Decriminalizing cannabis: the impact on crime Imran Rasul

There is a new audio from VoxEU.org in which Imran Rasul of University College London talks to Romesh Vaitilingam about his research with Jerome Adda and Brendon McConnell on the effects of a localized policing experiment that decriminalized cannabis possession in the London borough of Lambeth between 2001 and 2002.

Unemployment issues

At Marginal Revolution Alex Tabarrok raises a couple of interesting points about search-matching models of unemployment.

The first puzzle about unemployment when thought about from within the search-matching framework is that unemployment rates are highest among the least skilled and most homogeneous skills, i.e. among those worker/jobs with the easiest matches. It's hard to believe that it takes a year to match a construction worker to a job.

Closely related is the issue of how much uncertainty is holding back employment. The case for uncertainty is that hiring a worker is like exercising an option--once you hire, there are sunk costs of hiring (and potentially firing) that go beyond the wage such as administrative and training costs.

Note that you may not need a lot of uncertainty (i.e. you may not need regime uncertainty) to reduce hiring because you don't have to explain why firms aren't hiring only why they aren't hiring this day. Even if we assume, for example, that hiring would be profitable, all else equal, it doesn't take much uncertainty to make it worthwhile to delay hiring a little bit, to wait and see. It's precisely when sales are low and unemployment is high that firms don't mind waiting because uncertainty may resolve in due course and the workers aren't going away.

Ok, that's the positive case for uncertainty but the second puzzle is that uncertainty should matter most when hiring and firing costs are high and once again these costs are lowest for those workers with the greatest unemployment rates. It's one thing not to hire when you can't fire but when firing is easy what's the risk? Moreover, unemployment has increased more in the United States than in Europe even though hiring and firing costs are higher in Europe.

So we certainly learn things from the search-matching framework but it also appears that they don't tell us everything about unemployment. It still seems that things like aggregate demand shocks, sticky wages and prices are important for unemployment. Or in other words, the real world is complicated.

If real wars were like trade wars ....

At Cafe Hayek Don Boudreaux discusses what would happen if real wars were fought in the same manner as trade wars are fought. He gives a transcript of the communiqués between the leaders of two warring nations:

Leader of Absurditoptia (A): I say, leader of Stupidia – we demand that you stop occupying that contested strip of land. If you refuse, we’ll have no choice but to shoot our own citizens.

Leader of Stupidia (S): You don’t scare us! That land is ours. And if you do kill some of your own people, make no mistake that we will immediately – and just as cruelly – commence to killing our own people. Courage is our national motto!

(A): Ha! You’re bluffing. But I’m not. I’ve just courageously ordered my troops to mow down in cold blood ten percent of my fellow countrymen. Take that!

(S): How dare you attack you like that! You leave us no choice but to attack us. I am ordering the Stupidian army to slaughter 15 percent of innocent Stupidians here in Stupidia. How do you like them apples?!

(A): You are cruel and inhuman to damage us by killing your people. I hereby instruct all of my fellow Absurditopians to commit suicide! Only then will you nasty Stupidians get your proper comeuppance and we Absurditopians the justice that we are due!

(S): You can’t beat us, you Absurditopian you! Listen up. I’m ordering all of my fellow citizens – Stupidians all! – to commit suicide. We’ll see who emerges victorious!
....

Then a long, long silence.

Well said that man! The British economist Joan Robinson famously put the idea as, "if your trading partner has rocks in his harbour, that is no reason to throw rocks into your own".

Big Mac Index 2010

More Burgernomics from The Economist. From the Economist website in article dated July 22nd 2010. The Economist's Big Mac index, shows that currencies continue to be undervalued in the developing world but overvalued in Europe.

The Economist writes that,

The index is a lighthearted attempt to gauge how far currencies are from their fair value. It is based on the theory of purchasing-power parity (PPP), which argues that in the long run exchange rates should move to equalise the price of an identical basket of goods between two countries. Our basket consists of a single item, a Big Mac hamburger, produced in nearly 120 countries. The fair-value benchmark is the exchange rate that leaves burgers costing the same in America as elsewhere.

The New Zealand dollar is undervalued by 4% according to this measure.

Macroeconomics after the crisis

Ricardo J. Caballero has a new NBER working paper out entitled Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome. The abstract reads:

In this paper I argue that the current core of macroeconomics—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected.

Caballero opens the paper by saying,

The recent financial crisis has damaged the reputation of macroeconomics, largely for its inability to predict the impending financial and economic crisis. To be honest, this inability to predict does not concern me much. It is almost tautological that severe crises are essentially unpredictable, for otherwise they would not cause such a high degree of distress. Of course, it is well-known that certain elements can increase the fragility of a financial system, such as high levels of leverage or mismatches between short-term liabilities and long-term assets, and that these issues may justify policy intervention. But knowing these mechanisms is quite different from arguing that a severe crisis can be predicted. Modern Cassandras will always claim to have seen the crisis coming. What they will not say is how many times they saw things coming that never materialized, or how the specific mechanisms behind the crisis are different from those on which their predictions were based. In my view, the conviction that one can foretell a severe crisis in advance is mostly a manifestation of pareidolia—the psychological phenomenon that makes people see faces and animals in clouds and the like.

There is a nice point here, severe crises are essentially unpredictable, for otherwise they would not cause a high degree of distress, that is, they wouldn't be severe. If we could predict severe crises we could take actions to mitigate the effects of the crisis thereby rendering it less severe. Policymakers should keep this in mind. There is only limited scope for policy that can in advance eliminate the risk or costs of a financial crisis.

Only the French

From the New York Times we find out

"It was Cédric Villani, a 37-year-old professor at Lyon who won the 2010 Fields Medal, who gave the most spirited reply to France’s critics. Calling himself “a pure product of the French system,” Mr. Villani, a Normalien who has often taught in the United States, said that while American academic salaries were higher “and it’s easier to make big projects,” France also has particular strengths: “Our tradition, our quality of life, our social cohesion. My big problem in Princeton was finding a place to buy a decent cheese.”

To hell with the eduction, worry about the cheese!

(HT: Market Design)

Do economic freedom and entrepreneurship impact total factor productivity?

An interesting question, with an on the face of it strange answer, asked by Christian Bjørnskov and Nicolai J. Foss in a new working paper Do Economic Freedom and Entrepreneurship Impact Total Factor Productivity? The abstract reads:

The economics of growth has shown that countries not only grow by deploying higher levels of inputs to production, but also by better allocating whatever resources are at their disposal and by introducing productivity-enhancing innovations. We proffer arguments as to why and how entrepreneurship as well institutions of liberty (i.e., economic freedom, including the rule of law, easy regulations, low taxes and limited government interference in the economy) positively impact total factor productivity (TFP): These institutions allow entrepreneurial experimentation with the combination of factors to take place at low transaction costs. We test these ideas on a unique panel data set derived from Compendia, World Bank data and the Fraser Institute’s economic freedom data. We find that while entrepreneurship positively impacts TFP, the marginal contribution of entrepreneurship to TFP is strongest in economies with substantial government activity.

The strange bit is that they find that increasing the active involvement of the government in the economy as well as the tax burden actually increases the impact of entrepreneurship on TFP. Their explanation of this somewhat surprising, to say the least, finding is that a reduced supply of entrepreneurship increases the marginal productivity of entrepreneurship; thus, the best ideas do survive even in the relatively hostile welfare state environment. So entrepreneurs succeed despite the government rather than because of it.

(HT: Markets and Organization)

Who should pay for university?

This is the question asked by Tim Worstall. His answer?

The major beneficiaries of a degree are the people who hold that degree in the higher lifetime earnings they gain from having that degree. So it should be they that pay the costs of gaining that degree.

There’s no real way to have private funding of the loans though: yer average 18 year old isn’t the greatest credit risk for £50k now, are they? So government provision of the loans seems fine.

The greater societal benefit of having lots of graduates: I’m entirely unconvinced about that. Yes, I’d say there is a public good to having a largely numerate and literate society, thus meaning tax subsidy to that part of the education system that provides that (and if only we did have a part of the education system that does provide that) but having 40, 50% of the age cohort with degrees?

Given that the vast majority of them go on into careers which were not traditionally thought of as requiring a degree I don’t really see it I’m afraid.

In fact, I rather hope that the unwrapping of the current subsidy, the making plain what are the true costs, will mean fewer taking a degree in the first place.

But the basic concept being proposed seems just fine to me. Here’s what a degree costs, we’ll help finance it but you’ll have to pay for it: just fine by me.

And it seems pretty fine to me as well. As Tim notes getting a loan against human capital isn't easy as you cannot really sell the asset if things go pear-shaped. Thus government involvement in making loans may be a good idea. But they should be serious loans, that is, they should have the market rate of interest charged on them. Otherwise you are just subsiding a few years of beer consumption for many students. (Yes I know interest free loans are a great idea of you want the student vote. But getting a few votes isn't really a great basis for public policy. No matter what politicians tell you!) This would hopefully have the effect of making students actually think about whether or not going to university is a worthwhile idea, rather than it being just the default option.

2010 Nobel Prize in economics 2

Over at Marginal Revolution Tyler Cowen has written profiles on each of this year’s winners: Diamond, Mortenson, and Pissarides. Alex Tabarrok sums things up by saying,

The 2010 Nobel Prize awarded to Peter A. Diamond, Dale T. Mortensen, Christopher A. Pissarides can be thought of as a prize for unemployment theory.

A key breakthrough was to realize that the problem was not how to explain unemployment per se but rather how to explain hiring, firing, quits, vacancies and job search and to think of unemployment as the result of all of this underlying microeconomic behavior. Notice that the underlying behavior involves not just workers looking for jobs but also employers looking for workers so explaining unemployment would require a theory of job search, worker search and matching and each aspect of the theory would have to be consistent with every other aspect; i.e. how much workers search depends on how much employers are searching (e.g. advertising) and vice-versa and also on the quality of matching and all of these considerations need to be addressed together. It was Mortensen and Pissarides in particular, building on work by Diamond, who built just such a consistent model.

A very surprising empirical fact helped to motivate this perspective: even in a recession millions of jobs are being created every month. The figures we usually hear about the number of jobs created is the net figure but in the United States in August, for example, there were 4.1 million hires (and 4.2 million separations). Thus, as noted above, understanding unemployment requires understanding these much larger flows of job creation and destruction.

The Press Release from The Royal Swedish Academy of Sciences reads,

Markets with search costs

Why are so many people unemployed at the same time that there are a large number of job openings? How can economic policy affect unemployment? This year's Laureates have developed a theory which can be used to answer these questions. This theory is also applicable to markets other than the labor market.

On many markets, buyers and sellers do not always make contact with one another immediately. This concerns, for example, employers who are looking for employees and workers who are trying to find jobs. Since the search process requires time and resources, it creates frictions in the market. On such search markets, the demands of some buyers will not be met, while some sellers cannot sell as much as they would wish. Simultaneously, there are both job vacancies and unemployment on the labor market.

This year's three Laureates have formulated a theoretical framework for search markets. Peter Diamond has analyzed the foundations of search markets. Dale Mortensen and Christopher Pissarides have expanded the theory and have applied it to the labor market. The Laureates' models help us understand the ways in which unemployment, job vacancies, and wages are affected by regulation and economic policy. This may refer to benefit levels in unemployment insurance or rules in regard to hiring and firing. One conclusion is that more generous unemployment benefits give rise to higher unemployment and longer search times.

Search theory has been applied to many other areas in addition to the labor market. This includes, in particular, the housing market. The number of homes for sale varies over time, as does the time it takes for a house to find a buyer and the parties to agree on the price. Search theory has also been used to study questions related to monetary theory, public economics, financial economics, regional economics, and family economics.

Additional information is available here and here.

EconTalk this week

Douglas Irwin of Dartmouth College talks with EconTalk host Russ Roberts about the role the gold standard played in the Great Depression. Irwin argues that France systematically accumulated large amounts of gold in the late 1920s and 1930s, imposing massive deflation on the rest of the world. Drawing on a recent paper of his, Irwin argues that France's role in worldwide deflation was greater than that of the United States and played a significant role in the economic contraction that followed.

I discussed Irwin's work of the role of France and the gold standard during the great depression here.

Is foreign ownership of land so bad?

Stephen Hickson asked this question in yesterdays Press here in Christchurch. Steve teaches in the Department of Economics and the MBA programme at the University of Canterbury. The short answer is, of course, no but Steve explains it better:

Many New Zealanders also object to the inevitable consequence of foreign ownership of any New Zealand asset or business which is "profits going overseas". In August of this year, Winston Peters declared that he would ban the foreign ownership of rest homes. No doubt Mr Peters would strike a sympathetic chord with many when he says that in foreign ownership he sees "foreign owners getting rich at the expense of the elderly".

Hmmmm, Winston is against it, can't help thinking that means it has to do good!!! But Steve continues by asking an obvious, but not often asked question: Why do we have foreign investment in New Zealand?

New Zealand is a great place to do business and there are lots of good opportunities to grow businesses and create jobs. To grow requires funds and so businesses either borrow money or issue shares in order to finance that growth. This requires someone who is a saver to lend the money or buy the shares.

However, the pool of savings in New Zealand is too small to fund this expansion and so we use the savings of people overseas who are willing to invest in a great place with great prospects.

Naturally, those overseas who lend us money or buy shares in our businesses need to be paid interest or dividends - hence profits going overseas.

Take rest homes as an example and suppose we do not allow foreigners to own New Zealand rest homes. If we want the same number of rest homes to be built then we will have to build them with New Zealand savings.

To do this might mean building less of something else, perhaps schools, shops, roads or wind farms. Or maybe we could increase our own savings to pay for those rest homes.

To increase our savings is very simple - as a nation we just need to consume less. Of course the reality is never as simple as all that.

Are we prepared to reduce expenditure on health and education in order to save more? Remember the Government is a consumer and a saver as well. Are we prepared to reduce our standard of living in some other way? New Zealanders don't appear to be very willing to do so.

Alternatively we could just build fewer rest homes. That will reduce choice for New Zealanders looking to use rest homes and most likely push up the price of going into a rest home.

Now if these outcomes are not too appealing then we have no choice but to dip into the savings of the rest of the world. What then are the impacts that follow from restricting foreign ownership?

The most obvious impact of restricting foreign ownership in New Zealand is that we restrict the opportunities for business growth and job creation.

While some profits head overseas as a result of foreign investment, much does not and of course the wages, businesses and land stay right here.

Foreign owners, just like any business owner, want to see their investments perform as well as possible so they are also likely to reinvest and create even more value for New Zealand.

When we restrict foreign investment some New Zealand worker now finds it just that little bit harder to find a job than they otherwise would have.

There are other impacts,

New Zealand is a small trading nation in a much bigger world.

That bigger world has a lot to offer us and every time we restrict foreign ownership we also reduce our access to the best knowhow that the world has to offer.

For every foreign buyer looking to buy there is a New Zealander looking to sell. By restricting or preventing foreign ownership we are preventing a fellow New Zealander from selling what they themselves own for the best that they can get.

New Zealand is a nation that values freedom and choice.

One of the cornerstones of our society is that we are all free to buy, sell and own land and businesses.

When we impose restrictions on some people in society we tread dangerously on that freedom.

When it comes to private businesses, assets and land it is odd to think that "we" own them. On the day before a New Zealand farm is sold to a foreign owner, I didn't own it and I had no right to say how that farm should be used.

The day after it is sold I still don't own it and I still don't have any rights to say how it is used.

The new foreign owner is also subject to the laws of the land just as much as the previous owner. If a piece of land is important for, say, access to a river or beach then that should be written explicitly into the title of the land.

So if you don't want foreign ownership then the choice is, keep consumption constant and and have less investment, or increase investment and reduce consumption. If neither appeals then welcome foreign ownership.

Roger Kerr has also written on the topic of foreign ownership in New Zealand. In an article in the Otago Daily Times on the 8th October 2010 he said,

Start with some basic economic perspectives.

First, New Zealand has a freely floating currency. A foreigner wanting to acquire a New Zealand asset has to buy New Zealand dollars. The New Zealand dollar seller will be paid in foreign currency, which will logically be used to acquire some other overseas asset (maybe a farm). The country’s net asset position is unchanged.

Second, for a given balance of payments position, more restrictive rules on purchases by foreigners of some class of asset (say land) will automatically mean greater foreign ownership of some other assets (eg businesses). Are there sound grounds for biasing overseas investment in this way?

and added

The spokesman also said that “once land is gone it’s gone.” This is also incorrect. Some years ago a New Zealand company owned Land’s End and John O’Groats in the United Kingdom: iconic sites par excellence. Then it sold them to an English buyer.

Likewise Carter Holt Harvey, with forest land interests, was majority owned by US company International Paper. Then Graeme Hart bought it back (and has purchased land in many other countries).

You can’t physically take land away, nor can you force any owner to sell to foreigners.

There is also the question of if we stop foreigners owning property here should we also not stop New Zealanders owning property overseas?

Another aspect of globalisation is New Zealand investment in agriculture abroad. Fonterra and individual dairy farmers are investing in farms in China, India, Brazil and other countries. New Zealand Farming Systems owned farms in Uruguay (now being onsold to Singaporean interests).

Should other countries ban such New Zealand investment?

Do we really wan t to stop Fonterra and other firms from investing overseas?

Roger Kerr ends this article with a similar point to Stephen Hickson:

Nevertheless, New Zealand governments are entirely at liberty to impose tighter restrictions for non-economic reasons. If they do, however, the community should understand that they come at an economic cost.

or as Hickson put it:

The amount and type of foreign ownership that New Zealand allows is a political choice that we make as a society via the ballot box but there are consequences to the decisions that we make.

If we are to restrict or, in some cases, ban foreign ownership then we should be fully informed and understand the consequences. We might not find some of those consequences appealing.

There is no such thing as a free lunch. Restrictions on foreign ownership come at a cost.

2010 Nobel Prize in economics

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2010

has gone to

Peter A. Diamond
Massachusetts Institute of Technology, Cambridge, MA, USA,

Dale T. Mortensen
Northwestern University, Evanston, IL, USA

and

Christopher A. Pissarides
London School of Economics and Political Science, UK

"for their analysis of markets with search frictions".

More on this later.

Useless information for today

From the Nobel website:

On all "Swedish" Nobel medals the name of the Laureate is engraved fully visible on a plate on the reverse, whereas the name of the Peace Laureate as well as that of the Winner for the Economics Prize is engraved on the edge of the medal, which is less obvious. For the 1975 Economics Prize winners, the Russian Leonid Kantorovich and the American Tjalling Koopmans, this created problems. Their medals were mixed up in Stockholm, and after the Nobel Week the Prize Winners went back to their respective countries with the wrong medals. As this happened during the Cold War, it took four years of diplomatic efforts to have the medals exchanged to their rightful owners.

Only four years, relations must have been improving!!

High tech labour markets

One of the problem with developing a theory of the firm for firms based on human capital is that human capital can not be owned by the firm. Employees can always walkout the door in a way that non-human capital can not. This means that human capital firms can be very unstable with workers leaving anytime they want. Hart (1995: 56-7) goes so far as to argue that, at least some, nonhuman assets are essential to a theory of the firm. To see why this may be so consider a situation where 'firm' 1 acquires 'firm' 2, which consists entirely of human-capital. The question Hart raises is, What is to stop firm 2's workers from quitting? Without any physical assets - e.g. buildings - firms 2's workers would not even have to relocate themselves physically. If these workers were linked by telephones or computers, which they themselves own, they could simply announce one day that they had decided to become a new firm. For the acquisition of firm 2 by firm 1 to make economic sense there has to be a source of value in firm 2 over and above the human-capital of the workers. It makes little sense to buy a 'firm' if that 'firm' can just get up and walk away. Hart argues there must be some 'glue' (non-human assets) holding firm 2's workers in place.

So if firms can not own their human capital how do they overcome such a problem. What is the gue? It looks like companies in Silicon Valley tied to deal with the issue by agreeing not to hire people of each others companies.

Six leading technology companies, including Apple, Google and Intel, reached an antitrust settlement on Friday with the Justice Department that promises to increase the competition for sought-after technology workers. The government had conducted a yearlong investigation into agreements among companies not to poach employees from each other.

The investigation focused on five agreements by the companies not to make cold calls to employees that each company had placed on a do-not-call list. Each of the pacts, according to the Justice Department filing, involved a pair of companies: Apple and Google, Apple and Adobe, Apple and Pixar, Google and Intel, and Google and Intuit.

Anti-competitive or just an rational response to not being able to own some of your most valuable assets?

• Hart, Oliver D. (1995). Firms, Contracts, and Financial Structure, Oxford: Oxford University Press.

Recession and recovery in the euro area

From VoxEU.org come this audio interview:

CEPR’s Euro Area Business Cycle Dating Committee has announced that the recession that began in the first quarter of 2008 came to an end in the second quarter of 2009. Harald Uhlig of the University of Chicago, who chairs the committee, talks to Romesh Vaitilingam about how this recession compares with previous recessions and with the US recession, and about the components of GDP that are driving recovery.

Maurice Allais

From Alex Tabarrok at Marginal Revolution comes the news that Maurice Allais has died.

French physicist and economic Nobel Laureate Maurice Allais has died at age 99. Allais is best known among American economists for the Allais paradox but Allais was a polymath with contributions (and JSTOR here) in a huge number of areas many of which were often overlooked because his work was not translated into english (an unfortunate fact which is still true today).

To be honest I thought he had died years ago. Tabarrok continues with something I didn't know,

One thing that few people know about Allais was that he was a big proponent of the gold standard and Austrian business cycle theory, even citing Mises and Rothbard in some of his work. See in particular his paper in English, The Credit Mechanism and its Implications (1987) in Feiwel (ed), Arrow and the Foundations of the Theory of Economic Policy.

Interesting idea

Firm as a Nexus of Markets is a new paper by Ivan Jankovic. The abstract reads:

The Austrian School's conventional theory of the firm is based on an attempt to synthesize Coase's concept of the firm as a centrally planned hierarchy with the Austrian theory of entrepreneurship and monetary calculation. This paper is a critique of that program as well as an attempt to outline the alternative theory of the firm, one based on the synthesis of the contractual agency theory of the firm (Alchian-Demsetz, Jensen-Meckling) with the same Austrian arguments about entrepreneurship and calculation. The firm in this paper is defined as a nexus of various markets for goods as well as for labor and managerial services rather than as a hierarchy or “organization.” Both the neoclassical and Austrian critiques of the latter concept are utilized to prove that a clear distinction between the market and the firm cannot be established. That distinction is based on the misunderstanding of the firm's dynamics as exclusively tied to the managing/transaction costs ratio as well as on the mischaracterization of inter-firm relations as commanding ones (Demsetz-Alchian, Jensen, Meckling, Fama, Cheung). On the other hand, the central planning view of the firm is equally at odds with the key Mises's argument that rational economic planning is impossible in the absence of market prices (Mises, 1990). If this is so, the firm, as understood in a Coasian paradigm, would not have any reason to exist, or any reason to contribute positively to economic efficiency, because it would simply represent a centrally planned “island of incalculability” in a wider market setting (Rothbard, 2004). Since the firm is a nexus of various markets, its operation is contrary to the Coaseian assumptions led by the price signals. Only insofar as the internal firm's operation is driven by the price signals can the firm be efficient.

The idea that there is no distinction between the market and the firm has been tried before and has not been widely accepted. For me the Rothbard argument would hold but only when when the firm came to dominate the market since this would mean doing away with input prices which would make economic calculation impossible. This puts an upper limit on the size of the firm rather than saying hierarchical organisation can not exist.

Markets fail, so we need more markets

Bernard Hickey, one of New Zealand's business journalists, has been putting about some rather odd ideas that only prove he doesn't seem to understand economics. Matt Nolan and Eric Crampton have covered his nuttiness so I won't say anything more about that. What I think interesting is a point Eric made when he said,

The case for markets never lay in their perfection but rather in the relative imperfection of alternatives. I'm teaching intermediate micro this semester. We go through the welfare theorems, and they're beautiful. We know that they don't apply generally. However, it's really hard to improve on the imperfection of markets. Both markets and policies are imperfect instruments. Markets fail relative to blackboards, but regulatory solutions often fail relative to the real world market alternative.

This is a basic point that many people miss. A version of this idea I like is by Oliver Willaimson,

Students of the NIE eschew hypothetical ideals-which work off of omniscience, benevolence, zero transaction costs, full credibility, and the like-and deal instead with feasible organizational alternatives, all of which are flawed. Coase (1964) and Demsetz (1969) were among the first to take exception with the asymmetric standards that were once used in the "market failure" literature-according to which markets are beset with failures whereas "omniscient, omnipotent, benevolent" governments (Avinash Dixit 1996, p. 8) would reliably administer efficacious remedies. As we all should have recognized (but needed to be told), all feasible forms of organization-government included-are flawed.

What I have referred to as the remediableness criterion is intended to rectify this asymmetric state of affairs. This criterion holds that an extant mode of organization for which no superior feasible alternative can be described and implemented with expected net gains is presumed to be efficient.

To be sure, public policy analysis becomes more complicated when analysts can no longer condemn extant modes because they deviate from a hypothetical ideal, full stop. The remediableness criterion presses the public policy analyst to display a superior feasible alternative. If, moreover, a proposed feasible alternative cannot be costlessly implemented, then the costs of implementation are appropriately included in the net benefit calculus-which has major ramifications for the path dependency literature. Finally, grounds for rebutting the efficiency presumption need to be addressed-which brings in politics (Williamson 1996, 1999). Absent rebuttal, the remediableness criterion stands as a reminder of the obvious: it is impossible to do better than one's best. (Williamson 2000: 601-2)

Government can not do what Hickey seems to want to believe they can do, they are flawed and usually when compared to markets they are more flawed. Thus if Hickey want to show that the use of markets is wrong he has to show that there is a superior feasible alternative can be described and implemented by the government with expected net gains. That isn't easy to do.

So the argument, as Eric notes, for markets isn't that they are perfect, rather its that they are less imperfect than the alternative.

• Williamson, Oliver E. "The New Institutional Economics: Taking Stock, Looking", Journal of Economic Literature, Vol. 38, No. 3 (Sep., 2000), pp. 595-613.

Incentives matter: fire fighting file 2

Previous I posted on one way to deal with the free rider problem associated with firefighting. Now Scott Masten over at the Organizations and Markets blog has extended the discussion. He writes,

My guess is that the reason governments rather than private companies generally provide fire services has a lot to do with the difficulty of pricing fire services. (The Tennessee case involved a quasi-market transaction in that residents outside of South Fulton paid the city of South Fulton for fire protection.) It is certainly conceivable that private fire companies could offer homeowners and businesses a choice between (i) prepaid fire service for an annual fee and (ii) on-demand fire service. But how would you determine the price of the latter? I’m pretty sure you wouldn’t want to negotiate the price while your house is burning down. (Talk about temporal specificity!) And you wouldn’t want to negotiate the price after the fact either: Gee, guys, thanks for saving my house; can I buy you all a beer?

Another problem with on-demand fire services is would the courts enforce any agreement made while the house is burning down? So the obvious alternative is to set the price for on-demand fire protection ex ante.

But this poses problems, too. Either you need a price list (kitchen fire, $X; smoldering electrical fire, $Y; whole-house conflagration, single family ranch-style house, $ZZZZ; and so on) or you set a single price reflecting the cost of the average fire. But even then, you have questions like, what if the fire department were slow to arrive, or sent the wrong equipment or inadequate personnel, or whatever? Even if the department did everything it should, the house might burn down anyway (maybe because, like the first little pig, I’d built my house of straw). You can imagine the law suits over whether or not a homeowner should have to pay the on-demand fire suppression fee if the fire department’s efforts were unsuccessful. Government-supplied fire protection avoids all of these pricing issues. Sure, government supply has its own inefficiencies, but everything’s comparative, and the problems of pricing fire services seem pretty severe to me.

So public provision could be the least bad of two imperfect alternatives.

Econ Nobel at iPredict 2

Richard Thaler now leads with a 31% chance of winning, Robert Schiller in on 30%, Martin Weitzman is on 24% and Oliver Hart has a 20% chance of winning.

Does Robert Barro really have only a 1% chance of winning? There could be some money to be made there.

Eric Crampton has the economics department picks for the prize here. Not that I would trust any of them!