effective control over decisions). Formal authority need not confer real authority.

A similar situation can occur with ownership when the state regulates business activity. Formal ownership (the right to decide) may not confer real ownership (the effective control over decisions) in so much as many of the control rights normally associated with ownership are not in the hands of the formal owners. Formal owners may be left with only residual income rights and a limited range of control rights. Given the level of regulation of the Nazi economy, many of the rights usually thought of as making up (real) ownership had been effectively usurped by the state. 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.

So while formal ownership remained with the private sector, this was little more than just an empty shell since real ownership had been (mis)appropriated by the state.

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.

In short, I would argue that you can reasonably see the Nazi economy as being socialist.

Refs.:

• Aghion, Philippe and Jean Tirole (1997). ‘Formal and real authority in organizations’, “Journal of Political Economy”, 105(1): 1-29.
• Grossman, Sanford J. and Oliver D. Hart (1986). ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, “Journal of Political Economy, 94(4): 691-719.
• Holmes, Oliver Wendell (1881). “The Common Law”, Reprint. Boston: Little, Brown, 1946.

20% off

I've just noticed that the Book Depository is offering 20% off on my two favourite books right now.

The Theory of the Firm: An Overview of the Economic Mainstream

A Brief Prehistory of the Theory of the Firm

Can governments pick winners?

The short answer is, most likely, no. Two minutes on this question from Dave Donaldson.

Examples of geographical clustering in industries, such as Silicon Valley, suggest that firms have potentially positive external effects on other firms' productivities. Dave Donaldson discusses his research on the extent to which this is taking place, the strength of these economies of scale - for firms, workers, and consumers - and the role the government can play to foster this.

It really does exist!!

I was beginning to wonder.

Now go out and buy it! All of you!!

Race and economic opportunity in the United States

The sources of racial disparities in income have been debated for decades. This column uses data on 20 million children and their parents to show how racial disparities persist across generations in the US. For instance, black men have much lower chances of climbing the income ladder than white men even if they grow up on the same block. In contrast, black and white women have similar rates of mobility. The column discusses how such findings can be used to reduce racial disparities going forward.

This comes from a posting at VoxEU.org on Race and economic opportunity in the United States by Raj Chetty, Nathaniel Hendren, Maggie R. Jones and Sonya R. Porter. The findings of the study are:

Finding #1: Hispanic Americans are moving up in the income distribution across generations, while Black Americans and American Indians are not.

Finding #2: The black–white income gap is entirely driven by differences in men’s, not women’s, outcomes.

Finding #3: Differences in family characteristics – parental marriage rates, education, wealth – and differences in ability explain very little of the black–white gap.

Finding #4: In 99% of neighbourhoods in the United States, black boys earn less in adulthood than white boys who grow up in families with comparable income.

Finding #5: Both black and white boys have better outcomes in low-poverty areas, but black-white gaps are bigger in such neighbourhoods.

Finding #6: Within low-poverty areas, black–white gaps are smallest in places with low levels of racial bias among whites and high rates of father presence among blacks.

Finding #7: The black–white gap is not immutable: black boys who move to better neighbourhoods as children have significantly better outcomes.

The implications of the study are given as:

Differences in rates of mobility out of and into poverty are a central driver of racial disparities in the US today. Reducing the black–white gap will require efforts that increase upward mobility for black Americans, especially black men.

Our results show that the black–white gap in upward mobility is driven primarily by environmental factors that can be changed. But, the findings also highlight the challenges one faces in addressing these environmental disparities. Black and white boys have very different outcomes even if they grow up in two-parent families with comparable incomes, education, and wealth, live on the same city block, and attend the same school. This finding suggests that many widely discussed proposals may be insufficient to narrow the black–white gap themselves, and suggest potentially new directions to consider.

For instance, policies focused on improving the economic outcomes of a single generation – such as temporary cash transfers, minimum wage increases, or universal basic income programs – can help narrow racial gaps at a given point in time. However, they are less likely to narrow racial disparities in the long run, unless they also change rates of upward mobility across generations. Policies that reduce residential segregation or enable black and white children to attend the same schools without achieving racial integration within neighbourhoods and schools would also likely leave much of the gap in place.

Initiatives whose impacts cross neighbourhood and class lines and increase upward mobility specifically for black men hold the greatest promise of narrowing the black-white gap.There are many promising examples of such efforts: mentoring programmes for black boys, efforts to reduce racial bias among whites, interventions to reduce discrimination in criminal justice, and efforts to facilitate greater interaction across racial groups. We view the development and evaluation of such efforts as a valuable path forward to reducing racial gaps in upward mobility.

When it comes to entrepreneurs, youth isn't everything

While it is a widely held belief that youth and entrepreneurship go hand in hand, research finds that more successful entrepreneurs launch their enterprises in their 40s than in their 20s.
This is from the July 2018 issue of the NBER Digest. Alex Verkhivker gives a summary of the NBER working paper Age and High-Growth Entrepreneurship (NBER Working Paper No. 24489) by Pierre Azoulay, Benjamin Jones, J. Daniel Kim, and Javier Miranda.

Star innovators such as Bill Gates, who was 19 when he started Microsoft, Steve Jobs, 21 when he started Apple, and Mark Zuckerberg, 19 when he launched Facebook, have reinforced the longstanding impression that young people are the wellspring of entrepreneurship. Systematic data on firm founders, however, suggest that this impression is false.

In Age and High-Growth Entrepreneurship (NBER Working Paper No. 24489), Pierre Azoulay, Benjamin Jones, J. Daniel Kim, and Javier Miranda provide evidence that, on average, successful entrepreneurs are middle-aged. They analyzed administrative data from the U.S. Census Bureau on more than 2.7 million business founders whose companies subsequently hired at least one employee. The mean age of founders was 42. When looking at the highest-growth startups in the economy, the mean age at founding rose still higher — to 45.

The study explores not just the age of founders, but the factors that are correlated with firm success. Founders with prior work experience closer to the specific industry of the startup, and founders with longer experience in that industry, have substantially greater success rates. "For the 1 in 1,000 highest-growth firms, founders with three or more years of experience in the 2-digit industry see upper tail success at twice the rate" of founders with no experience in the 2-digit industry, the researchers report.

The study takes two approaches to examining growth-oriented startups. The first considers technology orientation, which can suggest the potential for high growth. The second considers the actual outcome for the firm, based on the three-, five-, or seven-year time window after founding.

Using third-party venture capital databases, the researchers determine whether a given company has received venture capital financing. They argue that such funding is suggestive of substantial growth potential. They also use employment growth and sales growth as defining characteristics of a high-growth new venture.

"...[C]omputing-oriented ventures as well as wireless telecom ventures appear to have the youngest founders," they write. "Yet even here the mean founder ages range from 38.5 to 40.8..."

The study also explores geographical heterogeneity, and separately considers California, Massachusetts, and New York. These three states account for the majority of high-growth startup activity in the U.S. Even in these states, successful entrepreneurs are still middle-aged. The youngest entrepreneurs in this part of the analysis, whose mean age was 38.7, were founders of venture capital-supported companies in New York.

When the set of 2.7 million founders was reduced to the 1,900 associated with companies that were both located in entrepreneurial hubs and received venture backing, the mean age of founders was 39.5.

The researchers conclude with a comment about current practices in the venture financing industry. "To the extent that venture capital targets younger founders, early-stage finance appears biased against the founders with the highest likelihood of successful exits or top 1 in 1,000 growth outcomes."

Two minutes on the minimum wage

Professor David Neumark a very quick summary of the research into the effects of minimum wage policy.


To read Professor Neumark's 2018 Adam Smith Lecture on “How policymakers should think about the minimum wage” see here. Well worth the read.

The gender earnings gap in the gig economy

A new NBER working paper on the gender wage gap.

The Gender Earnings Gap in the Gig Economy: Evidence from over a Million Rideshare Drivers
by Cody Cook, Rebecca Diamond, Jonathan Hall, John A. List, Paul Oyer

Abstract:

The growth of the "gig" economy generates worker flexibility that, some have speculated, will favor women. We explore this by examining labor supply choices and earnings among more than a million rideshare drivers on Uber in the U.S. We document a roughly 7% gender earnings gap amongst drivers. We completely explain this gap and show that it can be entirely attributed to three factors: experience on the platform (learning-by-doing), preferences over where to work (driven largely by where drivers live and, to a lesser extent, safety), and preferences for driving speed. We do not find that men and women are differentially affected by a taste for specific hours, a return to within-week work intensity, or customer discrimination. Our results suggest that there is no reason to expect the "gig" economy to close gender differences. Even in the absence of discrimination and in flexible labor markets, women's relatively high opportunity cost of non-paid-work time and gender-based differences in preferences and constraints can sustain a gender pay gap.