Incentives matter: tax file

From Carpe Diem comes this example of how taxes affect incentives.

TAMPA - Last spring, the cigar industry fretted that the government might tax so-called "little cigars" into oblivion. Several months later, though, it appears the makers of cigarette-shaped little cigars have found a way to escape the high taxes. The cigar makers have added more weight to their cigars, reclassified them as large cigars and now are subject to a lower tax rate, said Norman Sharp, president of the Cigar Association of America.Under the new tax rates, little cigars and large cigars are taxed differently, which apparently has given rise to some major changes in cigar production. For example, factories in the United States and Puerto Rico produced about 743 million large cigars in August, according to data from the U.S. Department of the Treasury. That's up 85 percent from August 2008, when they made 402 million large cigars (see chart above).

Meanwhile, production of little cigars plummeted. In August, factories in the United States and Puerto Rico produced about 145 million little cigars, down from about 480 million little cigars in August 2008. Cigars made outside of the United States and Puerto Rico saw a similar rise in large cigar production and decline in production of little cigars (see chart).

What's going on? Sharp, the cigar association president, said it appears cigar makers changed their production techniques to factor in the SCHIP tax. Cigar makers began adding enough extra weight to their little cigars so they exceeded the 3-pounds-per-1,000 threshold. So they could be classified now as large cigars.

The economic lessons from this are: If you tax something you get less of it and taxes are always distortionary, because taxpayers will change their behaviour in a effect to avoid or minimise the taxes. In other words taxes affect incentives. A possible exception incentive effect is a lump-sum tax.

Climate change and the world trading system

In this audio from VoxEU.org, Gary Hufbauer of the Peterson Institute for International Economics talks to Romesh Vaitilingam about potential conflicts between global agreements on tackling climate change and the rules of the international trading system, including possible outcomes from the upcoming Copenhagen climate conference.

Pay-by-the mile insurance

One for the markets in everything file. This from the Carpe Diem blog:

A first-of-its-kind plan is MileMeter available only in Texas, which last year began offering six-month policies with chunks of insured miles ranging from 1,000 to 6,000 miles. When the "tank" runs dry, motorists buy more.

Spending money on economists

At the Knowledge Problem blog Michael Giberson says In principle I’m in favor of spending money on economists. He is referring to the announcement that George Soros has promised to spend $5 million a year for 10 years to support an Institute for New Economic Thinking to be hosted at Central European University in Budapest, which Offsetting Behaviour commented on here and I commented on here. Giberson writes

As part of the announcement, Soros said:

The entire edifice of global financial markets has been erected on the false premise that markets can be left to their own devices, we must find a new paradigm and rebuild from the ground up. I decided to sponsor INET to facilitate the process. I hope others will join me.

I’d be surprised if we could find any significant part of the “global financial market” that wasn’t thoroughly entangled with law, regulation and politics, so I’m not sure which edifice he is talking about or where it has been erected. Furthermore, the idea that we can discard an existing social system, “find a new paradigm and rebuild from the ground up”, strikes me as intellectual arrogance of a very high order

Giberson also makes the same point I made about claim that the likes of Joseph Stiglitz, George Akerlof, Michael Spence, and Sir James Mirrlees in "marginalised" in the economics profsssion:

But whatever you think of economics, economists, or heterodox viewpoints, it seems odd to characterize winners of the Nobel price in economics and other distinguished economists as having been “marginalized” in the profession, as Michael Hirsch does in this Newsweek story on the INET announcement when he mentions the board of advisers. Yes, yes, pity the poor economist who was “marginalized” into tenured faculty position at some of the top universities in the world: Cal-Berkeley, Columbia, Harvard, Stanford, Oxford and Cambridge. In addition to the Nobel Prize, we have John Bates Clark awardees, former members of the President’s Council of Economic Advisers, and so on. The INET board of advisers is a collection of talented and honored members of the profession. Hirsch is discovering victims who perhaps didn’t notice their victimization during the recent spell of “free market fundamentalism” Hirsch observes in economics.

But Giberson also notes that it is Soros's money and thus he can do what he likes with it,

But he’s going to spend a lot of money on economists, and in any case I accept the premise that philanthropists should largely be left to their own devices, so I say he should go for it. It’s Soros’s money – largely built up from participating in that edifice of global financial markets, I understand – and he may as well spend it this way as on fancy cars or the Center for American Progress.

EconTalk this week

Michael Heller of Columbia Law School and author of The Gridlock Economy talks to EconTalk host Russ Roberts about the book and the idea that fragmented ownership is a barrier to innovation. Heller makes an analogy between the tragedy of the commons and what he calls the tragedy of the anticommons--the problem of bundling together numerous individual claims to a resource. Examples discussed include drug innovation when the innovator wants to use technologies of multiple patent holders, new music or visual media where the creator wants to use multiple copyrighted works, and allocation of spectrum rights and its role in wireless innovation

Bilateral trade agreements: good or bad?

Infometrics economist Gareth Kiernan argues that bilateral trade agreements are worthwhile for New Zealand. There is much in favour of such an argument. But there are also some counterarguments. Jagdish Bhagwati has written a book explaining why such preferential trade agreements can have a down side. See Termites in the Trading System: How Preferential Agreements Undermine Free Trade.

Bhagwati is University Professor at Columbia University and Senior Fellow in International Economics at the Council on Foreign Relations. He is one of the world's leading trade economists and a long time fighter for free trade - see, for example, his books Free Trade Today and In Defense of Globalization. So when I saw he had written a book arguing that Preferential Trade Agreements (PTAs) are bad for free trade I had to read it. This is relevant for New Zealand since most PTAs are in the form of Free Trade Agreements (FTAs), a number of which New Zealand has signed in recent years - including the one signed this week with Malaysia.

The standard objection to PTAs, due to Jacob Viner, is simply that they could divert trade from the cost-efficient nonmember countries to the relatively inefficient member countries. The reason, of course, is that the nonmembers continue to pay the pre-PTA tariffs, whereas the higher cost member countries no longer have to. It is obvious that shifting production away from a low cost country towards a high cost country must sabotage the efficient allocation among countries and thus reduce total welfare. This process is known as trade diversion. Viner was the first economist to note the possibility of trade diversion arising with discriminatory reductions in trade barriers via PTAs. But the negative effects of trade diversion can go further. The liberalising country itself may also be hurt. How so? Because when a country (call it the "home" country) shifts to a higher cost within-the-PTA supplier it is buying its imports more expensively, incurring what economists call a "terms of trade" loss. The terms of trade is the ratio of export prices to import prices. As import prices increase the terms of trade decrease which implies that the volume of imports that can be bought with one unit of exports decreases.

Bhagwati notes, however, that

Trade diversion is not a slam-dunk argument against PTAs, for offsetting the loss from trade diversion can be a gain if trade creation takes place. Trade may grow because consumers in the home country now pay lower prices in their own markets; the higher cost supply from the member country is still cheaper than what the domestic consumers had to pay before the PTA was formed. Again, the import competing producers in the home country will reduce their own inefficient production as the domestic price of imports falls after the PTA comes into operation; this also leads to welfare-enhancing trade creation. Therefore, whether a specific trade-diverting PTA brings loss or gain to a country depends on the relative strengths of the trade diversion and trade creation effects. (p. 50)

The important point about trade diversion is that we can no longer assume that it does not matter how we liberalise trade. The use of PTAs is a two-edged sword in which we could end up impaled. It can matter whether we liberalise via bilateral or multilateral agreements.

Bhagwati goes on to argue that proponents of PTAs are too complacent about trade diversion. He considers seven arguments (p.52-7):

1. There is evidence of fierce competition in many products and sectors today, with few managing to escape with "thick" margins of competitive advantage that provide comforting buffers against loss of comparative advantage.Thus, even small tariffs are compatible with trade diversion as tariffs are removed from members of a PTA while they remain in place on nonmembers.
2. The thinness of comparative advantage also implies that today we have what I have called kaleidoscopic comparative advantage, or what in jargon we economists call "knife-edge" comparative advantage. Countries can easily lose comparative advantage to some "close" rivals, who may be from any number of foreign suppliers. So even if preferences today do not lead to trade diversion, the menu of products where you develop comparative advantage in a world of volatility and rapidly shifting comparative advantage will be forever changing, and any given preferences may lead to trade diversion in the near future, if not today.
3. While Article 24 requires that the external tariffs not be raised when the PTA is formed so as not to harm nonmembers, the fact is that they can be raised when the external (MFN) tariffs are bound at higher levels than the actual tariffs. In these cases, a member of the PTA is free to raise the external MFN tariffs up to the bound levels, whereas typically the scheduled tariff reductions in the PTA, when a hegemonic power is involved, will be hard to suspend. This is in fact what happened during the Mexican peso crisis of 1994, when external tariffs were raised on 502 items from 20 percent or less to as much as 35 percent, while the NAFTA defined reductions in Mexican tariffs on U.S. and Canadian goods continued. So the prospect of trade diversion actually increased, despite the intent of those who drafted Article 24.
4. Article 24 freezes only external tariffs when the PTA is formed, with no increase in the external tariff allowed. But it does not address the modern reality that "administered protection" (i.e., antidumping and other actions by the executive) is both elastic and can be used and abused more or less freely in practice. Once you take into account the fact that trade barriers can take the form of antidumping measures, which are arbitrary in their design and protectionist in their practice, there is a real danger that initially welfare-enhancing trade creation can be transformed into harmful trade diversion through antidumping actions taken against nonmembers. Thus, if a member country is gaining a market in the member "home" country, creating trade by replacing inefficient home country production with less inefficient production and imports from another member country, that pressure could be accommodated, not by allowing domestic industry to yield to these imports from a member country, but by discouraging imports from the nonmember countries by using antidumping actions against them. Thus trade-creating imports from member countries could be replaced by trade-diverting restrictions on imports from nonmember countries.
   Such an "endogenous" response of the external trade barriers, typically in the shape of antidumping actions, violates the spirit of Article 24, which explicitly prohibits trade barriers on non-members from being raised but is confined to tariffs and does not extend to "administered protection."
5. There is plenty of evidence that trade diversion can occur through content requirements placed on member countries to establish "origin" so as to qualify for the preferential duties. Thus, typically, to qualify for the preferential tariffs in PTAs that include the United States, one must satisfy requirements such as that the imports of raw materials and components must come from the United States. For example, if apparel exports to the United States are accorded preferential tariffs, they must be made with U.S. textiles. This naturally diverts trade in textiles from efficient nonmember suppliers to inefficient U.S. textile producers.
6. Many analysts do not understand the distinction between trade diversion and trade creation and simply take all trade increase as welfare-enhancing. However, some recent analysts who are familiar with the phenomenon of trade diversion have tried to estimate it using what is called the "gravity model." Dating back some decades, this equation simply explains trade between two countries as a function of income and distance. Adapting this simple equation to their use, the economists Jeffrey Frankel and Shang-Jin Wei, who pioneered the use of gravity analysis to estimate trade creation and trade diversion, estimated total bilateral trade between any pair of countries as a function of their income and per capita incomes, with bilateral distance accounted for by statistical procedures. If the countries belonged to, say, the Western hemisphere and they traded more with each other than with a random pair of countries located outside the region, that would mean that the PTA between countries in the Western hemisphere had led to trade creation. But it is clear that even if one disregards other objections, the real problem with the analysis is that more trade between partners in a PTA can take place with both trade creation and trade diversion, so that one simply cannot infer trade creation alone from this procedure. Hence, the recent estimates based on gravity equation, which are improved variations on the original Frankel-Wei approach and which sometimes (but not always) suggest that PTAs in practice have led to more trade creation than diversion, cannot be treated as reliable guides to the problem of determining whether or not a PTA has led to trade diversion.
7. Several economists have suggested that we need not worry about trade diversion and that beneficial effects will prevail if PTAs are undertaken with "natural trading partners." The initial proponents of this idea, Paul Wonnacott and Mark Lutz, declared, "Trade creation is likely to be great and trade diversion small if the prospective members of an FTA are natural trading partners." One criterion proposed for saying that PTA partners are natural trading partners is the volume of trade already between them; the other is geographic proximity. Neither really works.
   At the outset, note that though some writers, including Paul Krugman and Larry Summers, both heavy hitters, have occasionally argued as if the two criteria go together, they do not. There is no evidence that pairs of contiguous countries or countries with common borders have larger volumes of trade with each other than do pairs that are not so situated, or that trade volumes of pairs of countries arranged by distance: between the countries in the pair will also show distance to be inversely related to trade volumes. This is evident from Table 3.1 [on p.58], which contains destination-related trade volume for major regions in 1980, 1985, and 1990. There are some compelling examples. Chile shares a common border with Argentina, but in 1993 it shipped only 6.2 percent of exports to and received only 5 percent of imports from Argentina. By contrast, the United States does not share a common border with Chile , nor are the two countries close geographically. Yet in 1993, the United States accounted for 16.2 percent of Chilean exports and 24.9 percent of its imports. The volume-of-trade criterion would thus make the United States, not Argentina, Chile's natural trading partner, clearly contradicting the claim that the volume-of-trade criterion translates into the regional criterion, even in a broad-brush sense. The two criteria, and their inappropriateness in ensuring that trade diversion will be minimized and beneficial effects of the PTA guaranteed, must therefore be assessed separately, as immediately below. [This is done on p.57-60.]

The General Agreement on Tariffs and Trade (GATT) was designed to reduce trade barriers via multilateral trade negotiations. Exceptions to the multilateral nature of negotiations had to be explicitly provided for, Article 24 - referred to above - is such an exception for free trade areas and customs unions:

Article 24 --Territorial Application; Frontier Traffic; Customs Unions and Free Trade Areas

Customs unions and free trade ease (FTAs) are exempted from the MFN clause, but such an arrangement must not increase existing levels of trade restrictions affecting nonmember countries. If existing trade barriers are raised to outsiders, compensation may be required. The arrangement must lead to significant liberalization --in particular, it must cover "substantially all" trade between participating countries --and interim arrangements should lead to formation of Ff As or customs unions within a reasonable period of time. Article 24 also provides that, regardless of political status, any area that maintains its own tariffs and commercial regulations may be treated as a contracting party.

Another problem with the ever increasing number of PTAs is the "Spaghetti Bowl" that they give rise to. There are two basic problems here. The first is that when a country enters into a number of FTAs, a given commodity will be subject to different tariff rates if the trajectories of tariff reductions vary across FTAs. This is normally the case. The second issue is the fact that tariffs on specific goods must depend on where a product is supposed to originate which gives rise to inherently arbitrary "rules of origin". Bhagwati writes

With PTAs proliferating, the trading system can then be expected to become chaotic. Crisscrossing PTAs, where a nation had multiple PTAs with other nations, each of which then had its own PTAs with yet other nations, was inevitable. Indeed, if one only mapped the phenomenon, it would remind one of a child scrawling a number of chaotic lines on a sketch pad. (p.61)

Rules of origin are there to determine which product is made by whom. But in this globalised world where multinational firms source components from all around the world trying to determine the origin of a given good is in Bhagwati's description "a mug's game". It is virtually impossible to say which product is whose. This gives rise to endless problems. As Bhagwati explains

There are in fact numerous cases where such questions have led to disputes that come for resolution before arbitration and bilateral dispute settlement panels. In a classic case, the U.S. Customs Service refused to certify Hondas produced in Ontario, Canada, as "North American," and hence eligible for duty-free exports from Canada to the United States, on the grounds that, in its own estimation, Canadian Hondas did not meet the local content requirement of more than 50 percent imposed by the Canada-U.S. Free Trade Agreement (CUFTA). Honda countered that its estimates showed that they did. There is no surefire, analytically respectable way to determine the truth in such a case: it all boils down to who has greater stamina and whether Honda is willing to put moneys into legal costs. (p.68)

Such problems so not arise if there is a multilateral agreement which imposes the same tariff on goods from all countries. Bhagwati quotes Hong Kong businessman Victor Fung, from the Financial Times, on the distortions and costs imposed on business by the spaghetti bowls,

Bilateralism distorts the flow of goods, throws up barriers, creates friction, reduces flexibility and raises prices. In structuring the supply chain, every country of origin rule and every bilateral deal has to be tacked on as an additional consideration, thus constraining companies in optimizing production globally. In each new bilateral agreement, considerations relating to "rules of origin" multiply and become more complex. This phenomenon is what trade experts call the "spaghetti bowl effect." While larger companies have a hard time keeping track, for small groups it is impossible. Bilateral agreements cause the business community to work below its potential. In economic terms, bilateral agreements destroy value. If left unchecked, their continued growth has the potential to hinder the development of the global production system. (p.70)

Additional problems enter the picture when "trade-unrelated" demands are placed on an FTA. Such issues are easier to put in PTAs than multilateral agreements where the possible number of parties who will oppose the move is much greater. Issues such as intellectual property protection, which has more to do with collecting royalties than with trade, is an obvious example. Other examples would be "values-based" demands on things such as labour standards and environmental standards. In many cases demands to harmonise such standards are just a form of protectionism for oneself against foreign rivals.

So the issue of New Zealand's FTAs just got a whole lot more complicated. How we deal with these issues will determine just how beneficial our FTAs turnout to be. If there is anything to the arguments above it would suggest we may need to rethink a position with regard to bilateral v's multilateral trade agreements.

Why are so many Economics departments housed in such lousy facilities?

Over at the Economic Logic blog the Economic Logician asks

Why are so many Economics departments housed in such lousy facilities? Ugly buildings, run-down, even inappropriate facilities, smelly restrooms, antiquated seminar rooms, dark hallways, 1950's or 1960' architecture, etc. While there are universities that are generally in bad shape, Economics departments surprisingly often get one of the worst draws on campus for their quarters, as long as they are not part of a business school. In the latter case, the situation is completely reversed.

So why are Economics departments that are not part of business schools so badly housed. My hypothesis is that economists really do not care. They are too obsessed with their work to notice where they are. They are all about efficiency, and a fresh coat of paint does not make a difference in that respect. Compared to other departments, it is also surprising to find how little economists bicker to obtain the best offices on the floor. It is just not that important. We achieve prestige in other ways, like a very competitive labor market. And this is where Deans allocate their money to.

A question would be, Are the salaries of those economists in bad accommodation higher than in other departments in better buildings. This would indicate that economists don't care about their surroundings as such and are willing to be compensated for those surroundings via increased salaries. All other things equal.

A second question is, Why is the situation in business schools completely reversed? Do economists in business schools self select because they are the one who do care about their surroundings? If so, why are salaries higher in business schools? Shouldn't they be lower since part of their compensation comes in the form of nice buildings etc? Or is it that economists don't like being in business schools and have to be compensated for being there via both better facilities and higher salaries?

Did the stimulus work?

Simon Johnson, Jeffrey Miron, Russ Roberts and Mark Thoma answer the question here.

Johnson says

The fiscal stimulus played a decisive role in reducing the depth and pain of the recession and is now helping to get a recovery under way.

Miron writes

The Obama administration and many economists believe the fiscal stimulus package caused the positive G.D.P. growth, but this conclusion is not warranted.

Roberts writes

The good news is that third quarter G.D.P. is up. But has government spending (or the tax cuts in the stimulus package) caused the growth or would it have occurred anyway?

It’s hard to say, but there are logical reasons to be skeptical of the impact of the stimulus.

Thoma explains

Increased consumer spending accounted for 2.4 percent of the 3.5 percent increase in output growth, and much of the increase in consumption was driven by the “cash for clunkers” and other government stimulus programs.

John B. Taylor's answer to the question is here. His title? "National Accounts Show Stimulus Did Not Fuel GDP Growth".

Austrian business cycle theory for dummies

Steve Horwitz at the Austrian Economists blog gives us Austrian Business Cycle Theory for Dummies: Recovery Chapter:

"I'm not throwing up and hungover, I'm just reallocating the malinvested resources of the boom."

Soros funding anti-economics

Also on Offsetting Behaviour Eric points out that George Soros is throwing $50 million at funding anti-economics economists.

George Soros throws $50 million at funding anti-economics economists. Will the academic outcries be as loud as when BB&T gave $1 million to fund a course in Ayn Rand studies? Similar bequests on the right have led to endless handwringing about subversion of the independence of academia: just remember the establishment of the Friedman Center. Why the silence now? Hmm.

Why the silence, is a good question.

If you read the post from the first link Eric gives, you find this said:

This week Soros is gathering some of the leading practitioners of the market-skeptic school, who were marginalized during the era of "free-market fundamentalism," among them Nobelists Joseph Stiglitz, George Akerlof, Michael Spence, and Sir James Mirrlees.

Now all of these guys are Nobel Prize winners, as noted. Getting the Nobel Prize is what being marginalised results in?! All of them have made huge contributions to the study of asymmetric information, the mainstay of microeconomics since the 1970s, that's what they got their Nobels for. But asymmetric information is part of every microeconomics, and many macroeconomic, course that students take. Again, this is what being marginalised results in? Being taught in every micro course around is being marginalised? Stiglitz is an ex-chief economist for the World Bank, Spence is head of the Commission on Growth and Development. Mirrlees got knighted for this work. This is what being marginalised results in?

Their ideas are well known and taught and fully discussed in the relevant economics literature. There is noway in hell any of those guys are marginalised.

Alcohol submission to the LC

Over at Offsetting Behaviour Eric notes that Matt Burgess has sent off their joint submission to the Law Commission. It's available here. Eric gives the highlights of the submission as:

• The best available evidence shows heavy drinkers respond less to price increases than do moderate drinkers; the costs on moderate drinkers of excise tax increases are therefore much higher than the Law Commission previously believed given their assertion that heavy drinkers respond more to price increases than moderate drinkers.
• Public health measures of social costs bear no resemblance to economic measures of social costs and should be treated with skepticism.
• Economists' recommendation to focus on external costs does not depend on strong rationality assumptions.
• Alcohol and other intoxicants are substitutes; raising the price of one may induce substitution towards others. DiNardo and Lemieux find the US drinking age increase to 21 resulted in an increase in marijuana prevalence more than half the magnitude of the decrease in alcohol prevalence.
• Individuals seem to overestimate the risks of becoming alcoholics, and youths especially overestimate this risk. Worries about "imperfect information" causing too much consumption are overblown. See Lundborg and Lindgren 2002.
• Rashad and Kaestner 2004 provide some apposite warnings of drawing causal relationships from correlations between youth drinking and adverse youth outcomes; underlying variables may cause both.
• The Law Commission should weigh more heavily the costs their proposed policies may impose on moderate and sensible drinkers.

All good points. Not that the LC will take any notice of them. My take on Palmer is that he has predetermined the (anti-alchhol) outcome of the LC's review. Reason and evidence be damned.

Just for fun: theory of the firm 9

One of the most well known approaches to the theory of the firm is often referred to as the "nexus of contracts view." While this approach derives its name from a passage in Michael Jensen and William Meckling's 1976 paper "The Theory of the Firm: Managerial Behavior, Agency costs and Ownership Structure",

The private enterprise or firm is simply one form of legal fiction which serves as a nexus for contracting relationships and which is also characterized by divisible residual claims on the assets and clash flows of the organization which can generally be sold without the permission of the other contracting individuals. (page 311)

the idea that the firm is nothing but a legal fiction can be seen in the 1972 paper by Armen Alchian and Harold Demsetz, "Production, Information Costs, and Economic Organization".

For Alchian and Demsetz, and the others following this approach, it is meaningless to draw a hard line between firms and markets. Although firms are clearly legal entities, and this fact has important economics consequences such as limited liability, the right to tax deductions for input costs, infinite lifetime for the firm and so on, they are still best thought of as a special kind of market contracting. A possible distinction firms and other market contracts is that firms have a continuity of association between input owners that other forms of contracting may not have.

An important result of this line of argument is that the distinction emphasised by Coase’s 1937 paper between authority-based and price-based modes of allocation is a misnomer. In reality, claim Alchian and Demsetz, there is no difference between “firing” one grocer and firing one’s secretary. What looks like a employment relationship is little more than a market relationship.

However the firm is a special form of market contracting and what makes it so has to do with team production. That is production where the individual production functions are inseparable. This means that marginal products are costly to measure. From this comes the fact that free riding is a problem since team-production can be a cover for shirking. With unknown individual productivities it is difficult to know who has done what and thus to detect shirking.

The Alchian and Demsetz answer to this problem is to appoint a monitor who has the right to hire and fire team members based on his observations of the employees’ marginal productivities. The monitor carries out the efficient amount of monitoring since he is given the right to the residual income of the team. The firm in this case is explained in terms of the reduction in post-contractual measurement costs.

There are, however, a number of problems with the Alchian and Demsetz approach to the firm. First, it is not clear why the monitor has to be the employer of the firm where he carries out his monitoring activities. He could be an employee of another firm which specialises in providing monitoring services. Also why can’t the employees monitor each other? Second, is it plausible that specialised monitoring eliminates the problem of inseparable production functions? Third, is it really meaningless consider authority in a situation where the employer/monitor has the right to prevent the employee from accessing the non-human capital – tools, machinery, equipment etc – that the employee needs to be productive? That is, if you fire your secretary, you keep the non-human assets but if you fire your grocer, the grocer keeps the non-human assets. In a world where human and non-human assets can be strongly integrated, this matters. Last, we observe more firms in the real world than can be explained by team production.

Despite these problems Alchian and Demsetz is still to be considered a seminal contribution to the theory of the firm. This is not just because it is still heavily cited but mainly because it gave rise to a still on going series of papers on the theory of the firm: see, for example, Barzel (1997 chapter 4), Fama (1980), Fama and Jensen (1983) and Jensen and Meckling (1976).

References:

• Alchian, Armen and Demsetz, Harold (1972 ). 'Production , Information Costs, and Economic Organization', American Economic Review, December, v. 62, iss. 5, pp. 777-95.
• Barzel, Yoram (1997). Economic analysis of property rights Second edition. Political Economy of Institutions and Decisions series. Cambridge; New York and Melbourne: Cambridge University Press.
• Fama, Eugene F. (1980). 'Agency Problems and the Theory of the Firm', Journal of Political Economy, April, v. 88, iss. 2, pp. 288-307.
• Fama, Eugene F. and Jensen, Michael C. (1983). 'Agency Problems and Residual Claims', Journal of Law and Economics, June, v. 26, iss. 2, pp. 327-49.
• Jensen, Michael C. and Meckling, William H. (1976). 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure', Journal of Financial Economics, October, v. 3, iss. 4, pp. 305-60.

Financial market reform

Over at Reason.com Jeffrey A. Miron gives his view on Financial Market Reform: Why new regulations must avoid moral hazards. Miron opens by saying,

In the coming weeks and months, Congress will be turning its attention to financial market reform, in hopes of avoiding future financial crises. According to perceived wisdom, the root cause of the 2008 financial crisis was excessive risk-taking, and proper regulation can detect and prevent such excess in the future.

This view is a pipe dream. Most new regulation will do nothing to limit crises because markets will innovate around it. Worse, some regulation being considered by Congress will guarantee bigger and more frequent crises.

He then notes that government-induced moral hazard caused the crisis.

The Financial Crisis of 2008 did not occur because of insufficient or ill-designed regulation. Rather, it resulted from two misguided government policies.

The first was the attempt to promote homeownership. Numerous policies have pursued this goal for decades, and over time they have focused mainly on homeownership for low-income households. These policies encouraged mortgage lending to borrowers with shaky credit characteristics, such as limited income or assets, and on terms that defied common sense, such as zero down payment.

The pressure to expand risky credit was especially problematic because of the second misguided policy, the long-standing practice of bailing out failures from private risk-taking. This practice meant that financial markets expected the government to cushion any losses from a crash in mortgage debt. Thus, the historical tendency to bail out creditors created an enormous moral hazard.

One crucial component of this moral hazard was the now infamous “Greenspan put,” the Fed’s practice under Chairman Alan Greenspan of lowering interest rates in response to financial disruptions that might otherwise cause a crash in asset prices. In the early to mid-2000s, in particular, the Fed made a conscious decision not to burst the housing bubble and instead to “fix things” if a crash occurred.

It was inevitable, however, that a crash would ensue; the expansion of mortgage credit made sense only so long as housing prices kept increasing, and at some point this had to stop. Once it did, the market had no option but to unwind the positions built on untenable assumptions about housing prices. Thus government pressure to take risk, combined with implicit insurance for this risk, were the crucial causes of the bubble and the crash. Inadequate financial regulation played no significant role.

The obvious conclusion from this is that if government-induced moral hazard caused the crisis, then new regulation should avoid creating or exacerbating this perverse incentive.

The only way to limit financial panics is to eliminate government-induced moral hazard, and that means letting failed institutions fail. Whether resolution is carried out by the FDIC or a bankruptcy court is not the crucial question; rather, it is whether that resolution process forces all the losses on the institution’s stakeholders rather than bailing them out with taxpayer funds.

So what should be done in the future?

To limit future financial crises, policy must first avoid the distortions inherent in the attempt to expand homeownership. This means eliminating the Federal Housing Administration, the Federal Home Loan Banks, Fannie Mae, Freddie Mac, the Community Reinvestment Act, the deductibility of mortgage interest, the homestead exclusion in the personal bankruptcy code, the tax-favored treatment of capital gains on housing, the HOPE for Homeowners Act, the Emergency Economic Stabilization Act (the bailout bill), and the Homeowners Affordability and Stability Plan. None of this is sensible policy.

In addition, policy must end its proclivity to bail out private risk-taking. This second task is difficult, since it requires policymakers to “tie their own hands.” Specific changes in policies and institutions can nevertheless support this goal. The first is avoiding new regulation that makes bailouts more likely. A second is repealing all existing financial regulation, since this would signal markets that they, and only they, can truly protect themselves from risk.

The third and perhaps most important way to reduce moral hazard is to eliminate the Federal Reserve. As long as the Fed exists, it will regard itself as, and be regarded as, the economic insurer of last resort. In a world with perfect information, appropriately humble central bankers, and an absence of political influence on monetary policy, such a protector might enhance the economy’s performance on average.

What's the bet no one listens to Miron's advice?!

Government meddling in bank executive pay is not going to help.

Over at the PBS-NBR website Steven Horwitz points out that Government Meddling in Bank Executive Pay is Not Going to Help. He writes,

The irony is that bank executives weren't the primary cause of the crisis, the very politicians and Federal Reserve who are now on their moral high horse were. Capping executive pay may make them feel good, but the consequences will be that the talent needed to restore confidence in the financial system will not see the lower pay as worth the trouble and will take their skills elsewhere.

More generally such meddling in markets sends broader anti-capitalist signal to the private sector. Other executives and investors, whether or not they were bailed out, will quite reasonably wonder "are we next?" And as they do, we may well begin to see their confidence in the system fall, leading to a broader withdrawal of financial and human capital. Obama and the Fed are playing with fire by flexing their political muscle this way. An understanding of the Great Depression suggests that they will get burned, further scorching an already crispy economy.

History offer some advice here: the economic historian Robert Higgs has argued that investors in the 1930s were hesitant to make investments because they simply did not know what the rules of the game were. Higgs notes that this "Regime Uncertainty" was one of the reasons that the Great Depression lasted so long. The inconsistent policy moves by both the Hoover and Roosevelt Administration as well as FDR's increasingly anti-business rhetoric and policies through the mid-30s led people to not want to take chances on longer-run investments. This lowered the rate of investment just at the time when investment was so badly needed. The recent moves by the Obama Administration and the Federal Reserve to look at what they claim is excessive pay to bank executives is yet another example of contemporary policy makers not learning this simple lesson from the Great Depression. Insofar as these moves increase regime uncertainty they will do nothing to help, and could more likely hurt, the current state of the economy.

Low prices are bad!

This comes from Mark Perry's blog Carpe Diem. Perry writes

From the American Booksellers Association letter to the Antitrust Division of the U.S. Department of Justice:

We ask that the Department of Justice investigate practices by Amazon.com, Wal-Mart, and Target that we believe constitute illegal predatory pricing that is damaging to the book industry and harmful to consumers.

As reported in the consumer and trade press this past week, Amazon.com, WalMart.com, and Target.com have engaged in a price war in the pre-sale of new hardcover bestsellers, including books from John Grisham, Stephen King, Barbara Kingsolver, Sarah Palin, and James Patterson. These books typically retail for between $25 and $35. As of writing of this letter, all three competitors are selling these and other titles for between $8.98 and $9.00.

The retailers are, in fact, taking orders for these books at prices far below cost. (In the case of Mr. King's book, these retailers are losing as much as $8.50 on each unit sold.) We believe that Amazon.com, Wal-Mart, and Target are using these predatory pricing practices to attempt to win control of the market for hardcover bestsellers.

Authors and publishers, and ultimately consumers, stand to lose a great deal if this practice continues and/or grows. If left unchecked, these predatory pricing policies will devastate not only the book industry, but our collective ability to maintain a society where the widest range of ideas are always made available to the public, and will allow the few remaining mega booksellers to raise prices to consumers unchecked.

We urge that the DOJ investigate and request an opportunity to come to Washington to discuss this at your earliest convenience.

Perry responds to all this by saying,

In other words, according to the booksellers, the "sky is falling," and the very foundations of our civilization are about to be destroyed by the rapacious book pricing policies of Amazon, Wal-Mart and Target. Where to start?

1. How exactly are low book prices "harmful to consumers?" Consumers have several remedies at their disposal to combat the "predation" whenever they feel they are being harmed by low prices: a) refuse to buy the book from Amazon or Wal-Mart for $9 and instead pay full price from an independent bookseller, b) refuse to buy the book at all, or c) offer to pay more than the "predatory" price from the "predator." That last option might not work so well at Amazon or Wal-Mart (if the book is priced at $9, it might be hard to actually pay $20 instead - how would the cashier ring it up?), but there might be some cases where a consumer could pay more than the listed price.

2. Keep in mind that about 90% of antitrust investigations involve one firm or group of firms complaining about one of their more efficient, low-cost competitors, like in this case.

3. Assuming that the predation worked and Amazon, Target and Wal-Mart were able to successfully drive all of the independent booksellers out of the market, there would be two problems:

a) They would still have to compete against each other and it could remain an intensely competitive book market even without the independents, to the continued benefit to consumers and

b) if the three oligopolists (Amazon, Target and Wal-Mart) did conspire to raise book prices to "book scalping" or "book gouging" levels, they could then: i) face antitrust charges, this time for high anti-competitive "monopoly" prices, and/or ii) face new competition from firms re-entering the market from the attractive "smell of profits" emanating from the monopoly pricing.

4. Notice in the Amazon listing above (click to enlarge) that Amazon offers "free shipping" on orders over $25, which is obviously below its actual cost. Isn't that then "predatory shipping?" Should that be investigated by the Dept. of Justice?

5. Also notice in the Amazon listing that there are more than 30 new copies of the Grisham book available from small, private booksellers at prices starting at $4.25, or more than 50% below Amazon's price of $9.59. Aren't those small booksellers engaged in predatory pricing AGAINST Amazon?

The point to remember when you see complaints about "predatory pricing," is that predatory pricing is basically a myth for which there is virtually no real-world examples of it ever being successful, harmful to consumers, or leading to anti-competitive behaviour in the long run. Low prices are not bad!

As I have noted before, Louis Phlips suggests that the necessary conditions for predatory pricing are,

To sum up, economic theory suggests that predatory pricing is a real possibility only when the following five conditions are simultaneously met:
1 The aggressor is a multimarket firm (possibly a multiproduct firm).
2 The predator attacks after entry has occurred in one of its markets.
3 The attack takes the form of a price cut in one of the predator's markets, which brings this price below a current non-cooperative Nash equilibrium price at which the entry value is positive for the entrant (possibly below a discriminatory current Nash equilibrium price with the same property).
4 The price cut makes the entry value negative (in present value terms) in the market in which predation occurs.
5 Yet the victim is not sure that the price cut is predatory. The price cut could be interpreted by the entrant as implying that its entry value is negative under normal competition. In other words, the victim entertains the possibility that there is no room for it in the market under competitive conditions.

It seems unlikely that such conditions are ever met in the real world and such conditions also mean that it is unlikely that competition agencies will find a robust and simple rule to use to detect predatory pricing. Most just seem to fall back on the old presumption that firms with market power are always suspect. William Landes tells the story about why Ronald Coase gave up antitrust,

“Ronald [Coase] said he had gotten tired of antitrust because when the prices went up the judges said it was monopoly, when the prices went down they said it was predatory pricing, and when they stayed the same they said it was tacit collusion.”

–William Landes, “The Fire of Truth: A Remembrance of Law and Econ at Chicago”, JLE (1981) p. 193.

It's only in the strange world of competition policy that any price you charge can be considered illegal.

50 Years of Coasean brilliance

Peter Boettke over at the Austrian Economists blog writes on 50 Years of Coasean Brilliance. Boettke is discussing the the 50th anniversary of the publication of Ronald Coase's watershed article on the Federal Communications Commission.

For those who only know Coase via the so-called "Coase Theorem" (which is in fact due to George Stigler) and the implications of a zero transaction cost world, it should be pointed out that Coase never believed in zero transaction costs. His zero transaction cost analysis (most famously in his "Problem of Social Cost" paper) served mainly as an attack on the standard Pigovian analysis and is there to show that under the assumptions of that analysis, in particular zero transaction costs, the Pigovian remedies - Pigovian taxes and subsidies - are not needed. Coase wanted to move economics away from the zero transaction cost assumption to consider the world of positive transaction costs. It is only in a positive transaction cost framework that things like firms make sense.

Learning to love insider trading

Donald J. Boudreaux suggests we should be Learning to Love Insider Trading. Writing in the Wall Street Journal Boudreaux points out that

Far from being so injurious to the economy that its practice must be criminalized, insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest—in keeping prices from lying to the public about corporate realities.

Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.

And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large.

I have never really understood the problem with insider trading. Letting informed people trade on their information just makes that information available to everyone in the market. Why not set up a situation where companies have to say whether or not they will allow insider trading in their stocks, then the market can price this information into the stock price of that company. If you don't like insider trading don't buy the stocks of firms that allow such trades.

EconTalk this week

Charles Calomiris of Columbia Business School talks with EconTalk host Russ Roberts about the financial crisis. Calomiris argues that it is important to put the crisis in historical perspective in the context of other bank crises. He argues that bank crises differ widely across time and place--some times and some places are placid, others are prone to regular crises. Calomiris argues that frequent episodes of failure are tied to government guarantees such as various forms of deposit insurance or similar incentives for risk-taking. Looking at the current crisis, Calomiris indicts "too big to fail," the government's reliance on ratings agencies as a measure of risk, and poor corporate governance as the key causes.

EconTalk this week

Mike Munger of Duke University talks with EconTalk host Russ Roberts about the limits of prices and markets, especially in the area of health. They talk about vaccines, organ transplants, the ethics of triage and what role price should play in allocating. The discussion concludes with a discussion of how markets respond to price controls, particularly minimum wages.

Just for fun: theory of the firm 8

The obvious missing discussion from the previous seven theory of the firm postings, and one on the theory of the farm, is a discussion of Oliver Williamson's work on the theory of the firm. This omission is all the more glaring now that Williamson has won the Nobel Prize in Economics. This posting is drawn from an interesting attempt at a formalisation of Williamson's work by Robert Gibbons.

In his 2005 essay (see also here) on the major mainstream economic theories of the firm, Robert Gibbons argues that there are two (formal) theories which can be discerned within the informal theoretical arguments offered in Oliver Williamson's work. The first theory is what Gibbons refers to as a "rent seeking " theory and the second an "adaptation" theory. Within Gibbons's discussion, the theory of the firm means the Coasian "make-or-buy " decision, that is, vertical integration or the theory of the boundaries of the firm.

Gibbons argues that the rent seeking theory was first articulated in Williamson (1971, 1979, 1985) and Klein et al (1978). In the rent seeking theory, the advantage of vertical integration is that it can stop socially destructive haggling over "appropriable quasi-rents" (AQR). Williamson (1971: 114-5) argues, for example, that "fiat is frequently a more efficient way to settle minor conflicts ... than is haggling". The important point here is that given the existence of AQRs, non-integration cannot avoid inefficient haggling because, while "jointly (and socially) unproductive, it constitutes a source of private pecuniary gain," so integration, including its dispute-resolution by fiat powers, can be more efficient.

An important source of AQRs is relationship specific investments, that is, investments that have a higher value within a successful, on going, relationship between the contracting parties than they do should the relationship breakdown. This can trap the investing party in the relationship. If the investment is only (or at least, largely) productive within a given relationship, it will have a higher value or higher rents within that relationship than within any other relationship. These additional rents can be haggled over. The basic idea is that the larger are AQRs, the more likely is integration. This is because the larger the AQRs the more likely or costly (or both) is socially destructive haggling.

There is a problem here. One feature of this theory is that its assumptions are not entirely clear. As Gibbons explains

[...] the rent-seeking theory explicitly assumes that integration can stop the haggling induced by AQRs, but this explicit assumption requires an implicit focus on certain kinds of haggling. Specifically, if the haggling were accomplished by manipulation of alienable (say, physical) capital, then integration could remove the relevant control rights from the haggler, but if the haggling were accomplished by manipulation of inalienable (say, human) capital, then integration could not stop rent-seeking. More generally, the most that integration can do is to unify the alienable control rights; any inalienable control rights are staying put, by definition. Thus, the distinctive point in (this telling of) the rent-seeking theory of the firm is that ownership can stop haggling that is undertaken via alienable instruments. (Gibbons 2005: 204-5)

Looking at the world around us, what we see is many hold-ups between firms that do not result in integration. Gibbons continues,

To explain these observations, the rent-seeking theory has two options: (1) assert that these hold-ups utilized inalienable instruments (so that the observed hold-ups are unavoidable), or (2) enrich the theory to include a downside of integration (so that the observed hold-ups are a lesser evil than integration would have been). As I have so far told the rent-seeking theory, it says nothing about what life was like as the Fisher division of General Motors and, hence, gives no insight into whether integration could ever be the greater of two evils. As a result, the prediction I stated above is flawed: so far, we can conclude that larger AQRs make non-integration more costly, but we cannot draw an inference about the likelihood of integration until we say something about the costs of integration. (Gibbons 2005: 205)

Thus the rent seeking theory is, in the main, a theory of the benefits of integration and not the costs of integration.

The second theory, the adaptation theory of the firm, is based on work from Simon (1951); Williamson (1971, 1973, 1975, 1991); Klein and Murphy (1988, 1997); Klein (1996, 2000). The question here is whether or not integration facilitates "adaptive, sequential decision-making" (Williamson 1975: 40) in environments where uncertainty is resolved over time better than non-integration.

The key theoretical challenge in developing such a theory is to define an environment in which neither contracts ex ante nor renegotiation ex post can induce first-best adaptation after uncertainty is resolved, so that the second-best solution may be to concentrate authority in the hands of a “boss” who then makes (potentially self-interested) decisions after uncertainty is resolved. This emphasis on the boss’s authority places the adaptation theory together with the rent-seeking theory in making control the central issue in the theory (whereas the incentive-system theory ignores control in favor of incentives and the property-rights theory blends the two). (Gibbons 2005: 208)

Williamson (1971: 113) hints at the adaptation theory of the firm, arguing that "only when the need to make unprogrammed adaptations is introduced does the market versus internal organization issue become engaging". This idea gets much more development in Williamson (1975). Chapter 4 of the 1975 book used Simon (1951) to explain why many labour transactions are more efficiently conducted in a firm instead of over a market.

In Simon’s model (which is cast as a theory of employment rather than a theory of the firm), two parties choose between (a) negotiating a decision before uncertainty is resolved or (b) allocating authority to one party (the “boss”) who can then make a self-interested decision after uncertainty is resolved. Simon calls the latter an employment contract. Under such a contract, the subordinate faces a tradeoff between flexibility and exploitation: she can sacrifice flexibility by locking in a decision now, or she can risk exploitation by allowing the boss to decide later. Simon provides plausible conditions (roughly, that the parties’ payoffs depend importantly on tailoring the decision to the state, and that the parties’ preferences regarding such tailoring are not too divergent) under which it is optimal for the parties to choose the employment contract. (Gibbons 2005: 2008)

Williamson then carries the argument from Chapter 4 into Chapter 5 where he makes an explicit parallel case for intermediate products: "The argument here really parallels that of Chapter 4 in most essential respects” (Williamson 1975: 99). Thus Willaimson turns Simon’s argument for the labour contract into an argument for the make-or-buy decision and thus a theory of the firm's boundaries.

Gibbons then asks is Williamson been inconsistent or confused or wrong given that he has two theories.

Thus, I do not conclude from this close textual analysis that Williamson has been inconsistent or confused or wrong; rather, I conclude that his collected works suggest two theories of the firm—rent-seeking and adaptation. Much of the literature has focused on rent-seeking, often with AQRs created by specific investments and sometimes without any mention of adaptation. Williamson himself typically emphasizes both asset specificity and adaptation—probably reflecting the view that both will be important if a full-blown theory of the firm is to be realistic, but possibly reflecting the view that both are necessary if an elemental theory of the firm is to be coherent. (Gibbons 2005: 208-9)

References:

• Klein, B. (1996). ‘Why hold-ups occurs: the self-enforcing range of contractual relationships’, Economic Inquiry, 34: 444-63.
• Klein, B. (2000). ‘The role of incomplete contracts in self-enforcing relationships’, Revue D’Economie Industrielle, 92: 67-80.
• Klein, B., R. Crawford and A. Alchian (1978). ‘Vertical integration, appropriable rents and the competitive contracting process',Journal of Law and Economics, 21: 297-326.
• Klein, B. and K. M. Murphy (1988). ‘Vertical restraints as contract enforcement mechanisms’, Journal of Law and Economics, 31: 254-97.
• Klein, B. and K. M. Murphy (1997). ‘Vertical integration as a self-enforcing contractual arrangement', American Economic Review, 87: 415-20.
• Gibbons, Robert (2005). 'Four formal(izable) theories of the firm?', Journal of Economic Behavior and Organization, 58(2) October: 200-45.
• Simon, Herbert (1951). 'A Formal Theory of the Employment Relationship', Econmetrica, 9(3) July: 293-305.
• Williamson, Oliver E. (1971). 'The vertical integration of production: market failure considerations', American Economic Review, 61(2) May: 112-123.
• Williamson, Oliver E. (1973). 'Markets and hierarchies: some elementary considerations', American Economic Review, 63(2) May: 316-25.
• Williamson, Oliver E. (1975). Markets and Hierarchies: Analysis and Antitrust Implications, New York: The Free Press. Press.
• Williamson, Oliver E. (1979). 'Transaction cost economics: the governance of contractual relations',Journal of Law and Economics, 22: 233-61.
• Williamson, Oliver E. (1985).The Economic Institutions of Capitalism, New York: The Free Press. Press.
• Williamson, Oliver E. (1991). 'Comparative economic organization: the analysis of discrete structural alternatives',Administrative Science Quarterly, 36: 269-96.