Competition policy, again (updated)

In the latest Insights newsletter at the New Zealand Initiative Oliver Hartwich discusses the recent decision by the government not to criminalise cartel behaviour. Hartwich writes,

On Tuesday, Minister of Commerce Paul Goldsmith decided not to proceed with the long debated criminalisation of cartel behaviour.

The Minister’s explanation was telling: “In weighing up the benefits of criminalising cartel activity, the government had to consider the significant risk that cartel criminalisation would have a chilling effect on pro-competitive behaviour between companies.”

As Hartwich notes it may sound strange that pro-competitive behaviour of companies could ever be confused with anti-competitive behaviour. Hartwich writes,

The problem lies in the nature of competition law. It is an area of law which is prone to arbitrariness. Practically everything is a matter of interpretation.

William Landes summaries the point in the following quote on why 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”, Journal of Law and Economics (1981) p. 193.)

If everything is illegal what is a firm to do?

Hartwich continues,

Similarly, the benchmark of “competition” is vague. For what should it mean? Is it the theoretical but unrealistic state of so-called “perfect competition” taught in many economics textbooks? Or is it the process of companies actually competing with each another? And if so, how do you measure that?

Then there is the difficulty in finding proper definitions. To quote the late economist Murray Rothbard, “there is nothing anticompetitive per se about a cartel, for there is conceptually no difference between a cartel, a merger, and the formation of a corporation: all consist of the voluntary pooling of assets in one firm to serve the consumers efficiently.” Indeed. Yet somehow the formation of a corporation is fine whereas a merger or a cartel might be illegal.

Rothbard's point about cartels being illegal while mergers which can achieve the same result being legal is comment on a relatively recent change in thinking on competition policy. If you go back to, say, the 1950s integration was looked at with just as much suspicion as cartels are today. Recently I came across an interesting comment on the old view on integration and antitrust policy by Joseph J. Spengler

RECENT decisions suggest that the United States Supreme Court is beginning to look upon integration as illegal per se, under the antitrust laws. It may be presumed, in so far as this inference is valid, that the Court believes that integration necessarily reduces competition "unreasonably." No sharp distinction is made by the Court between vertical and horizontal integration. (Joseph J. Spengler, "Vertical Integration and Antitrust Policy", Journal of Political Economy, Vol. 58, No. 4 (Aug., 1950), pp. 347-352.)

This was written in 1950 and things have changed since it is now accepted that there are often efficiencies that result from integration and now the US Antitrust Division typically requires a showing of market power before it considers whether a such arrangement poses serious competitive concerns.

At least part of the reason for the change in view is due to the work of Oliver Williamson, Williamson was sceptical of the conventional wisdom of the time (1960s), which presumed that the purpose and effect of many integration practices was the enhancement of market power and the erection of entry barriers. Contrary to this view, which was widely adopted by antitrust lawyers and courts in the 1960s, Williamson could see rationales for various integration practices that were based instead on economic efficiency.

If we accept that integration can have efficiency justifications then why not cartels? At least we should ask what the reasons for the formation of the cartel are and not just assume that cartels are evil per se. The government's decision can be seen as a small step in this direction.

Update: Donal Curtin at the Economics New Zealand blog takes a more traditional (and anti) view of the government's decision when he argues "Hard core" cartelists are criminals.

Do we need competition policy?

On twitter Vanilla Thrilla asked,

NZ - the weakest competition law regime in the developed world? https://t.co/t2H2NOGBj5

— Vanilla Thrilla (@Vanilla_Thrilla) December 8, 2015

I replied,

@Vanilla_Thrilla no competition policy the best policy?

— Paul Walker (@psw1937) December 8, 2015

then Vanilla Thrilla said,

@psw1937 interesting question. pretty sure self-licensing professional guilds, labour unions and large corporates would all say yes

— Vanilla Thrilla (@Vanilla_Thrilla) December 8, 2015

and then I said,

@Vanilla_Thrilla Companies can use competition law to protect their position and harm competitors

— Paul Walker (@psw1937) December 8, 2015

Let me expand a bit on my general point with an argument from a previous post on this topic.

Many people seems to think that a body such as the Commerce Commission is needed and that it should be a powerful player in its role as competition regulator. I ask why? May be the commission does more harm than good. Would it be better to do away with it?

The idea behind competition law in New Zealand is, according to the Act, “to promote competition in markets for the long-term benefit of consumers”. This is to say, it is believed, by the Act's supporters, that markets left to themselves, without any oversight from regulators, without any regulation of prices, quantities, or structure, would be harmful to consumers. Such a view rests on the notion that there is a large danger of monopoly power being used to harm consumers and, therefore, competition is a state of affairs which must be regulated and managed by the authorities because undesirable situations of monopoly can emerge all the time.

Frederic Sautet, ex-economist at NZ Treasury and the Commerce Commission, makes the point that this thinking is wrong headed:

At the end of the day, the problem assumed by competition law is only exacerbated by regulation, while economics shows that the entrepreneurial process solves it. So while there may be situations where competition law may seem warranted, in fact there is no crime at the crime scene. While competition law aims to protect consumers, the danger is that it may affect the self-correcting properties of the market system — an outcome worse than the disease it tries to cure.

Much of the problem is due to the fact that competition law was established on an misunderstanding of the nature of competition. The law in New Zealand aims to achieve "workable competition" but the practice of competition law relies on the view of competition as a static (equilibrium) state of affairs - derived from the idea of perfect competition. However, actual competition is a rivalrous entrepreneurial process by which the knowledge enabling a better coordination of individual plans is discovered over time. Again, as Frederic Sautet points it

[...] it must be understood that the competitive process takes place within a set of institutions that guarantee the functioning of entrepreneurial discovery and the exploitation of business opportunities over time. These institutions and regulation must guarantee entry into any market to anyone desiring to compete.

Sautet goes on to make the important point that

Under the disguise of consumer protection, competition law has in fact protected some producers from the greater efficiency of their potential competitors. Indeed, competition can be difficult for some incumbents who run the risk of being outcompeted. However, this process is necessary if the ultimate goal is to let consumers (indirectly) dictate the allocation of resources according to their preferences. The danger with competition law is that it interferes with the entrepreneurial process — a cure worse than the disease.

Thus the danger of the Commerce Commission is that it may so damage or restrict the true competitive process that it harms the very people it set out to help, consumers, but helps the people it wished to control, producers. The law of unintended consequences strikes again.

As far as empirical evidence goes it tends to suggest that competition policy does not improve consumer welfare by much. Robert W. Crandall and Clifford Winston look at the effects of antitrust enforcement in the US and ask Does Antitrust Policy Improve Consumer Welfare? And the short answer is, not much. Crandall and Winston write,

In this paper, we argue that the current empirical record of antitrust enforcement is weak.

and they add

We then synthesize the available research regarding the economic effects of three major areas of antitrust policy and enforcement: changing the structure or behavior of monopolies; prosecuting firms that engage in anticompetitive practices, namely, price fixing and other forms of collusion; and reviewing proposed mergers. We find little empirical evidence that past interventions have provided much direct benefit to consumers or significantly deterred anticompetitive behavior.

Overall I'm not sure that we really do want a strong interventionist Commerce Commission.

At the very lest we should start a discussion about the nature of the Commerce Act and the role of the Commerce Commission by asking questions about what form of competition policy we really want.

References:

The Sautet paper, which is well worth reading, is "The Shaky Foundations of Competition Law", New Zealand Law Journal, pp. 186-190, June 2007.

The Robert W. Crandall and Clifford Winston paper is "Does Antitrust Policy Improve Consumer Welfare? Assessing the Evidence", Journal of Economic Perspectives, 17(4) Fall 2003.

Worstall on Davies on Coase on housing

In a previous post I commented on the idea of Steve Davies to apply Coaseian thinking to solving the British (and other countries) housing problem. In part Davies wrote

For Coase the solution was to assign a property right to one of the two sides and then allow a process of bargaining to take place. If the first group have the right then those who do not want development would have to pay them not to do it. If the second, then the developers (and ultimately the buyers) have to pay for the right to develop. Crucially it does not matter which of these two we go for: in either case we will end up with the outcome that maximises total welfare so long as the bargaining process itself is not too costly.

Now at the Adam Smith Institutes's blog Tim Worstall comments on this idea. He writes

We have no doubt this would work and that should be good enough as a solution. However, while it would work we’re really not convinced that it is the correct solution. For what it is saying is that those who wish to prevent building upon land that they do not own have some form of right to say or insist so. That’s why they might be due some compensation from those who do build. And we rather reject that basic contention.

Property ownership does mean that one should be able to dispose of the property as one wishes. Consistent with this is that other people do not have the right to impose their views upon you of how you should dispose of that property. Thus we’re uncomfortable with the idea of creating a right which can then be subject to such Coasean bargaining.

Tim has a point, sorting out who has what rights to object to a housing development could raise the transaction costs of Coaseian type bargaining to such a degree that it would become impractical. And if multiple people or groups claim said rights negotiating with each of them could be expensive and time consuming. However if it is clear who the parties involved are and there are only a few of them, ie transactions costs really are low, then the Coaseian solution could be an improvement over the current situation.

EconTalk this week

If you have 250 million tons of food to give away every year to local food banks how should you do it? Canice Prendergast of the University of Chicago's Booth School of Business talks with EconTalk host Russ Roberts about how he and a team of economists created an artificial currency and a daily auction for the national food bank Feeding America so that local food banks could bid on the types of food that were the most valuable to them. Prendergast explains the results of the new system and the cultural and practical challenges of bringing prices, even artificial ones, to a world accustomed to giving things away.

A direct link to the audio is available here.

Efficiency of female leaders in family and non-family firms

There has been recent discussion of the idea that economic research shows that companies that have a balanced representation of women and men on their boards perform better, a claim made by the Treasury Secretary Gabriel Makhlouf . Eric Crampton at the Offsetting Behaviour blog has pointed to research that shows this is not the case.

Today I came across this working paper - Efficiency of Female Leaders in Family and Non-Family Firms by Per-Olof Bjuggren, Louise Nordström and Johanna Palmberg - that draws a distinction between family-owned and non-family owned firms when looking at the performance effects of female leadership. In their conclusion the authors write,

Our study shows that female leadership is more common in family than non-family corporations. This female leadership has also a strong positive impact on performance in family firms while the performance impact is surprisingly strongly negative in non-family firms.

Insofar as Makhlouf's comments were about non-family owned firms, and most large firms are of this form, then the above comment doesn't offer much support for his claim. When considering family-owned firms however, he may be on stronger ground.

The paper's abstract reads:

Female leadership is an expanding area of research. It is a popular topic discussed frequently in both academia and in the popular press. Despite this, comparative studies of the impact of female leadership on firm level performance between family and non-family firms are rare. The present study has the ambition to fill this gap. This paper investigates female leadership in family firms and how it affects firm profitability. A unique database of ownership and leadership in private Swedish firms makes it possible to analyze difference in firm performance due to female leadership in family and non-family firms. Even though much has been written regarding the role of women in family firms we do not know so much about how female leadership in family firms affect the profitability of the firm. The analysis indicates that female leadership makes much more of a positive difference for performance in family firms. The effect is negative in non-family firms.

This leaves open the question as to what drives the difference in leadership performance between the two types of firms.

AFA Lecture: Andrei Shleifer

"The Transformation of Finance" an address to The American Finance Association by Andrei Shleifer, January 2011.

The 20 most influential books in history

From the World Economic Forum comes a list of The 20 most influential books in history. The top ten are,

Davies on Coase on housing

At the LSE's British Politics and Policy blog Steve Dacies writes that low house-building levels and the unaffordability of existing homes are problems that have been plaguing Britain for decades. And this is true not just in the UK but most other countries, like New Zealand, as well.

Davies writes,

There is now something of a consensus among academics and commentators that the shortage of housing (and buildings of all kinds) is one of our most pressing problems. Many others such as welfare costs and low productivity are at least partly caused by the lack of house building and the consequent high price of housing. However, this has not as yet led to any political action. The problem of course is the conflict of interest between people who want to build, buy or rent new houses on the one hand, and people who do not want new development on greenfield sites on the other. The second group have so far been able to block any action and this does not seem likely to change.

But the work of Coase shows that this deadlock is quite simply unnecessary and avoidable if we only think about it in the right way, as Mark Pennington explains. Current policy on development is shaped by conventional welfare economics, where two people engaging in a transaction can impose costs on bystanders. So a developer and a house buyer can impose costs on existing home owners and people who wish to preserve the rural environment. This is dealt with by regulations through planning laws.

As Pennington explains, Coase rejects this model. For him the costs are reciprocal – there are two sides each of whom is potentially imposing costs on the other. One wants to build houses, the other to preserve space. To the extent that one side gets its way the other suffers a loss. What we actually have is not an externality or pollution but a conflict over how to use land.

For Coase the solution was to assign a property right to one of the two sides and then allow a process of bargaining to take place. If the first group have the right then those who do not want development would have to pay them not to do it. If the second, then the developers (and ultimately the buyers) have to pay for the right to develop. Crucially it does not matter which of these two we go for: in either case we will end up with the outcome that maximises total welfare so long as the bargaining process itself is not too costly.

Fortunately, in the case of land use the cost of negotiation is low. If we applied this model instead of a complex and costly planning procedure we would simply have a default right, either to build or not, which would have to be bought out. We could make one default apply in some parts of the country and the other in the rest (although this should not matter, it might be politically astute). There would then be a process of bargaining and through this we would actually find out how much people really valued one alternative or the other (as opposed to their asserting it – words are cheap).

The result would be development in some areas but not in others and this would reflect the actual value that people collectively placed on the two competing uses and the associated moral values. This would be different in different places (unlike the inflexible present system). As Pennington points out this would also be an ethically superior outcome because it would reflect ethical and value pluralism rather than having one group’s values imposed on the rest through the political process which is what we have now.

For Coase the world of positive transaction costs is the world we should consider when thinking about policy. High transactions costs can prevent otherwise efficient trades from taking place. But if we can structure things so that transaction costs are low then bargaining between parties will lead us to efficient outcomes. Thus as Davies notes if we assign property rights to either developers or to those who wish to prevent new development and let them bargain the two groups can work the problem out for themselves. Bureaucrats not needed.

Such an approach to housing really would be RMA change!

Do people maximise their well-being?

As a followup to the last posting on Coase v. Becker on utility theory I came across this new working paper by Marc Fleurbaey and Hannes Schwandt which asks Do People Seek to Maximize Their Subjective Well-Being?

The abstract reads,

In a new survey we ask respondents, after a standard Subjective Well-Being (SWB) question, if they can think of changes in their lives that would improve their SWB score. If the SWB score is just one argument among others in the respondents’ goals in life, they should easily find ways to improve it, at the expense of other dimensions they care about. Our results suggest that close to 90% of the respondents actually seek to maximize their SWB. The life satisfaction question appears the best contender as the “maximand” in the contest, before the ladder-of-life question and felt happiness. Among the other goals that people pursue and for which they are willing to sacrifice some of their SWB, the prominent appear to be about their relatives and about their future self.

So 90% of us seem to want to maximise our subjective well-being. One interesting question is what does this tell us about assuming utility maximisation as a starting point for modelling consumer behaviour?

Coase v. Becker on utility theory

An interesting, and all too short, exchange between Ronald Coase and Gary Becker on utility theory. Coase was not much of a believer in the usefulness of utility theory whereas Becker was.


The video comes from freetochoose.tv.

Why politics and business should not mix

In a new column at VoxEU.org Jiangtao Fu, Daichi Shimamoto and Yasuyuki Todo discuss Politically connected lending and economic development.

A long held view of many economists is that firms with good political connections obtain loans with more relaxed terms than those who are not politically connected. The Fu, Shimamoto and Todo column presents evidence from Indonesia that firms whose owners or directors have a personal relationship with a politician are more likely to have their loans approved by state-owned banks, and are more likely to receive the full amount applied for. However, the labour productivity of such firms is on average lower. This suggests that in some cases, politically connected lending may distort the efficiency of resource allocation and be detrimental to economic development.

Fu, Shimamoto and Todo write,

The Indonesian government implements policies to facilitate credits to SMEs with growth potential. However, our results suggest that such public credits are most likely to be given to unproductive but politically connected firms. The distorted allocation of resources may harm the economic growth of Indonesia and lead the economy into a middle-income trap. Possible solutions to this problem include reducing the political influence in state-owned banks (e.g. their privatisation), building SMEs’ credit information sharing system, and strengthening the ability of financial institutions to evaluate loan applications.

These results highlight, if such highlighting is really needed, why politics and business should never mix. Some countries are better at separating business from politics but all countries need to be aware of the dangers of the mixing of the two. Those dangers include reducing much needed economic growth. The column also points to one advantage of privatisation, in this case of state-owned banks, it helps depoliticise business decisions.

EconTalk this week

Are we on the verge of driverless cars and other forms of autonomous robots and artificial intelligence? David Mindell of MIT and the author of Our Robots, Ourselves talks with EconTalk host Russ Roberts about the robotic revolution. Mindell argues that much of the optimism for autonomous robots ignores decades of experience with semi-autonomous robots in deep-sea operation, space, air, and the military. In all of these areas, the role of human supervision remains at a high level with little full autonomy. Mindell traces some of the history of the human interaction with robots and artificial intelligence and speculates on what the future might hold.

A direct link to the audio is available here.

Incentives and thinking

"The main point is that having commercial economic incentives in place causes us to perceive new information in more positive-sum terms than otherwise would be the case, or at least that is how I interpret his results" or so writes Tyler Cowen about a new working paper An Offer You Can’t Refuse? Incentives Change How We Think by Sandro Ambuehl.

An interesting idea worth thinking about, especially when you find on page 4 of the paper the sentence "In the first experiment I use cash to induce subjects to eat whole insects, including silkworm pupae, mealworms, and various species of crickets." What's not to love?

The paper's absract reads:

Around the world there are laws that severely restrict incentives for many transactions, such as living kidney donation, even though altruistic participation is applauded. Proponents of such legislation fear that undue inducements would be coercive; opponents maintain that it merely prevents mutually beneficial transactions. Despite the substantial economic consequences of such laws, empirical evidence on the proponents’ argument is scarce. I present a simple model of costly information acquisition in which incentives skew information demand and thus expectations about the consequences of participation. In a laboratory experiment, I test whether monetary incentives can alter subjects’ expectations about a highly visceral aversive experience (eating whole insects). Indeed, higher incentives make subjects more willing to participate in this experience at any price. A second experiment explicitly shows in a more stylized setting that incentives cause subjects to perceive the same information differently. They make subjects systematically more optimistic about the consequences of the transaction in a way that is inconsistent with Bayesian rationality. Broadly, I show that important concerns by proponents of the current legislation can be understood using the toolkit of economics, and thus can be included in cost-benefit analysis. My work helps bridge a gap between economists on the one hand, and policy makers and ethicists on the other.

Munger on North

The great economic historian Douglass North died a few days ago and today while reading a book chapter on "Coase and the 'sharing economy' " by Michael Munger I came across the following comment. Munger is talking about two related questions: Why if markets are so great are there firms? and Why if firms are so great is there more than one firm? Munger writes,

My own introduction to Coase's answer was memorable, though rather painful. When I was in graduate school at Washington University, Douglass North was on my dissertation committee. At my defence, he asked a question. It seemed like a complicated question, and I went to the board and wrote some equations. Finally (and mercifully), Doug interrupted me. Waving his hand slowly, addressing a not-very-bright child, he said, 'Michael, the answer is two words ... transaction costs!'

And I should have known. For North, it didn't really matter what the question was, the answer, or at least the start of the answer, had to do with transaction costs. He had fully appreciated the Coasian insight that economic (and many political and social) institutions had as their primary function the optimisation of transaction costs.

And North went on to develop that insight in ways that hugely enhanced our understanding of both economic history and the new institutional economics.

Of course in some cases institutions develop to minimise transactions costs, firms, for example, occur when they can carryout an activity at a lower cost than the market but in other cases institutions develop to increase transaction costs. Take as an example the secret ballot which makes it impossible to tell if someone has voted in the way he was bribed to vote or not. Such an increase in the transaction costs of voting makes vote buying that much harder.

Now this is just crazy

From stuff.co.nz comes this bit of crazy news.

Prediction website iPredict is to be closed down, with the Government deciding it represents a money laundering risk.

The site, run by Victoria University of Wellington, issued a statement to its website on Thursday and on Twitter.

According to the iPredict statement, Associate Justice Minister Simon Bridges refused to grant it an exemption from the Anti-Money Laundering and Countering Financing of Terrorism Act, declaring that it was a "a legitimate money laundering risk" because of the lack of customer due diligence.

The website added that Bridges "formed these views without any discussions with us".

Bridges office could not immediately comment on iPredict's statement.

As well as economic forecasting, iPredict allows traders to place bets on political events. Currently, for example, Simon Bridges is rated as having only a 4 per cent chance of becoming the next leader of the National Party.

Although iPredict said that most of its transactions were small, three traders hold portfolios on the website worth in excess of $10,000. The wbesite claims to have more than 9000 traders including more than 4000 who have deposited $20 or more, although most are understood to be inactive accounts.

One of the site's higher profile traders, Kiwiblog author David Farrar said the decision was hard to fathom.

"Their turnover is teeny. You could only money launder a few hundred [dollars], maybe a thousand, because their's just not enough people," Farrar said, adding that the requirement to give bank accounts or credit card details meant the money should be traceable.

"You could money launder many times larger amounts and much more effectively by going to gaming machines," Farrar added.

What is really going on here? As David Farrar points out the amount of money you could launder is so small that I find it very hard to believe that this is the real reason for the closing down of iPredict. The average trader has a net worth of $41. So what is Bridge's real agenda here?

Given the amount of interesting data that iPredict generates keeping makes sense. It would be nice if the markets were a bit thicker perhaps but on the other hand a thin market, as Farrar notes, does limit the amount of money laundering that could be done via the site.

Seven years of fun and information ends due to stupid government actions.

The statement from iPredict is available here.

EconTalk this week

Michael Munger of Duke University makes his 29th appearance on the 500th episode of EconTalk alongside EconTalk host Russ Roberts. He talks about his personal intellectual journey, his interest in public choice, and Unicorn economics. Other topics include the origins of EconTalk, Roberts's intellectual roots, and the EconTalk theme music. The conversation closes with a brief reprise of a few highlights from past Munger appearances on EconTalk.

A direct link to the audio is available here.

International Business Lecture: Standing on the Shoulders of Midgets: Dominant Firms and Innovation Incentives

International Business Lecture:
Standing on the Shoulders of Midgets: Dominant Firms and Innovation Incentives

Presenter:
Luís Cabral
Paganelli-Bull Professor of Economics and International Business, Stern School of Business, New York University

When: Thursday 17 December 2015, 5:15pm – 7:15pm
Where: Laws 108 Lecture Theatre, Business and Law Building 
(Google map link)

The Department of Economics and Finance warmly invites you to hear Luís Cabral, Paganelli-Bull Professor of Economics and International Business at New York University’s Stern School of Business. Professor Cabral’s research focuses on the dynamics of firm competition, from both antitrust and strategic perspectives. In this lecture he discusses his innovation model featuring asymmetry between large and small firms, technology transfer by acquisition, and the process of gradual innovation.

Join us for refreshments at 5:15pm, followed by the lecture at 6pm.

RSVP by 11 December 2015 to: meredith.henderson@canterbury.ac.nz

Abstract

I develop a dynamic innovation model with three important features: (a) asymmetry between large and small firms ("giants" and "midgets"); (b) technology transfer by acquisition; and (c) the distinction between gradual innovation (i.e. within a certain "paradigm") and disruptive innovation (i.e. that which induces a new paradigm). I provide conditions such that (a) greater asymmetry between giant and midget decreases incremental innovation but increases disruptive innovation; and (b) allowing for technology transfer increases incremental innovation but decreases disruptive innovation.

About the presenter

A native of Portugal, Luís Cabral is a graduate of Stanford University (PhD, Economics, 1989). He taught at the London Business School, Berkeley, Yale, NYU and IESE. He is currently the Paganelli-Bull Professor of Economics and International Business at NYU's Stern School of Business. Cabral's research is focused on the dynamics of firm competition, both from the antitrust and from the strategy perspectives. His research topics include reputation, learning, network effects, sunk costs, innovation, strategic risk choice. In addition to numerous journal articles, he is the author of Introduction to Industrial Organization, a textbook translated and adopted by universities in dozens of countries worldwide. Professor Cabral consulted with a variety of organisations (firms, universities, governments, tax and law enforcement agencies, even sports teams) on a variety of economics issues. He was a leading expert witness in the Airbus-Boeing WTO disputes. From 2004-2009, he was a member of European Commission President Barroso's Group of Economic Policy Analysis (a group of 12 members). Other than economics, Professor Cabral's interests include painting (his art work has been exhibited on both sides of the Atlantic) and saxophone playing (performed with the NYU Stern Faculty All Stars and other equally reputed bands).

Stigliz on Coase

In his book Whither Socialism? Joseph Stigliz writes,

Coase went wrong in assuming that there are no transaction costs and no information costs. But the central contention of this book is that information costs (what can be viewed as a special form of transaction costs) are pervasive. Assuming away information costs in an analysis of economic behavior and organization is like leaving Hamlet out of the play.

But as is obvious to anyone who as read Coase the last thing he did was to ignore transactions costs. In fact the opposite is true, Coase's whole framework is based on the very notion of positive transaction costs. To quote Coase,

The world of zero transaction costs has often been described as a Coaseian world. Nothing could be further from the truth.It is the world of modern economic theory, one which I was hoping to persuade economists to leave.

For example, within a Coaseian framework the firm only makes sense in a positive transaction cost setting, if transactions costs are zero then production can take place via market transactions, with no firms needed. As Nicolai Foss has noted,

With perfect and costless contracting [due to zero transaction costs], it is hard to see room for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and wouldn't need the services of the intermediaries known as firms.

When thinking about the law and the actions of the courts Coase made the point that when the courts assign rights and liabilities in a context of zero transaction costs their decision does not matter. If an inefficient allocation of rights is made then the parties can bargain to an efficient one. But if transaction costs as are positive, as Coase stressed they are, then there is no inherent tendency for a welfare-maximising result to emerge, since the existence of these costs may block potentially mutually beneficial exchanges between the parties. In such a case the court's decision does matter.

When it comes to a Coaseian approach to policy Mark Pennington has noted,

[ ... ] the purpose of Coase’s analysis was to highlight the policy implications that flow from recognising the significance of transaction costs. Imperfections or frictions in markets may result in less than optimal outcomes – but these imperfections or frictions exist under any institutional alternative which involves direct government intervention. Deciding whether to rely on one mechanism or another requires a comparative institutions approach which considers the extent of the likely transaction costs under different types of ‘solution’.

So again positive transaction costs are central to the argument.

Stiglits's view show a profound misunderstanding of Coase's work. But it is a misunderstanding that is all too common.

Make or buy decisions over upstream and downstream inputs

One of the big questions in the theory of the firm is about determining the boundaries of the firm. This is normally thought about as a "make or buy" decision. That is, firms can vertically integrate, or outsource, upstream and downstream functions. The more functions you do in house, "make", the larger is the firm and the more functions you outsource, "buy", the smaller is the firm. This is true whether or not the firm outsources to firms in their own country or to firms overseas. In fact trade in intermediate inputs now accounts for as much as two-thirds of international trade. Firms must decide which segments of their production processes to own and which to outsource.

A new column, Make or buy decisions over upstream and downstream inputs: An investigation of firm boundaries along value chains by Laura Alfaro, Pol Antràs, Davin Chor and Paola Conconi, at VoxEU.org looks at firms’ organisational choices along value chains. Using global plant-level data, this column empirically examines the organisational choices that firms make along the value chains. Decisions to integrate or outsource upstream and downstream functions are found to depend on demand elasticity relative to the substitutability of inputs. These results provide strong evidence that integration decisions are driven by contractual frictions.

Alfaro, Antràs, Chor and Conconi start by developing a theoretical framework of firm behaviour that is amenable to estimation using firm-level data. They "describe an incomplete-contracts model in which the manufacturing of final goods entails a large number of production stages that need to be performed in a predetermined order. Suppliers provide the different stages by undertaking relationship-specific investments to make their components compatible with those of other suppliers in the value chain". They also "allow for heterogeneity in the importance of inputs for production, as well as in the marginal cost of production faced by suppliers at different points along the value chain".

As to the empirical bits,

To bring the model to the data, we use WorldBase, a comprehensive plant-level dataset that provides information on the activities of firms located in many countries and territories. Plants belonging to the same firm can be linked via information on domestic and global parents using a unique identification number. Our main sample consists of more than 300,000 manufacturing firms in 116 countries. For each plant, WorldBase provides information about its primary production activity and secondary activities. To distinguish between integrated and non-integrated inputs, we combine this information with Input-Output tables [...]. We also use Input-Output tables to construct a new measure of the position of different industries along the value chain. This measure is industry-pair specific and captures the ‘upstreamness’ of each input i in the production of output in sector j. Figure 1 provides an illustration of the variation contained in this measure, when focusing on one particular input industry, Tires and Inner Tubes (SIC 3011). Notice that the upstreamness measure is smaller for industries that use tires almost exclusively as a direct input, such as Mobile Homes (2451), Lawn and Garden Equipment (3524), Industrial Trucks and Tractors (3537), Motorcycles, Bicycles, and Parts (3751), and Transportation Equipment (3799). This new measure is distinct and more informative than the one developed in Antràs et al (2012), which restricted attention to the distance of an input relative to final demand (see the horizontal line in Figure 1 for the case of Tires).

Figure 1. Upstreamness of tires (SIC 3011) in the production of all other manufacturing industries

The richness of our data allows us to exploit variation in the organisation of different firms, as well as within firms across their manufacturing stages. In line with the key prediction of our theoretical model, we find that a firm's propensity to integrate upstream (as opposed to downstream) inputs depends crucially on the relative size of the elasticity of demand for the firm's final good and the elasticity of substitution across its production stages. The higher the demand elasticity faced by the firm relative to the substitutability of its inputs, the more likely it is that the firm will outsource upstream suppliers rather than downstream ones. The intuition for this result is that, when the demand is elastic or inputs are not particularly substitutable, input investments are sequential complements; that is, the marginal incentive of a supplier to undertake relationship-specific investments is higher, the larger are the investments by upstream suppliers. In this case, the firm finds it optimal to contract at arm’s length with upstream suppliers in order to incentivise their investment effort, while integrating the most downstream stages to capture surplus. When demand is inelastic or inputs are sufficiently substitutable, input investments are instead sequential substitutes; that is, investments by upstream suppliers lower the investment incentives of downstream suppliers. When this is the case, the firm chooses to integrate relatively upstream stages, while engaging in outsourcing with downstream suppliers.

Alfaro, Antràs, Chor and Conconi contiue,

We also construct a measure of input contractibility for each SIC industry (following Nunn 2007) and examine how firms' ownership decisions are shaped by the degree of contractibility of upstream versus downstream inputs. We find that a greater degree of contractibility of upstream inputs increases the likelihood that a firm integrates upstream inputs, when the firm faces a high elasticity of demand (both in absolute terms, as well as relative to our proxy for input substitutability). This result is also in line with the predictions of our theoretical model, according to which greater upstream contractibility reduces a firm's need to rely on organisational decisions and arrangements to elicit the right incentives from suppliers positioned at early stages in the value chain.

The firm-level empirical patterns that we uncover in our analysis provide strong evidence that considerations driven by contractual frictions are critical in shaping the integration choices of firms along their value chains.

Jonah Lomu RIP

No Kiwi will ever tire of watching this.