Anti-Dismal

The past and present of the theory of the firm

noreply@blogger.com (Paul Walker) — Fri, 10 Feb 2012 01:29:00 +0000

There is a new paper available at SSRN that looks at The Past and Present of the Theory of the Firm.

The abstract reads,

In this survey we give a short overview of the way in which the theory of the firm has been formulated within the 'mainstream' of economics, both past and present. As to a break point between the periods, 1970 is a convenient, if not entirely accurate, dividing line. The major difference between the theories of the past and the present, as they are conceived of here, is that the focus, in terms of the questions asked in the theory, of the post-1970 literature is markedly different from that of the earlier (neoclassical) mainstream theory. The questions the theory seeks to answer have changed from being about how the firm acts in the market, how it prices its outputs or how it combines its inputs, to questions about the firm's existence, boundaries and internal organization. That is, there has been a movement away from the theory of the firm being seen as developing a component of price theory, namely issues to do with firm behavior, to the theory being concerned with the firm as a subject in its own right.

More MED mercantilism?

noreply@blogger.com (Paul Walker) — Mon, 06 Feb 2012 14:09:00 +0000

From Groping towards Bethlehem we learn that

[...] MED in its Briefing to the Incoming Minister pointed out that the high exchange rate means we are all a little bit richer? Don’t be silly. ‘Cause, see, it’s all about the exports. The opening sentence:

The Government’s aim of building a stronger economy will require a substantial increase in the share of exports in the economy.

The question I would ask of MED is, But why does building a stronger economy require an increase in the share of exports? In simple terms, doesn't building a stronger economy just mean producing more - and thus increasing our real wealth - and who we sell our output to doesn't matter?

I mean if we produce a widget here in Canterbury, does MED really mean that selling that widget to someone in Auckland doesn't help our economy, since it wouldn't increase the share of exports, but selling it to someone in Sydney does, since it does increase the share of exports in the economy?!!

EconTalk this week

noreply@blogger.com (Paul Walker) — Mon, 06 Feb 2012 13:52:00 +0000

William Black of the University of Missouri-Kansas City and author of The Best Way to Rob a Bank Is to Own One, talks with EconTalk host Russ Roberts about financial fraud, starting with the Savings and Loan debacle up through the current financial crisis. Black explains how bank executives can use fraudulent loans to inflate the size of their bank in order to justify large compensation packages. He argues that "liar loans" were a major part of the crisis and that policy changes made it easy to generate such loans without criminal repercussions.

Shleifer on the transition from communism

noreply@blogger.com (Paul Walker) — Mon, 06 Feb 2012 02:23:00 +0000

At VoxEU.org Andrei Shleifer tells us about the Seven things I learned about transition from communism. These seven things being:

First, in all countries in Eastern Europe and the former Soviet Union, economic activity shrunk at the beginning of transition, in some very sharply. In many countries, economic decline started earlier, but still continued. In Russia, the steepness and the length of the decline (almost a decade) was a big surprise. Countries with the biggest trade shocks (such as Poland and Czechoslovakia) experienced the mildest declines. To be sure, the true declines were considerably milder than what was officially recorded – unofficial economies expanded, communist countries exaggerated their GDPs, defence cuts, and so on – but this does not take away from the basic fact that declines occurred and were surprising. These declines contradicted at least the simple economic theory that a move to free prices should immediately improve resource allocation. The main lesson of this experience is for reformers not to count on an immediate return to growth. Economic transformation takes time.

Second, the decline was not permanent. Following these declines, recovery and rapid growth occurred nearly everywhere. Over 20 years, living standards in most transition countries have increased substantially for most people, although the official GDP numbers show much milder improvements and are inconsistent with just about any direct measure of the quality of life (again raising questions about communist GDP calculations). As predicted, capitalism worked and living standards improved enormously. One must say, however, that for a time things looked glum. So lesson learned: have faith – capitalism really does work.

Third, the declines in output nowhere led to populist revolts – as many economists had feared. Surely reform governments were thrown out in some countries, but not by populists. Instead of populism, politics in many countries came to be dominated by new economic elites, the so-called oligarchs, who combined wealth with substantial political influence. From the perspective of 1992, this came as a huge surprise. Ironically, in some countries in Eastern Europe populism appeared 20 years after transition started, after huge improvements in living standards were absolutely obvious. Indeed, people in all transition countries were unhappy with transition: they were unhappy even in countries with rapidly improving quality of life (and this itself is another surprise and major puzzle – something for future reformers to keep in mind). But the lesson is clear: a reformer should fear not populism but capture of politics by the new elites.

Fourth, economists and reformers overstated both their ability to sequence reforms, and the importance of particular tactical choices, eg, in privatisation. In retrospect, many of the theories that animated the discussion of reform – whether institutions should be built first, whether companies should be prepared for privatisation by the government, whether voucher privatisation or mutual fund privatisation is better, whether case by case privatisations might work – look quaint. Reformers nearly everywhere, including in Russia, had a vastly overstated sense of control. Politics and competence frequently intervened and dictated to a large extent most of the tactical choices. Still, most countries, despite different choices, ended up with largely similar outcomes (notable and sad exceptions are Belarus, Uzbekistan, and Turkmenistan). In various forms, all had privatisation and macroeconomic stabilisation as well as legal and institutional reform to support a market economy. Lesson learned: do not over-plan the move to markets, but, more importantly, do not delay in the hope of having a tidier reform later.

Fifth, economists have greatly exaggerated the benefits of incentives by themselves, without changes in people. Economic theory of socialism has put way too much weight on incentives, and way too little on human capital. Winners in the communist system turned out not to be so good in a market economy. Transition to markets is accomplished by new people, not by old people with better incentives. I realised this and wrote about it in the mid-1990s, but the lesson both in firms and in politics in profound: you cannot teach an old dog new tricks, even with incentives.

Sixth, it is important not to overestimate the long-run consequences of macroeconomic crises and even debt defaults. Russia experienced a major crisis in 1997–98, which some extremely knowledgeable observers said would set it back by 20 years, yet it began growing rapidly in 1999–2000. Similar stories apply elsewhere, from East Asia to Argentina. Debt restructurings do not necessarily make permanent scars. This experience bears a profound lesson for reformers, who are always intimidated by the international financial community: do not panic about crises; they blow over fast.

Seventh, it is much easier to forecast economic than political evolution. Although nearly all transition countries have eventually converged to some form of capitalism, there has been a broader range of political experiences, from full democracies, to primitive dictatorships, to just about everything in between. There appears a strong geographic pattern in this, with countries further West, especially those involved with the European Union, becoming clearly democratic, and countries further East remaining generally more authoritarian. For countries in the middle, including Russia and Ukraine, the political paths over the 20 years have wiggled around. Lesson learned: middle-income countries eventually slouch toward democracy, but not nearly in as direct or consistent a way as they move toward capitalism.

Ricardo and comparative advantage 2

noreply@blogger.com (Paul Walker) — Mon, 06 Feb 2012 01:20:00 +0000

Thanks to an email from Jorge Morales Meoqui I have been alerted to his recent paper in the journal History of Political Economy on "Comparative Advantage and the Labor Theory of Value". The abstract reads,

With the famous numerical example of chapter 7 of the Principles (1817) David Ricardo intended to illustrate first and foremost the new proposition that his labor theory of value does not regulate the price of international transactions when the factors of production are immobile between countries. Unfortunately, later scholars have often omitted this proposition when referring to Ricardo's numerical example. Instead, they have highlighted only the comparative-advantage proposition, although Ricardo considered it as a corollary of the omitted proposition and therefore inextricably linked to it. This inexplicable omission has led to an incomplete understanding of the logical construction of Ricardo's numerical example, as well as to the misinterpretation of the four numbers as unitary labor costs. With an accurate understanding of Ricardo's numerical example and the logical relationship between the two propositions it meant to prove, it is relatively easy to refute the main objections that have been raised against the very same numerical example in the past. Moreover, it reaffirms the sustained relevance of Ricardo's two propositions as important insights for understanding the current process of economic globalization.

Jorge also has a working paper "On the distribution of authorship-merits for the comparative-advantage proposition". The abstract reads,

Due to a better understanding of the logical interrelationships between the comparative- advantage proposition, the classical rule of specialization and the proposition regarding the non- appliance of the labor theory of value in international exchanges in Ricardo’s famous numerical example in the Principles, it is now possible to arrive to a definite conclusion regarding the longstanding academic debate about the true author of the comparative-advantage proposition. Torrens is not entitled to the same amount of merit as David Ricardo with regard to the comparative-advantage proposition since he fell short of formulating a full prove of it prior to the publication of Ricardo’s Principles. In the 1815 example of English cloth being traded for Polish corn, Torrens missed to apply the classical rule of specialization for Poland. For the featured international exchange to take place, though, there has to be gains from trade for both trading partners. More importantly, Torrens also failed to recognize the crucial role of Ricardo’s insight regarding the non-appliance of the law of value in international exchanges in proving the comparative-advantage proposition. Therefore, the bulk of the authorship-merit for this proposition rightly belongs to Ricardo.

Ricardo and comparative advantage

noreply@blogger.com (Paul Walker) — Sat, 04 Feb 2012 02:22:00 +0000

David Ricardo is probably most famous because of his introduction of the idea of comparative advantage into economics. Today comparative advantage is the standard reason given as to why countries gain from trade. But is Ricardo the author of the famous pages in his "Principles of Political Economy"?

In a footnote on page 132 of the fifth edition of his "Economic Theory in Retrospect" Mark Blaug writes

Ironically enough, it is now been shown that the famous pages on comparative advantage in the chapter on foreign trade were almost certainly written by James Mill. Moreover, Ricardo's own conception of foreign trade never effectively went beyond the idea of absolute advantage; in short, he does not deserve the credit he has been given for the theory of comparative advantage.

The basis for Blaug's claim is the paper, by William O. Thweatt, "James Mill and the Early Development of Comparative Advantage", History of Political Economy 8 (Summer 1976) 207-34.

A quick look at Douglas Irwin's book "Against the Trade: An Intellectual History of Free Trade" gives rise to another footnote, from page 91, which reads,

Thweatt's case is plausible because Mill worked closely with Ricardo on the Principles and commented extensively on drafts. Inconclusive evidence against his interpretation comes in a letter from Mill to Ricardo in which he states: "... that it may be good for a country to import commodities from a country where the production of those same commodities cost more, than it would cost at home: that a change in manufacturing sill in one country, produces a new distribution of the precious metals, are new propositions of the highest importance, and which you fully prove." See David Ricardo (1952, 7: 99). Futher, in his article on colonies Mill also credits Ricardo with the theory.

I had known that Mill explained the idea of comparative advantage better in his "Elements of Political Economy", published after Ricardo's "Principles", but not that he could have been the author of Ricardo's original discussion.

EconTalk this week

noreply@blogger.com (Paul Walker) — Thu, 02 Feb 2012 12:21:00 +0000

Eugene Fama of the University of Chicago talks with EconTalk host Russ Roberts about the evolution of finance, the efficient market hypothesis, the current crisis, the economics of stimulus, and the role of empirical work in finance and economics.

Food aid and civil war: is there a link?

noreply@blogger.com (Paul Walker) — Mon, 30 Jan 2012 15:02:00 +0000

It looks like the answer is yes. There is a new NBER working paper out on Aiding Conflict: The Impact of U.S. Food Aid on Civil War by Nathan Nunn and Nancy Qian.

The abstract reads:

This paper examines the effect of U.S. food aid on conflict in recipient countries. To establish a causal relationship, we exploit time variation in food aid caused by fluctuations in U.S. wheat production together with cross-sectional variation in a country's tendency to receive any food aid from the United States. Our estimates show that an increase in U.S. food aid increases the incidence, onset and duration of civil conflicts in recipient countries. Our results suggest that the effects are larger for smaller scale civil conflicts. No effect is found on interstate warfare.

If you are starving, you can't fight?

Great thinkers in economics?

noreply@blogger.com (Paul Walker) — Sat, 28 Jan 2012 05:27:00 +0000

Palgrave-Macmillan has a book series on "Great thinkers in economics". Titles in the series include Adam Smith, Alfred Marshall, Joseph A. Schumpeter and John Maynard Keynes, about which I would think no one could complain.

But the series also includes the likes of John Kenneth Galbraith, Michal Kalecki, Joan Robinson, Piero Sraffa, Gunnar Myrdal, Nicholas Kaldor, Dennis Robertson, Franco Modigliani and Roy Harrod.

First, are these really the greatest thinkers economics has to offer? What of, for example, Menger, Jevons, Walras, Marx, Mill - both James and J.S. - Ricardo, Malthus, Mises, Hayek, Arrow, Becker, Coase, Buchanan, Tullock or Milton Friedman?

Second, isn't there a somewhat obvious Keynesian, largely Post-Keynesian, bias to the books so far published?

The nature of the firm and its financing

noreply@blogger.com (Paul Walker) — Thu, 26 Jan 2012 05:52:00 +0000

The AFA presidential address by Raghuram Rajan is now out as an NBER working paper. The abstract reads:

The nature of the firm and its financing are closely interlinked. To produce significant net present value, an entrepreneur has to transform her enterprise into one that is differentiated from the ordinary. To achieve the control that will allow her to execute this strategy, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain rights over going-concern surplus. I argue that the availability of a vibrant stock market helps the entrepreneur commit to these two transformations in a way that a debt market would not. This helps explain why the nature of firms and the extent of innovation differ so much in different financing environments.

The idea that the entrepreneur has to be replaceable is important, without this a firm would die with its founder or would die if the founder tried to leave the firm. For a firm to have any chance of outlasting its founder, the human capital of the founder has to be made replaceable.

"The quality of new music has not fallen since Napster."

noreply@blogger.com (Paul Walker) — Wed, 25 Jan 2012 23:53:00 +0000

With issues around Megaupload being in the news, this summary, by Linda Gorman, of an NBER working paper - "Copyright Protection, Technological Change, and the Quality of New Products: Evidence from Recorded Music Since Napster" - from the latest NBER Digest makes the point that "The quality of new music has not fallen since Napster."

Napster was the first widely used program that allowed music lovers to share music by exchanging MP3 files, thereby allowing millions of people to enjoy music without paying for it. Recorded music revenues plunged, raising a concern that piracy would stem the flow of good new music. In Copyright Protection, Technological Change, and the Quality of New Products: Evidence from Recorded Music Since Napster (NBER Working Paper No. 17503), Joel Waldfogel explores the possibility that technological changes in the music industry "may have altered the balance between technology and copyright law for digital products." Despite music industry claims that digital piracy harms consumers by undercutting its revenues and reducing the amount of new music that it can bring to market, he constructs indexes of music quality based on critics' best-of lists, airplay, and sales that show no evidence of a decline in music quality since Napster.

Waldfogel's first index of music quality is based on critics' retrospective lists of the best music (for example, "best of the decade"). It encompasses 88 different rankings from the United States, England, Canada, and Ireland, and covers more than 16,000 musical works from 1960 to 2007. Statistically combining information from these sources results in an overall quality index that rises between 1960 and 1970, declines through the 1980s, rises again in the mid-1990s, declines in the latter half of the 1990s, and is stable for the period after 2000. Waldfogel concludes that although the index was falling prior to the appearance of Napster, it is stable after 2000 and thus shows no evidence of a decline in quality.

His second and third indexes are derived from data on radio airplay and sales of music. Music is aired on radio less, and sells less, as it gets older; but if a vintage is better, it will receive more sales or airplay after accounting for such depreciation. Using data on the frequency with which songs originally released as early as 1960 were aired on the radio from 2004 to 2008, Waldfogel constructs an airplay-based vintage quality index suggesting that music quality rose from 1960 to 1970, fell until at least 1985, and rose substantially after 1999. The analogous sales-based index is derived from Recording Industry Association of America Gold (sales greater than 500,000 copies) and Platinum (sales greater than one million copies) certifications. The sales-based index echoes the result of other indexes: it rises from 1960 to 1970, falls to the 1980s, and then rises sharply after 1999.

Based on the movements of these three indexes over time, Waldfogel concludes that "the quality of new music has not fallen since Napster." The post-Napster flow of product appears to be as strong as or stronger than it was before Napster, with independent labels accounting for a growing share of successful albums. Although it is impossible to determine whether creative output is as high as it would have been without Napster, the evidence does not suggest that innovations in digital technology, and associated changes in effective copyright protection, reduced the quality or quantity of new music.

So the effects of technological changes in the music industry may not be as the industry would have us believe.

Odd things you read

noreply@blogger.com (Paul Walker) — Tue, 24 Jan 2012 18:05:00 +0000

I've been reading parts of Roger Backhouse's book "The Ordinary Business of Life: A history of economics from the ancient world to the twenty-first century". From what I've read thus far the book is, by and large, a good read for the general reader with an interest in the history of economic thought. But every so often you come across something strange. For example at one point Backhouse writes,

Politically, the Austrians were conservatives [...].

How you can conclude that economists like Mises, Hayek or Rothbard were conservatives I'm not sure. Mises, for example, wrote a book on "Liberalism: The Classical Tradition" while Hayek wrote a very famous essay on "Why I'm Not a Conservative". All this seems very non-conservative to me.

Later Backhouse writes,

The term 'transaction costs' was first used by Marschak in 1950, but the idea has a long history.

Actually the term was used at least 10 years before Marschak. Tibor de Scitovszky in an article - A Study of Interest and Capital - published in the journal Economica in 1940 wrote,

One reason must be liquidity preference, another, perhaps equally important one, seems to be the high transaction costs (brokerage charges, stamp duties, commissions, etc.) on long-term securities. (Emphasis added.).

The idea of transaction costs or frictions was explained by John Hicks in 1935,

The most obvious sort of friction, and undoubtedly one of the most important, is the cost of transferring assets from one form to another

Backhouse also writes that

Transaction costs are the costs of transferring ownership from one person to another.

and

Coase pointed out that activities could be organized in two ways. One is through the market. The other is by management within the firm. Both methods involve transaction costs, but the costs are different.

If the costs are different then I would think one of them isn't a transaction cost. In fact I would interpret Coase as saying only the market costs are transactions costs. In his 1937 paper "The Nature of the Firm" Coase attributed the existence of the firm to the cost of using the price mechanism and Coase's point about about firms is that they suppress the price mechanism. Costs inside a firm are management costs or some such thing.

Related, if transaction costs are defined as the costs of transferring ownership - which seems reasonable - then how can costs within a firm be transaction costs? Ownership isn't transferred within a firm.

Views change with time, even in economics

noreply@blogger.com (Paul Walker) — Mon, 23 Jan 2012 14:16:00 +0000

In his classic book "A History of Economic Analysis" Joseph Schumpeter argued that there was one general equilibrium system and Walras had given it to us.

As far as pure theory is concerned, Walras is in my opinion the greatest of all economists. His system of economic equilibrium [...] is the only work by an economist that will stand comparison with the achievements of theoretical physics. Compared with it, most of the theoretical writings of the period - and beyond - [...] look like boats beside a liner, like inadequate attempts to catch some particular aspect of Walrasian truth.

Compare this with the view, I have noted before, of a later great of the history of economic thought, Mark Blaug,

We may conclude that GE theory as such is a cul-de-sac: it as has no empirical content and never will have empirical content. Moreover, even as research programme in social mathematics, it must be condemned as an almost total failure.

The high watermark for Walrasian general equilibrium was arguably Debreu's 1959 book "Theory of Value" but is Till Duppe right when he says of Debreu’s influence today that,

[f]rom the point of view of today Debreu’s influence on the body of economics could be called zero, in that general equilibrium theory (GET) is the economics of yesterday.

The question all this raises in my mind is, If Blaug and Duppe are right then does this explain why so much of post-1970 economics, e.g. contract theory, game theory, theory of the firm, industrial organisation etc, turned its back on general equilibrium theory and has worked within a partial equilibrium framework?

For the case of contract theory Bernard Salanie has argued,

The theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well-defined institutional settings.

What will the next great writer on the history of economic thought make of the 20th century giants of the field? As far as general equilibrium theory is concerned, Will he be a supporter of Schumpeter or Blaug?

EconTalk this week

noreply@blogger.com (Paul Walker) — Mon, 23 Jan 2012 14:10:00 +0000

David Rose of the University of Missouri, St. Louis and the author of The Moral Foundation of Economic Behavior talks with EconTalk host Russ Roberts about the book and the role morality plays in prosperity. Rose argues that morality plays a crucial role in prosperity and economic development. Knowing that the people you trade with have a principled aversion to exploiting opportunities for cheating in dealing with others allows economic actors to trust one another. That in turn allows for the widespread specialization and interaction through markets with strangers that creates prosperity. In this conversation, Rose explores the nature of the principles that work best to engender trust. The conversation closes with a discussion of the current trend in morality in America and the implications for trust and prosperity.

The DIY economy

noreply@blogger.com (Paul Walker) — Thu, 19 Jan 2012 04:20:00 +0000

The standard neoclassical (Arrow-Debreu) approach to general equilibrium has been criticised by many economists, for many reasons. Mark Blaug, for example, has written,

We may conclude that GE theory as such is a cul-de-sac: it as has no empirical content and never will have empirical content. Moreover, even as research programme in social mathematics, it must be condemned as an almost total failure.

When looking at the production side of the model a common criticism made is that the model has not reason for the existence of firm. As Foss, Lando and Thomsen summarise it:

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

Nicolai Foss uses a few less words to make this point when he notes

With perfect and costless contracting, 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.

In other words the neoclassical model is DIY on steroids!!

Interestingly, in addition to the above comment on GE Mark Blaug notes that the fictional auctioneer famous from Walras's model of general equilibrium isn't in fact due to Walras.

[..] Walras never mentioned the concept of a fictional auctioneer announcing and changing prices until an equilibrium price is agreed upon - this is one of those historical myths that subsequent generations invented [..]

One wonders who invented the idea.

EconTalk this week

noreply@blogger.com (Paul Walker) — Mon, 16 Jan 2012 12:36:00 +0000

Nassim Taleb, author of Fooled By Randomness and The Black Swan, talks with EconTalk host Russ Roberts about antifragility, the concept behind Taleb's next book, a work in progress. Taleb talks about how we can cope with our ignorance and uncertainty in a complex world. Topics covered include health, finance, political systems, the Fed, your career, Seneca, shame, heroism, and a few more.

When is a contract incomplete?

noreply@blogger.com (Paul Walker) — Sun, 15 Jan 2012 13:20:00 +0000

Things you think about over a sunny weekend.

One way to think about the different types of contracts modelled in contract theory is to divide contract theory into three groups: complete contacts, comprehensive contracts and incomplete contracts. Complete contracts are those which are written in a zero transaction cost, Arrow-Debreu type, world. Such contracts can be made continent on all variables in all states of the world. They result in the first-best being achieved in all states of world. Comprehensive contracts are those written under conditions of asymmetric information, that is, in a world with moral hazard and/or adverse selection. Such contracts are "constrained optimal" in that they are optimal given the existence of the information asymmetry. Comprehensive contracts maximise the objective function of the agent subject to the informational constraint. Incomplete contracts do not maximise the objective function of the agent, they result in "money being left on the table", even taking into account any informational asymmetries. A standard incomplete contracts model will be a symmetric information model and thus neither moral hazard or adverse selection are driving the model's results. The issue for incomplete contracts is generally argued to be one of "non-verifiability" rather than asymmetric information. That is, the informational problem with incomplete contracts is between that contracting parties and the courts rather than between the contracting parties themselves, as in asymmetric information models.

In the law and economics literature it is argued that there are two forms of incompleteness: obligationally incomplete [OI] and informationally incomplete (or insufficiently state contingent) [II] contracts. A contract is obligationally incomplete if it does not fully describe the obligrations of each party in every state of the world. That is, the contract has a "gap" and thus will be silent on what should happen in any state of the world which falls within the "gap". The problem here is why should a contract be ever be obligationally incomplete since it should be possible to complete a contract with an obligration that applies to a broadly enough defined set of contingencies at a reasonable cost. A contract is informationally incomplete if it fails to describe an efficient set of obligations in each possible state of the world. As Oliver Hart puts it

[...] the contract might not specify what is to happen if the supplier's factory burns down, because this is not anticipated [OI]; or the contract might say that the supplier must always supply one widget, rather than a number of widgets that varies with the state of the world, because it is too costly to distinguish between different states of the world [II].

A problem here is that if a contract with an inefficient set of obligations specified is incomplete then why are asymmetric information contracts not incomplete?

Eric Maskin writes that

I will consider a contract to be “incomplete” if it is not as fully contingent on the state of the world” (the resolution of uncertainty about the future) as the parties to the contract might like it to be.

This seems to mean that asymmetric information contracts are incomplete. But in a footnote Maskin says

This definition is so broad that it covers many contracts in the literature that are not normally considered "incomplete", e.g., insurance contracts with adverse selection.

So moral hazard and adverse selection contracts are not, it seems, incomplete contracts. The issue is that asymmetric contracts are verifiable, the variable on which the incentive contract is written is assumed to be observable and verifiable so that the courts can fully enforce the contract. As noted above the standard assumption for incomplete contracts is that they are incomplete because some relevant variable is not verifiable, to the courts. Another way to look at this is that if performance of the terms of a contract would result in the gains from trade not being fully exploited, given the information that the contracting parties and the courts have available to them at the time performance takes place, then the contract is incomplete. Under the assumptions of complete or comprehensive contracting any gains from trade available are always exploited to the fullest extent possible.

But the assumption of non-verifiability has its own problems as Maskin and Tirole have pointed out. Maskin and Tirole argue that information which is observable to the contracting parties (symmetric information) can be made verifiable (to a third party) by the use of ingenious revelation mechanisms. The contracting parties write into their contract a game which when played gives the appropriate incentives for them to truthfully reveal their private information in equilibrium. This undermines the non-verifiability approach to incomplete contracts.

To deal with the Maskin and Tirole critique, Hart and Moore developed the 'reference point' approach to incomplete contracts. Very briefly the Hart and Moore reference point theory argues that when the parties meet at date 0 there is uncertainty about the state of the world. This uncertainty is resolved shortly before date 1. There is symmetric information throughout, but the state is not verifiable. A date 0 contract serves as a reference point for the contracting parties' feelings about entitlements at date 1. Specifically, neither party feels entitled to an outcome outside those permitted by the contract but within the contract there can be disagreement about the appropriate outcome. To simplify matters, it is supposed that each party feels entitled to their best possible outcome permitted by the contract. Of course, this means that usually at least one party will be disappointed or "aggrieved" by any particular outcome. Hart and Moore assume that no outcome from a transaction is perfectly contractible even at date 1. In particular, they assume that each party has the discretion to provide "perfunctory" performance rather than "consummate" performance. Performing at the lower perfunctory level rather than the higher consummate level is referred to as shading and it is assumed that shading cannot be penalised by a court. A court can, however, enforce the perfunctory level of performance. When a party is aggrieved he shades, by an amount theta times his level of aggrievement where 0< theta <=1. Consummate performance does not cost significantly more than perfunctory performance to whomever is providing the good or service, and a party will provide consummate performance if he feels "well treated" but not otherwise. Shading hurts the other party and causes a deadweight loss. The important point here is that the reference point approach does not suffer from the Maskin and Tirole critique but get around it by introducing a number of ad hoc behavioural assumptions, e.g. aggrievement and shading.

After all of this we find that M'hand Fares argues that the difference between complete and incomplete contracts is not verifiability at all but the ability to commit to not renegotiating the initial contract.

In the controversy on the theoretical foundations of the property rights approach, Hart and Moore [...] and Maskin and Tirole [...] point out that a key distinction between complete and incomplete contracting is the ability of risk neutral parties to commit not to renegotiate the initial contract. The renegotiation design issue in contract solutions to the hold-up problem restates this view in a more general fashion as a contrast between (i) a world where contract can determine the entire relationship between the parties and (ii) a world where contract can only influence an existing underlying game between them, that is, the renegotiation game. This implies that the capacity of a contract to influence this game defines its 'incompleteness' or 'degree of incompleteness' [...]: the more a contract is able to design the renegotiation game, the less it is incomplete.

So in the end we are left with Jean Tirole's point that,

[f]or all its importance, there is unfortunately no clear definition of "incomplete contracting" in the literature. While one recognizes one when one sees it, incomplete contracts are not members of a well-circumscribed family; at this stage an incomplete contract is rather defined as an ad hoc restriction on the set of feasible contracts in a given model. The concept of "ad hoc restriction" is of course subjective: to give it some content, we will [...] take the standard approach to contract theory as the benchmark. The methodology developed in the last thirty years to treat moral hazard, adverse selection, and implementation problems provides a well-defined delineation of the set of feasible outcomes by incentive constraints. Incomplete contracting then relates to a focus on a subset of feasible outcomes through the imposition of restrictions on the set of allowable contracts.

Thus I'm left asking, When is a contract incomplete?

Peter Boettke on Austrian Economics

noreply@blogger.com (Paul Walker) — Sun, 15 Jan 2012 13:17:00 +0000

Professor Pete Boettke of George Mason University was recently interviewed by "The Browser" on Austrian Economics.

A take home message:

Analytically, the biggest difference between the Austrians and their mainstream brethren is a focus on processes of adjustment and changing conditions, as opposed to static or equilibrium states of affairs. In a supply and demand curve, a standard economist would focus on the price and quantity vector that would clear the market. The Austrians want to talk about all the exchanges and activity that take place that results in that vector being discovered and the market being cleared.

Imagine if refrigeration wasn’t an option and you had some fish to sell. You start selling them at $10 a fish, and this many people buy the fish. After a while it slows down and you still have some fish remaining. As the day wears on you’re trying to get rid of the fish because they’re going to spoil. So you adjust your price down, you sell it at $8 a fish, or $6 a fish or $5 a fish. Eventually the market clears and all the fish find a buyer. In standard economics, we talk about the price and quantity vector that would clear that market, and the formal techniques of economics – a series of simultaneous equations – would get us to that vector. The Austrians don’t disagree with that price and quantity vector. But they want to talk about all the activity, a lot of which is what we call entrepreneurship – people adjusting the price, arbitrage opportunities and so on. Eventually you get to that vector, but your focus isn’t on the vector, it’s on all the stuff that goes on before it’s discovered.

EconTalk his week

noreply@blogger.com (Paul Walker) — Tue, 10 Jan 2012 00:55:00 +0000

Dean Baker of the Center for Economic Policy and Research talks with EconTalk host Russ Roberts about the financial crisis. Baker sees the crisis as part of a broader set of phenomena--rising inequality and declining unionization. Baker is highly critical on both economic and political grounds of the policy attempts to stimulate the economy as well as the governance structure of the Federal Reserve. The conversation closes with a discussion of potential innovations to lower the budgetary cost of health care.

Partical privatisation good, full privatisation better

noreply@blogger.com (Paul Walker) — Fri, 06 Jan 2012 02:23:00 +0000

Given that the current government wants to partially privatise several SOEs the question to ask is, What effect will this have on firm performance? Some insight into this question is offered by a recent paper in the Scottish Journal of Political Economy (Volume 59, Issue 1, pages 1–27, February 2012). The paper "What Drives the Operating Performance of Privatised Firms?" by Laura Cabeza García and Silvia Gómez Ansón argues that the greater the amount of privatisation the better the performance of the firm. Not an entirely surprising result as the full force of market discipline can only be applied if the firm is fully in private hands but it is something for the government to keep in mind. It would suggest that any performance improvements due to the government's privatisation plans will be modest.

The abstract reads,

Using a panel data analysis of Spanish privatised firms, we study how different factors influence the operating performance of divested companies. The results show that it is not privatisation per se but other factors that matter. After controlling for possible sample selection bias related to government timing of divestments, we find that the greater the relinquishment of State control and the smaller the percentage of ownership held by managers and/or employees, the better the firms’ post-privatisation performance. Moreover, privatisations that are accompanied by liberalisation programmes and occur during buoyant economic cycles turn out to be more successful. (Emphasis added.)

EconTalk this week

noreply@blogger.com (Paul Walker) — Thu, 05 Jan 2012 06:11:00 +0000

Scott Sumner of Bentley University and the blog The Money Illusion talks with EconTalk host Russ Roberts about the state of monetary policy, the actions of the Federal Reserve over the past two years and the state of the economy. Sumner argues that monetary policy has been too tight and helped create the crisis. He disputes the relevance of the so-called liquidity trap and argues that aggressive monetary policy is both possible and desirable. The conversation closes with a discussion of what we have learned and failed to learn during the crisis.

Happy birthday Ronald Coase

noreply@blogger.com (Paul Walker) — Fri, 30 Dec 2011 01:22:00 +0000

Coase was born at 3:25 p.m. on December 29th, 1910 in a house in Willesden, a suburb of London so he now a young and sprightly 101!

Coase received the 1991 Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel

“for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy”

In its press release on Coase’s Nobel award, The Royal Swedish Academy of Sciences makes mention of only two papers: "The Nature of the Firm" and "The Problem of Social Cost". It is largely on these two contributions to the theory of the firm and the theory of externalities that Coase’s rightful claim to be the greatest economist of the 20th century is based.

Incentives matter: marketing file

noreply@blogger.com (Paul Walker) — Wed, 28 Dec 2011 02:58:00 +0000

Thanks to Tim Worstall for this wonderful example of a bad marketing promotion and the rational response to it.

To introduce you to a little bit of English English. To “do a Hoover” is not exactly everyday language, even here, but it will be understood by those discussing retail promotions. It means doing something sufficiently silly that it ends up enraging your customers, costs you a lot of money and in general is entirely counter-productive. You may have started off trying to sell more goods and thus making more profit but that’s not quite the way it turns out.

It comes from what the UK subsidiary of Hoover did back in 1992. In order to sell more of those machines that suck the dirt out of your carpet (a “spangler” we might say) the company decided that anyone who bought more than £100 worth of the company’s goods would be entitled to two free roundtrip air tickets.

Seeing that sales did go up they decided to expand the offer, to two roundtrip tickets to the US. Which is where the roof really started falling in. For instead of simply accelerating future purchases, moving them from the future to today (this was a time of severe recession in the UK so that could have been a decent tactic), or transferring sales from competitors to Hoover, what was actually happening was that people who wanted to visit the US bought a sucking machine.

In fact, the classifieds sections of local papers across the country began to fill up with new, unused but very cheap Hoovers. For what the promoters of the scheme seemed to have missed was that the value of two roundtrip tickets (from memory, at the time, perhaps £300 to £400) was rather larger than the amount they were asking people to spend with the company.

So, rational beings that people are, people were buying the Hoover as a cheap way of getting the tickets. Chaos obviously ensued, it became very difficult to actually cash in on the offer (they had not limited it to the first 1,000, or 10,000) and Hoover was desperately running around trying to book cheap flights from the airlines. Who, of course, knowing that they had them over a barrel, were not playing ball.

In the end this cost the company £50 million (yes, even in our funny money, quite a significant sum) the people responsible were fired and Hoover US sold off the UK company to some Italians. The court cases were still rumbling on years later.

EconTalk this week

noreply@blogger.com (Paul Walker) — Tue, 27 Dec 2011 20:25:00 +0000

Alex Tabarrok of George Mason University talks with EconTalk host Russ Roberts about his new book, Launching the Innovation Renaissance. Tabarrok argues that innovation in the United States is being held back by patent law, the legal system, and immigration policies. He then suggests how these might be improved to create a better climate for innovation that would lead to higher productivity and a higher standard of living.

Productivity does matter

noreply@blogger.com (Paul Walker) — Thu, 22 Dec 2011 02:36:00 +0000

From Mark Perry at the Carpe Diem blog:

According to new data just released by the United Nations, China surpassed the United States in 2010 to become the world's No. 1 manufacturing nation, ending America's dominance as the world's largest manufacturer since the late 1800s (see chart above of the top five manufacturing countries). China's manufacturing output in 2010 of $19.222 trillion and 18.89% share of world manufacturing output of $10,176 trillion,was slightly ahead of America's manufacturing output of $1.855 trillion and 18.24% share of global manufacturing production.

But note:

China's manufacturing workforce is estimated to be around 100 million and could be as high as 120 million, compared to America's manufacturing employment of about 11.5 million. Therefore, China is producing roughly the same manufacturing output as the U.S. but Chinese worker productivity is so low it needs 9-10 workers for every one American factory worker.

So China's workforce is huge and not very productive, but cheap.

Even though China is now the world largest manufacturer, its GDP per capita of only $2,800 (data here from the USDA) is just now reaching a level of output per person that the U.S. achieved back in 1878, 133 years ago.

Put simply having low productivity results in low income per capita. Paul Krugman makes the point when he writes,

Economic history offers no example of a country that experienced long-term productivity growth without a roughly equal rise in real wages. In the 1950s, when European productivity was typically less than half of U.S. productivity, so were European wages; today average compensation measured in dollars is about the same. As Japan climbed the productivity ladder over the past 30 years, its wages also rose, from 10% to 110% of the U.S. level. South Korea's wages have also risen dramatically over time. ("Does Third World growth hurt First World Prosperity?" Harvard Business Review 72 n4, July-August 1994: 113-21.)

Thus in the battle to improve wages and the standard of living, China (and New Zealand) must improve its productivity.