Child labour

The problem of child labour is discussed over at the Economic Logic blog. Many organisations argue for a ban on child labour. Economists argue against such a ban on the grounds that in some cases poverty forces parents to send their kids out to work just to survive. These parents are consciously neglecting the future returns of schooling for the obvious need of immediate survival. It is also argued that proper infrastructure is needed, but is often missing, to make sure that kids would actually go to school if given the opportunity. Lastly bans or boycotts of particular products, based on a child labour, are now thought to be counterproductive as they impoverish even further the targeted populations.

At Economic Logic they continue

Matthias Doepke and Fabrizio Zilibotti add further arguments against bans and boycotts by considering their political economy aspect. A boycott or a ban from outside directly impacts only the export sector. Children are thus pushed to the non-traded sector, typically local agriculture where children engage in physically less demanding work than adults. Thus specialization occurs and children do not compete with adults. There is no local support for a child labor ban.

If there is no outside intervention, then children stay in the export sector and are in competition with the local unskilled adults. Those will now want to support a local ban of child labor so as to get rid of this competition for jobs. Thus, paradoxically, an attitude of laissez-faire in the rest of the world would lead to a child labor ban. Intervening would prevent the ban from happening.

Just for fun: the theory of the firm 6

The neoclassical theory of the firm. The only model of the "firm" that most students meet and that found in most microeconomic textbooks, isn't a "theory of the firm" in any meaningful sense. The output side of the standard neoclassical model is a theory of supply rather than a true theory of the firm. In neoclassical theory, the firm is a 'black box' there to explain how changes in inputs lead to changes in outputs. It is a black box in the sense that inputs go in and outputs come out, without any explanation of how one gets turned into the other. The firm is taken as given; no attention is paid to how it came into existence, the nature of its internal organisation, where the boundary between one firm and another is or between a firm and the market; or whether anything would change if two firms merged and called themselves a single firm. The firm is a conceptualisation that represents, formally, the actions of the owners of inputs who place their inputs in the highest value uses, and makes sure that production is separated from consumption. The firm produces only for outsiders, there is no on-the-job or internal consumption, no self-sufficiency. In fact there are no managers or employees to indulge in on the job consumption and as production is separated from consumption, no self-sufficiency. Production for outsiders is, according to Demsetz (1995), the definition of a firm in the neoclassical model:

"[w]hat is needed is a concept of the firm in which production is exclusively for sale to those formally outside the firm. This requirement defines the firm (for neoclassical theory), but it has little to do with the management of some by others. The firm in neoclassical theory is no more or less than a specialized unit of production, but it can be a one-person unit" (Demsetz 1995: 9).

As inputs are combined in the optimal fashion by the actions of independent owners of inputs motivated solely by market prices, there is no need for `management of some by others', there is no role for managers or employees. Also note that as competition assures the absence of profits and losses in equilibrium, there is no need to have a residual claimant. This means that, in one sense at least, there are no owners of the firm. Hansmann (1996), for example, states

"[a] firm's "owners," as the term is conventionally used and as it will be used here, are those persons who share two formal rights: the right to control the firm and the right to appropriate the firm's profits, or residual earnings (that is, the net earnings that remain with the firm after it has made all payments to which it is contractually committed, such as wages, interest payments, and prices for supplies)." (page 11)

He later adds

"[n]ot all firms have owners. In nonprofit firms, in particular, the persons who have control are barred from receiving residual earnings." (page 12).

As there are no physical assets controlled by the firm, there are no (residual) control rights over these assets to allocate. This implies there are no owners of the firm in the Grossman Hart Moore sense.

The neoclassical production function is a way of representing the (efficient) black box conversion of inputs into outputs but tells us little about the inner workings of the black box. The production function is independent of the institutional framework of output creation. It can be given two interpretations: it can represent the production method of a single firm, of which all known firms are just divisions or, equally, it could represent the outcome of a series of purely market based transactions which give rise to the observed outputs. Thus it represents the 'firm' without explaining the 'firm'. The boundaries of the firm is an issue described by Williamson (1993: 4) as one of

"[...] make-or-buy. What is it that determines which transactions are executed how? That posed a deep puzzle for which the firm-as-production function approach had little to contribute."

Hart (1995: 17) criticises the neoclassical model based on three characteristics of the theory. First, he notes that the theory completely ignores incentive problems within the firm. The firm is a perfectly efficient `black box'. Second, the theory has nothing to say about the internal organisation of the firm. Nothing is said about the hierarchical structure, how decisions are made, who has authority within a firm. Third, the theory tells us nothing about how to pin down the boundaries of the firm. The theory is as much a theory of plant or division size as firm size. As Hart points out

"[t]o put it in stark terms [...] neoclassical theory is consistent with there being one huge firm in the world, with every existing firm [...] being a division of this firm. It is also consistent with every plant and division of an existing firm becoming a separate and independent firm" (Hart 1995: 17).

Cyert and Hedrick (1972) addressed similar points. They argue that in the neoclassical system the firm doesn't exist, that no real world problems of firms are considered, that there are no organisational problems or any internal decision-making process at all.

"In one sense the controversy over the theory of the firm has arisen over a non-existent entity. The crux of microeconomics is the competitive system. Within the competitive model there is a hypothetical construct called the firm. This construct consists of a single decision criterion and an ability to get information from an external world, called the "market" [8, Cyert and March, 1963, pp. 4-16]. The information received from the market enables the firm to apply its decision criterion, and the competitive system then proceeds to allocate resources and produce output. The market information determines the behavior of the so called firm. None of the problems of real firms can find a home within this special construct. There are no organizational problems nor is there any room for analysis of the internal decision-making process" (Cyert and Hedrick 1972: 398).

Thus within the neoclassical model of the price system, the firm's only role is to allow input owners to convert inputs into outputs in response to market prices. Firms have no internal organisation since they have no need of one, they have no owners since there is nothing to own. Questions about the existence, definition and boundaries of the firm are to a large degree meaningless within this framework since firms, by any meaningful definition of that term, don't really exist. As Foss, Lando and Thomsen (2000: 632) summarise it:

"The pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist" (Foss, Lando and Thomsen 1998: 1-2).

Another way to think of why the neoclassical firm is just a phantom is follow Coase (1937) and note that the neoclassical model in one of zero transaction costs, and as Martin Ricketts has noted,

"If market transaction were costless there would be no rationale for the existence of firms." (Ricketts 1999: 50, note 15)

Given there is no serious modelling of the firm within the neoclassical framework it is not surprising that there are no organisational problems or any internal decision-making process, in fact, that there is no organisational structure at all. And thus there is no role for managers, employees or owners. There are no boundaries to the firm, we can't say where one "firm" begins or ends or where firms end and markets begin because they are all one and the same. In short, there are no firms.

References:

• Coase, Ronald Harry (1937). 'The Nature of the Firm', Economica, n.s. 4 no. 16 November: 386-405.
• Cyert, Richard M. and Charles L. Hedrick (1972). 'Theory of the Firm: Past, Present, and Future; An Interpretation', ournal of Economic Literature, 10(2) June: 398-412.
• Cyert, Richard M. and James G. March (1963). A Behavioral Theory of the Firm, Englewood Cliffs, New Jersey: Prentice-Hall, Inc.
• Demsetz, Harold (1995). The Economics of the Business Firm: Seven Critical Commentaries, Cambridge: Cambridge University Press.
• Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics, Volume III, Cheltenham U.K.: Edward Elgar Publishing Ltd.
• Hansmann, Henry (1996). The Ownership of Enterprise, Cambridge, Mass.: Harvard University Press.
• Hart, Oliver D. (1995). Firms, Contracts, and Financial Structure, Oxford: Oxford University Press.
• Ricketts, Martin (1999). The Many Ways of Governance: Perspectives on the control of the firm, London: The Social Affairs Unit.
• Williamson, Oliver E. (1993). 'Introduction'. In Oliver E. Williamson and Sidney G. Winter (eds.), he Nature of the Firm: Origins, Evolution, and Development, New York, Oxford: Oxford University Press.

The broken window fallacy: Robert Barro on 'cash for clunkers'

Robert Barro comments on the "cash for clunkers programme" in the US:

The most ludicrous (though, fortunately, small) intervention thus far has to be the cash-for-clunkers program. It’s not surprising that subsidising people to destroy old cars would raise GDP, because measured GDP includes the replacement cars but not the value lost from destruction. Why not also blow up houses and factories and then enjoy the expansion of GDP from the replacement investment? (Actually, it’s best cosmetically to blow up refrigerators and other consumer durables because GDP does include rental income on houses and factories.)

Hogan on Wolak

At the Offsetting Behaviour blog Seamus Hogan has three useful posts on the Wolak report. This was the report the Commerce Commission had done into electricity markets in New Zealand. The result that got all the headlines was the $4.3b figure that the electricity companies ostensibly have overcharged everyone. See Did electricity companies really overcharge by $4.3b? Part 1, Did electricity companies really overcharge by $4.3b? Part 2 and Did electricity companies really overcharge by $4.3b? Part 3 to understand what the report actually said and how it came to its very dubious conclusions.

Life among the Econ

The single greatest work in the history of Econological research is available on line. Life Among the Econ by Axel Leijonhufvud is available here. This is a must read for anyone who wishes to understand the vast bleak and dismal territory that the Econ tribe occupies in the far North. It is one a the very few studies that tries to understand the social structure and ways of life of the Econ tribe. The information that we do have indicates that, for such a primitive people, that social structure is quite complex but this information is fragmentary and not well validated. Further study is much needed.

(HT: The Austrian Economists)

Supply really doesn't move (updated)

Below I have reproduced a diagram and explanation from a posting - Padding pockets, not houses - by Marty G at The Standard.

In the real world, it’s different. A new supply curve (S1) can be plotted that is the amount of the subsidy below the original supply line. Where the new supply line intersects with D gives the new level of price and quantity – note, it’s not as low as the full subsidy and quantity is less than what would be demanded if the full subsidy was passed on. (emphasis added)

What is wrong with Marty G's analysis? In short, S1 is not, as he claims, a supply curve.

I have redrawn Marty G's diagram below with an extra point on it, P2. Let us assume that we are at the new equilibrium P1,Q1. At this point the quantity traded is Q1 and the price paid by the consumer is P1. Question: If Q1 is to be supplied, what price must the producer receive? We know that the consumer price and the producer price must differ by the amount of the subsidy and that the consumer pays P1. Thus the producer receives P1 + the subsidy, which equals P2 on my diagram. But note that the P2,Q1 combination corresponds to the curve S, NOT the curve S1. That is, to induce the firm to supply an amount Q1 it must receive the price P2. Therefore S is the supply curve after the subsidy is introduced, as well as before it is. But if S is the supply curve both pre and post subsidy, then S1 is NOT the supply curve in either case. That is, the supply does not move with the introduction of the subsidy.

If we don't move the supply curve from S to S1, how do we find the new quantity traded, Q1, when the subsidy is put on? Note that the consumer and producer prices differ by the amount of the subsidy, so we increase the quantity traded starting from Q until the vertical distance between the supply and demand curves is equal to the amount of the subsidy. This is will give Q1 without having to move the supply curve.

Update: Matt Nolan over at TVHE has some additional issue with Subsidises and complaints.

Tyler Cowen interview

From Bloggingheads.TV, comes this interview of Tyler Cowen by Will Wilkinson. They discuss human neurodiversity and Cowens new book Create Your Own Economy.

EconTalk this week

Eric Hanushek of Stanford University's Hoover Institution talks with EconTalk host Russ Roberts about the current state of education and education policy. Hanushek summarizes the impact of No Child Left Behind and the current state of the charter school movement. Along the way, he and Roberts discuss the role of testing as a way of measuring achievement. The conversation concludes with a discussion of school finance, the role of the court system, and suggestions for improving finance to create better incentives.

Just for fun: the theory of the firm 5

The incentive-system theory. This approach to the theory of the firm was developed by Holmstrom and Milgrom (1991, 1994); Holmstrom and Tirole (1991) and Holmstrom (1999) and has been described by Gibbons (2005: 206) as an "accidental theory of the firm". The reason for Gibbons's description is that the focus of these papers was not on the make-or-buy problem of the transaction cost or Grossman/Hart/Moore approaches but rather on a multi-task, multi-instrument principal-agent problem and its application to the firm was an "accidental" outcome of this endeavour.

To analyse this approach to the firm, we will take advantage of Gibbons (2005: 210-2) "stick-figure rendition" of the theory. In the simple Gibbons model, there is a technology of production which is a linear combination of the agent's actions: $y=f_1a_1+f_2a_2+\varepsilon$ where the $a_1$ and $a_2$ are actions chosen by the agent and $\varepsilon$ is a noise term. Evaluation of performance by the agent is based on an indicator $p$ which is a different linear combination of the agent's actions: $p=g_1a_1+g_2a_2+\phi$, where $\phi$ is another noise term. Gibbons assumes that both parties are risk-neutral, $\omega$ is the total compensation paid by the principal to the agent and $c(a_1,a_2)$ represents the agent's cost function. Gibbons makes the assumption that:

\begin{equation}c(a_1,a_2)=\frac{1}{2}a^2_1+\frac{1}{2}a^2_2.\nonumber\end{equation}

In addition, Gibbons assumes that the principal and the agent sign a linear contract, $\omega=s+bp$, based on the performance indicator $p$.

To provide a theory of the firm, this model has to be extended to include physical capital, a machine, which is used by the agent during the production of $y$. Post production this capital has a value determined by a third linear combination of the agent's actions: $v=h_1a_1+h_2a_2+\xi$ where $\xi$ is a third noise term. The choice variables in the model are therefore the agent's actions $a_i, i=1,2$ and $b$ the slope of the optimal contract. As a point of comparison, note that the first-best actions of the agent are those which maximise the expected total surplus, that is, they will maximise the expected value of the sum of the principal's payoff, $y-\omega$, the agent's payoff, $\omega-c(a_1,a_2)$, and the value of the physical asset, $v$.

\begin{eqnarray}TS^{FB}&=&E(y-\omega+\omega-c(a_1,a_2)+v)\nonumber\\&=&E(y+v)-c(a_1,a_2)\nonumber\\&=&E(f_1a_1+f_2a_2+\varepsilon+h_1a_1+h_2a_2+\xi)-c(a_1,a_2)\nonumber\\&=&f_1a_1+f_2a_2+h_1a_1+h_2a_2-c(a_1,a_2)\nonumber~~\textrm{assuming}~E(\varepsilon)=E(\xi)=0\\&=&f_1a_1+f_2a_2+h_1a_1+h_2a_2-\left(\frac{1}{2}a^2_1+\frac{1}{2}a^2_2\right)\nonumber\end{eqnarray}

and therefore $a^{FB}_1=f_1+h_1$ and $a^{FB}_2=f_2+h_2$. $TS^{FB}$ is independent of the value of $b$.

If the principal owns the machine, then the agent is an employee of his firm and the principal's payoff is $y+v-\omega$, while the agent's payoff is $\omega-c$. In this case, the agent's optimal actions maximise

\begin{eqnarray*}E(\omega)-c(a_1,a_2)&=&E(s+bp)-\left(\frac{1}{2}a^2_1+\frac{1}{2}a^2_2\right)\\&=&E(s+b(g_1a_1+g_2a_2+\phi))-\left(\frac{1}{2}a^2_1+\frac{1}{2}a^2_2\right)\\&=&s+bg_1a_1+bg_2a_2-\left(\frac{1}{2}a^2_1+\frac{1}{2}a^2_2\right)~~\textrm{assuming}~E(\phi)=0.\end{eqnarray*}

The optimal actions are therefore, $a^\star_{1E}(b)=bg_1$ and $a^\star_{2E}(b)=bg_2$. The efficient contract slope, $b^\star_E$, maximises the expected total surplus, $E(y+v)-c(a_1,a_2)$ or

\begin{equation}TS_E(b)=(f_1+h_1)a^\star_{1E}(b)+(f_2+h_2)a^\star_{2E}(b)-\left(\frac{1}{2}a^\star_{1E}(b)^2+\frac{1}{2}a^\star_{2E}(b)^2\right).\nonumber\end{equation}

Alternatively, the machine can be owned by the agent. Gibbons interprets this case as the agent being an independent contractor. In this situation, the payoffs for the principal will be $y-w$ and for the agent they are $w+v-c$. The optimal actions for the agent will therefore be, $a^\star_{1C}(b)=g_1b+h_1$ and $a^\star_{2C}(b)=g_2b+h_2$. For this case, the efficient slope, $b^\star_C$, will maximise the expected total surplus of

\begin{equation}TS_C(b)=(f_1+h_1)a^\star_{1C}(b)+(f_2+h_2)a^\star_{2C}(b)-\left( \frac{1}{2}a^\star_{1C}(b)^2+\frac{1}{2}a^\star_{2C}(b)^2\right).\nonumber\end{equation}

Gibbons (2005: 211) summaries the analysis so far as:

"[...] having the agent own the asset causes the agent to respond to a given contract slope $(b)$ differently than when the agent does not own the asset, so the make-or-buy problem amounts to determining which of the agent's best-response functions $-$ that of the employee, $(a^\star_{1E}(b), a^\star_{2E}(b))$, or that of the independent contractor, $(a^\star_{1C}(b), a^\star_{2C}(b))$ $-$ allows the parties to achieve greater total surplus."

The discussion so far has relied on an implicit assumption that the value of the asset is not contractible and therefore the owner of the asset receives its value. Since the asset's value is not contractible, putting ownership in the hands of the agent provides him with incentives that cannot be replicated via a contract. But providing the agent with the incentive to increase the value of the asset may or may not help the principal control the agent's incentives via contract. That is, if the agent owns the asset, he has two sources of incentives, the asset's post-production value and the contracted for performance. Without ownership, he concentrates solely on the contracted for performance. Integration would be efficient, that is, having the principal own the asset is efficient, when having the agent do so hurts the principal's efforts to create incentives via contract.

In sum, the distinctive point of the incentive-system approach to the firm is that asset ownership can be one instrument in a multi-task incentive problem. Asset ownership has two sets of effects; one it provides incentives via the value of the asset itself and two it provides incentives via changes induced in the optimal incentive contract. Joint optimization over asset ownership and contract parameters illustrates the system approach to incentive problems. in line with the property-rights approach, the incentive-system theory has the advantage of providing a unified account of both the costs and benefits of integration. In addition the incentive-system theory counters one problems of the property-rights theory in that workets now face incentives, they are no longer act like robot drones.

There are some problems with this approach however. First, most employees are not governed by formal incentive contracts. We just don't see, in the real world, the type of contract the incentive system suggest should be written. Second, and perhaps even more importantly, the elemental incentive system theory omits one of the central and appealing aspects of the rent-seeking and property-rights theories: control. That is, in the elemental incentive-system theory, whether the agent owns the asset affects only the agent's payoff function, it does not effect the agent's action space.

References:

• Gibbons, Robert (2005). 'Four formal(izable) theories of the firm?', Journal of Economic Behavior and Organization, 58(2) October: 200-45.
• Holmstrom, Bengt (1999). 'The Firm as a Subeconomy', Journal of Law, Economics, and Organization, 15(1) April: 74-102.
• Holmstrom, Bengt and Paul Milgrom (1991). 'Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design', Journal of Law, Economics, and Organization, 7(Special Issue): 24-52.
• Holmstrom, Bengt and Paul Milgrom (1994). 'The Firm as an Incentive System', American Economic Review, 84(4) September: 972-91.
• Holmstrom, Bengt and Jean Tirole (1991). 'Transfer Pricing and Organizational Form', Journal of Law, Economics, and Organization 7(2) Fall: 201-28.

Jeanette meet economics .... (updated)

Jeanette Fitzsimons needs to do a bit of reading on economics as this posting at the frogblog shows,

Electricity is unique among industries. With shoes or toothpaste, increased demand gives economies of scale and tends to bring prices down. With electricity, which cannot effectively be stored on any scale, and where the cheapest sites for hydro and wind and geothermal are always built first, and the price of fossil fuels is rising, increased demand raises prices.

First, economies of scale are determined by the costs of firms, not by the demand they face. Put simply if the average cost curve of a firm is declining then you have economies of scale, if it is increasing you have diseconomies of scale. Demand is not in the picture. Second, demand will enter the picture when price is determined. As demand increases the price tends, in general, to increase, not decrease. If there is a natural monopoly then price changes resulting from demand increases could be negative as costs will be decreasing. But here the regulation that the firm is under will be a big determinant in prices changes. Third, the cheapest methods of production are always built first. This is true in general, and not just for electricity. Fourth, as just noted, if there is a natural monopoly then increased demand could decrease prices. But electricity production is more likely a natural oligopoly and thus increased demand could increase prices, independently of fuel price increases. Fifth, increased fossil fuel prices will tend to increased the cost of production, and for a given level of demand this will also increase the price of electricity. If demand was however to fall enough then prices could fall, and if both demand and fuel prices increased then price would tend to rise more than they would with only one of the two increases. In other words it is supply and demand that determines price not just one of them. Last, electricity is not unique among industries in that it has large fixed (sunk) costs. There are many industries with this property.

Update: Tom M comments in a similar manner when he suggests Supply, Meet Demand.

Correlation is not causation.

From an article in the New York Times,

For example, in the late 1940s, before there was a polio vaccine, public health experts in America noted that polio cases increased in step with the consumption of ice cream and soft drinks, according to David Alan Grier, a historian and statistician at George Washington University. Eliminating such treats was even recommended as part of an anti-polio diet. It turned out that polio outbreaks were most common in the hot months of summer, when people naturally ate more ice cream, showing only an association, Mr. Grier said.

Statistics can be bad for your health, or at least bad for your utility. Just how often do we mistake correlation for causation?

Happiness: the impact of growth, inequality and recession

From VoxEU.org comes this interview with Justin Wolfers of the University of Pennsylvania’s Wharton School in which he talks to Romesh Vaitilingam about happiness economics – the state of knowledge; the explosion of data; the debate about the Easterlin paradox; the impact of inequality and the business cycle on people’s happiness; and the implications for public policy.

The good old days weren't that good

Or so says Bryan Caplan. Caplan documents one way that life for children in America, at least, today is far better than it was during the so-called "golden years" of the 1950s.

Incentives matter: medical file

This from MacDoctor: Mercenary-medicine,

The reason so many young doctors (and a few of us oldies) are willing to endure such terms in exchange for extra money is because the difference in money is substantial. In case anyone thinks it is not an issue primary of pay, let me point out that Waitakere hospital has all but closed its ED in the evenings because they cannot staff it, yet there is a 24 hour Whitecross A&M just down the road that appears to be managing to staff the place just fine, despite the current shortage of locum doctors. The only difference is about a 60 dollar an hour difference in pay scales.

In addition, there is not much of a disincentive for junior doctors to locum. As the report points out, the junior doctors in hospital positions, work long, dangerous hours, get little continuing medical education and even less in-house training. So, apart from sick leave provision, hardly a big concern for fit, healthy young doctors, the DHBs are offering nothing except markedly lower pay.

And then they wonder why junior doctors leave and become full-time locums.

May be they just don't understand about incentives.

Buy American?

From Reason TV comes this great video exposing the destructive and nonsensical claims of the 'buy American' clause in the US stimulus bill.

Interesting blog bits

1. Eric Crampton on Further on the price elasticity of demand for alcohol. The Law Commission's report claims that youth are particularly price sensitive and that heavy drinkers are no less price sensitive than moderate drinkers. As noted a couple of days ago, the latter claim is absolute nonsense.
2. Brad Taylor on Coherence versus Political Reality. Politics as it’s practised on the ground isn’t a competition between alternative coherent worldviews, but competing myths, symbols, and identity groups.
3. Save the Humans on Bin City Blows $19m on Recycling in a Recession. What on earth is going on in the People's Republic? The council has purchased a company which processes recycling material that no one wants.
4. Philip Salter asks, Should taxpayers fund the arts? My answer, in short, no.
5. John Blundell asks Should the government cut arts funding? Yes, he says.
6. Matt Nolan gives us a Cartoon: Night classes.
7. José Cuesta asks Are policymakers better equipped for the next food price crisis? The food crisis caught some policymakers off guard. Will they be ready next time? This column argues that most studies of the crisis offer little in the way of tractable policy responses. This knowledge gap leaves policymakers unprepared to prevent or mitigate the next food price crisis.

Because, Your Majesty, no one could predict it

Queen Elizabeth famously asked why economists did not predict the financial crisis. The best answer I have seen so far comes from Bill Easterly, who offers us the Idiot’s Guide to answering the Queen. Easterly writes,

First, Your Majesty, economists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it. The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices. If you think it is useless to be told you cannot predict the market, then you should change your Palace investment advisor. This knowledge will protect you from a lot of investment scams like Mr. Madoff’s and will also provoke a serious discussion of how to protect your Royal Wealth against risk in an uncertain world.

Second, economists did just fine pointing to fundamentals that were creating large risks of a financial crisis. Even an outsider like me heard long before the crisis hit about the dangers of opaque instruments like derivatives, excessive mortgage lending and leverage, and the bubble in housing prices. Economists have contributed a lot to understanding bubbles, but we can’t time exactly when they will burst (see EMH above).

Easterly ends his guide by suggesting,

So please tell your subjects in poor countries to keep studying basic mainstream economics. This economics not only survived the crisis, it also is the proven set of ideas that get countries out of poverty.

Well said that man.

Just for fun: the theory of the firm 4

One of the standard approaches to the theory of the firm today is the property-rights view of the firm associated with the work of Grossman and Hart (1986), and Hart and Moore (1990). What is important in these papers is the ownership of, or (residual) control over, non-human assets. Such control generates the indirect influence that a "boss" has over his workers. Note that human capital is assumed to be inalienable. The influence the "boss" has, is due to him owning and controlling the physical assets which are important to the workers' productivity.

First up an obvious question is, What does the 'ownership' or 'control' of a physical asset entail? The Grossman/Hart/Moore approach borrows from the transaction-cost literature the ideas that contracts are typically incomplete: there are always unforeseen states of nature - or certain actions, such as making specific investments - that cannot be contracted upon. This in turn arises the question: Who decides how physical assets should be used in uncontracted-for eventualities? This is how ownership is defined. An owner of an asset has residual control rights, to use the asset in any way he sees fit except to the extent that particular usages have been specified in some initial contract. In particular, an owner of an asset has the right to deny access to anyone else.

This brings us to the issue of a definition of a firm. A firm is identified with the collection of physical assets over which the owner - the boss - has the residual control rights. Note that the boss exerts authority over workers because, in the event of a dispute, the boss can deny the worker access to important non-human assets. Moore (1992: 497) explains the importance of this,

I am going to show that if an agent does not own an asset, then his actions will depend on who does own it. For example, it will matter to the workers of a firm if their firm is taken over by another firm. The costs and benefits of integration can be understood primarily in terms of the (aggregate) effects on the incentives of the workers of the firms involved.

A simple example from Moore (1992) will help show this.

Suppose there is just one asset, a luxury yacht. There are three agents: agent 1, a chef; agent 2, a skipper; and agent 3, a tycoon. At date 1, agents 1 and 2 provide agent 3 with a service, gourmet seafare. We consider three models, with increasing degrees of complexity:

Model A. For the service to be useful, at date 0 the chef must take an action - say the preparation of a particular cuisine. This is a private effort decision, and cannot be contracted over. No other yachts are sailing nearby; hence the action is nontransferable. There are many other (potential) skippers at date 1; that is, agent 2 is dispensable. However, the tycoon is indispensable (only he can afford to fly to these waters). The cost to the chef of his action equals 100. The benefit to the tycoon equals 240. Finally, transactions costs prevent the writing of any long-term contracts at date 0.

So the question is, Will the chef take his action? Note that the action is socially efficient, since 240>100. The answer depends on who owns the yacht, the main non-human asset. If either the chef or the tycoon owns the yacht, then the date 1 (gross) surplus of 240 will be bargained over and split between the two of them, since each of them is crucial to the generation of the surplus (the chef has to provide the meal, and the tycoon is the only customer). Moore assumes that bargaining leads to both parties getting a half share, i.e., 120. The skipper receives none of the surplus, since he is dispensable. Since the chefs anticipated private return of 120 at date 1 exceeds his private cost of 100, he will take his action at date 0.

The other possible owner is the skipper. If he owns the yacht, then the surplus must be divided among all three of them (now the skipper is important, by virtue of his controlling access to the crucial asset). Here Moore assumes that three-way bargaining leads to each party getting a third, i.e., 80. Anticipating a private return of only 80 at date 1, the chef will not take his action at date 0 given that the cost is 100.

From this, one important point should be noted. The chef is more likely to take an action specific to the tycoon if the tycoon is his boss than if the skipper is his boss. A worker puts more weight on his boss's requirements than on someone else's. An employer indirectly gains 'authority' over an employee as a result of owning an important asset.

Model B. Modify Model A so that at date 0, the skipper also has an action-say to learn the history of the local islands to plan a better itinerary. Assume that the chef as well as the skipper is dispensable. The cost to the skipper of his action equals 100. The additional benefit to the tycoon equals 240. (So if both the chef and the skipper take their respective actions, there will be a total surplus of 480 to divide.)

In this case the question becomes, Will the chef, the skipper, or both take their respective action? Applying the same logic as in Model A, we can conclude:

	Chef's share of his 240	Chef act?	Skipper's share of his 240	Skipper act?
Chef owns yacht	120	Yes	80	No
Skipper owns yacht	80	No	120	Yes
Tycoon owns yacht	120	Yes	120	Yes

The main result that can be seen from Model B is that when both the chef and skipper take actions specific to the tycoon, it is strictly better for the tycoon to own the yacht. That is, it may be efficient to give ownership of assets to agents who are indispensable even though they make no important effort or investment decisions.

Model C. As Model B, except that now the yacht comprises two pieces, the galley and the hull. These are strictly complementary, in that one is useless without the other. Also modify Model B so that the chef and skipper's actions are no longer specific to this tycoon; he too is dispensable. Finally, suppose that at date 0 the tycoon also has an action - say wooing business people to attend dinner parties aboard the yacht. The cost to agent i of his own action equals ci (i=1,2,3). The benefit of each agent's action to the tycoon equals 240 (making a total potential gross surplus of 720).

In this case Moore compares non-integration, that is, the chef owns the galley, and the skipper owns the hull with integration, that is, the chef owns the entire yacht (both galley and hull).

Applying the logic of Model A to this cases results in:

	Chef acts iff	Skipper acts iff	Tycoon acts iff
Integration	c1<=120	c2<=120	c3<=80
Non-integration	c1<=240	c2<=120	c3<=120

Moore (1992: 499) writes,

For example, under nonintegration, for the tycoon to enjoy the additional 240 (gross) surplus arising from his own action, he must bargain with both the chef and the skipper since they each own a piece of the yacht. Accordingly, the tycoon's private return will be only 80. However, if the chef owned the entire yacht (integration), the tycoon would only need to bargain with one owner, and would obtain a private return of 120. Notice that the skipper's incentives to act are not diluted by losing control to the hull of the chef. The reason is that under nonintegration, the skipper has to bargain with the chef anyway (who owns the strictly complementary asset, the galley), and so it makes no difference to the skipper's incentives that the chef owns both pieces. The conclusion from Model C is that giving both pieces of the yacht to one agent (the chef in this case) leads to fewer hold-ups and greater efficiency. That is, assets that are strictly complementary should be owned together.

Importantly what Model C suggests to us is that complementary assets should be owned together, that is they should be integrated to form a single firm. A general proposition to this effect appears in Hart and Moore (1990: Proposition 8). There is a corresponding proposition, Hart and Moore (1990: Proposition 10), which tell us that asset that are economically independent should be owned separately owned, that is, they should not be part of a single firm. This is simply because from the viewpoint of the workers of the firm which has be bought, integration would amount to little more than bringing in an 'outside' owner who does nothing but dilute the incentives they face. This, then, means we have an explanation for the U-shaped average cost curve. Firms initially have increasing returns (stemming from the coordination of complementary assets) and then decreasing returns (stemming from the loss in incentives from outside control) - i.e. we have a theory for ,the optimal size of a firm based on transactions and technology.

Moore (1992: 500-1) makes a few comments on the theory developed above.

First, great emphasis is placed on ex ante (date 0) inefficiencies - i.e., underinvestment. We believe, however, that we may be picking up some of the same effects as one might obtain in a model in which there were ex post inefficiencies - due to the difficulty of striking bargains at date 1, particularly in a multilateral context such as this. For example, as in Model B, an agent who is crucial to the generation of ex post surplus (the tycoon) should have control rights, because agreement has to be reached with him anyway, so why increase the number of agreements necessary by giving control rights to others? It would be highly desirable to analyse the consequences of ex post inefficiencies in a systematic manner.

The next comment is related. The theory has no discussion of coordination, or information flows, at date 1. A boss never has to tell a worker what to do; the worker simply figures it out for himself. Equally, there is no discussion of hierarchy and delegation of decision making. A very important topic for future research is to extend the model to incorporate coordination, hierarchy and delegation.

Finally, the theory assumes that there is a date 0 market for assets which works perfectly, and that there are no wealth constraints. For example, in Model C, if the chef arrived at the date 0 market owning the galley, and the skipper arrived owning the hull, what would happen if the chef did not have the cash available to buy the hull? Remember, it is efficient for the chef to own both the galley and the hull,' so it is tempting simply to say that the chef borrows the money from a bank. But what security can the bank be offered in a world in which the chef has no resources except for his human capital - which, we have argued, is inalienably his?

References:

• 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) August: 691-719.
• Hart, Oliver D. and John Moore (1990). 'Property Rights and the Nature of the Firm', Journal of Political Economy, 98(6) December: 1119-58.
• Moore, John (1992). 'The Firm as a Collection of Assets', European Economic Review, 36(2-3) April: 493-507.

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