Paul Walker

Dr Paul Walker is an economist at University of Canterbury. He has expertise in microeconomics, institutional economics and industrial Organization. He blogs for The Dismal Science.

50 years of “A Behavioral Theory of the Firm” - The Dismal Science

Apr 29, 2013

In his latest weekly newsletter from economicprincipals.com David Warsh writes about attending a program celebrating the fiftieth anniversary of the publication of A Behavioral Theory of the Firm by March and Richard Cyert. Warsh says,

The corporate landscape today is, of course, all but unrecognizable compared to what it was when March and Cyert wrote in 1963. The outlines of any number of vivid company stories loomed as I listened to the panels and papers at the conference. In fact, a bountiful new field of organizational economics has grown up in the nexus of the interest in organizations that March shared with Kenneth Arrow, Ronald Coase, Oliver Williamson, Herbert Simon and Sidney Winter.

That field was an empty lot when March started, not long after finishing his PhD, at Yale. A Behavioral Theory of the Firm was a broadside aimed at standard textbook economics, especially the branch of it known as the theory of the firm. The book begins,
The “firm” of the theory of the firm has few of the characteristics that we have come to identify with actual business firms. It has no complex organization, no problems of control, no standard operating procedures, no budget, no controller, no aspiring “middle management.”
In fact the neoclassical model can be seen as a model with no firms at all! As Nicoli Foss remarks,
“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”.
The ‘Behavioural models’ of the firm have been developed since the 1950s. In these models it is assumed that there is a separation between ownership and control. Behavioural theorists consider the consequences of conflict between self-interested groups within firms for the way in which firms make decisions on price, output etc. The emphasis in these models is on the internal relations of the firm with little attention being paid to the external relations between firms.

Although some of the seminal work on the behavioural theories can be traced back to work by Herbert Simon in the 1950s, the theory has largely been developed by Cyert and March, in their book A Behavioral Theory of the Firm, with whose names it has been connected right up to today.

In behavioural theory the corporation has a multiplicity of different goals. Ultimately these goals are set by top management via a continual process of bargaining between the groups within the firm. An important point here is that the goals take the form of aspiration levels rather than strict maximisation constraints. Attainment of the aspiration level ‘satisfices’ the firm: the behavioural firm’s behaviour is ‘satisficing’ in contrast to the maximising behaviour of the traditional firm. The firm seeks levels of profits, sales, rate of growth etc that are ‘satisfactory’, not those that are maxima. Satisficing is seen as rational behaviour given the limited information, time and computational skills of the firm’s management. The behavioural theory redefines rationality, rationality is now that of ‘bounded rationality’.

Cyert and March argue that there are two sources of uncertainly that a firm has to deal with. The first is uncertainty that arises from changes in market conditions, that is, from changes in tastes, products and methods of production. The second is uncertainty arising from the behaviour of competitors. According to the behavioural theory the first form of uncertainty is avoided, as much as it can be, by search activity, by spending on R&D and by concentrating on short-term planning. A difference between the traditional and behavioural theories is the importance given in the behavioural theory to the short-run, at the expense of the long-run. To avoid competitor-originated uncertainty, Cyert and March arguethat firms operate within a ‘negotiated environment’, that is, firms act collusively with their competitors.

The instruments the behavioural firm uses in decision-making are the same as in the traditional theories. Both theories consider output, price and sales strategy as the major instruments. The difference between the theories lies in the way firm choose the values of these instruments. In the neoclassical theory such values are selected so to maximise long-run profits. In the behavioural theory the choice is made so that the outcome is the ‘satisficing’ level of sales, profits, growth etc. The behavioural theory also assumes that the firm learns from its experience. In the beginning a firm isn't a rational institution in the neoclassical sense of ‘global’ rationality. In the long run the firm may tend towards global rationality but in the short run there is an important adaptive process of learning. Firms make mistakes, there is trial and error from which the firm learns. In a sense the firm has memory and learns via its past experience.

An aspect of the firm neglected by the traditional theory is the allocation of resources within the firm and the decision-making process that leads to that allocation. In the neoclassical theory the firm reacts to its environment, the market, while the behavioural theory assumes that firms have some discretion and do not take the constraints of the market as definite and impossible to change. The important point here is that the behavioural theory looks at the mechanisms for the allocation of resources within the firm, while the neoclassical theory examines the role of the market, or price, mechanism for the allocation of resources between the different sectors of the economy. The concept of of ‘slack’ is used by Cyert and March to refer to payments made to groups within organisation over and above that needed to keep that group in the organisation. Slack is therefore the same as ‘economic rent’ accruing to a factor of production in the traditional theory of the firm. What is significant about the behavioural school is their analysis of the stabilising role of ‘slack’ on the activities of the firm. Changes in slack payments in periods of good and bad business means that the firm can maintain its aspiration levels despite the changes to its environment.

The behavioural theories can be seen as an early attempt to develop a theory of the firm at the level of the individual firm, a theory which, as Oliver Williamson has said of the Cyert and March (1963) book, was an attempt to “pry open what had been a black box, thereupon to examine the business firm in more operationally engaging ways”. But the success of this attempt was limited in economics. Williamson’s interaction with people such as Herbert Simon, Richard Cyert and James March while he was at Carnegie-Mellon University did play a role in the development of the transaction cost theory of the firm but outside of this the behavioural/managerial theories have had little effect on the mainstream economic theories of the firm. Consider the representation of the firm in standard microeconomics textbooks. If you look at both undergraduate and graduate microeconomics textbooks, it is difficult to find a discussion of behavioural or managerial models. Koutsoyiannis (1979) is one of the few that gives serious attention to these models, and it is now more than 30 years old.

In fact the impact of the behavioural theories may have been greater in management than economics. Argote and Greve claimed in a 2007 paper that A Behavioral Theory of the Firm “continues to be one of the most influential management books of all time”.

Interesting blog bits - The Dismal Science

Apr 26, 2013

A debate on efficient/inefficient institutions.

  • Pirate Democracy? Acemoglu and Robinson argue that democracy arises when nondemocratic elites are forced to cede power to the previously disenfranchised and not as a way to solve some inefficiency. Acemoglu and Robinson claim that this view that democracy solves an inefficiency, a view referred to as the “efficient institutions view”, is wrong but underlies Peter Leeson's view of pirate democracy. In Acemoglu and Robinson's view pirate democracy is better explained in terms of power.
  • Why did Pirates Choose Democracy? Peter Leeson replies to Acemoglu and Robinson. Leeson says Acemoglu and Robinson are right to characterise his view of pirate institutions as efficient. Leeson claims that pirates choose a system of democracy and separated powers to solve a principal-agent problem, to stop abuse of power by their captains and Leeson says the evidence shows this.
  • Efficient Organization among Pirates? Acemoglu and Robinson counter that they find the general presumptions upon which the efficient institutions view rests fairly unconvincing. What are exactly the forces that will ensure that institutions are efficient? And efficient for whom? Note that legitimate ships, 18th-century merchantmen, from which pirates were drawn were not democratic, but pirates were, Why?. If democracy was efficient for pirates, why not for merchantmen too?
  • Efficient Institutions are Context Dependent. Leeson replies that democracy’s cost was far higher for merchantmen than for pirates. Merchantmen were organized and outfitted by external financiers—wealthy landlubbers who had commercial expertise and capital, but weren’t sailors and thus hired seamen to sail their ships. To make sure crewmembers didn’t shirk, embezzle cargo, or steal the vessels they sailed on in owners’ absence, owners appointed officers to monitor and control them. Allowing crewmembers to democratically elect their officers instead would’ve been extremely costly in this context. Merchant sailors who could choose their officers democratically would have an incentive to elect the opposite kind of officer from what owners wanted—the kind of officer who would let sailors do whatever they pleased, destroying voyages’ profitability. Pirate ships, in contrast, weren’t organized or financed by external landlubbers. Pirates stole their vessels jointly: they were both the owners and employees of their ships. Because of this, democracy’s major potential cost on merchantmen—the prospect of crewmembers electing lax officers and thus undermining voyages’ profitability—was absent on pirate ships. Pirates who elected lax officers, qua employees, would’ve undermined their own interest, qua owners. Their incentive was therefore to elect the kind of officer that maximized profit. Consequently, for pirates, democracy was cheap

What use is a graduate programme? - The Dismal Science

Apr 24, 2013

Recently when thinking about developments in university education Bill Kaye-Blake asked What’s the point of academic research? Is it to be 'critic and conscience of society' or is it to 'advance knowledge and understanding'? Or both? Whatever the answer, the results of research are certainly one of the two major outputs of universities. The second main output of a university relates to the results of teaching, both undergraduate and graduate, students of the institution. With regard to teaching I wish to ask, What use is a graduate programme?

What does a university department need to be be serious? Can a department live without a graduate programme? If a department within a university didn't have such a programme what effect would it have on that department? How would the department hold current staff and how would it attract new staff? What effect would it have on students?

In terms of student numbers obviously you would lose all your graduate students, but if you are planning to do away with a grad programme I guess it would be because it didn't have many students to begin with so it wouldn't be a great loss, as far as the bean-counters are concerned. One may argue that a small but high quality programme is worth keeping on grounds of quality rather than quantity. Can graduates of the programme get good jobs in good places, can they succeed in good overseas Ph.D. programmes?

But what effect would the closure of a graduate programme have on undergraduate student numbers? If you can't do a graduate degree at a given university you have to ask, Why do an undergraduate degree there? Given that you are going to have to move to another university for grad school why not just move to the second university for your undergrad degree as well? Importantly in New Zealand, unlike for example the U.S., an undergrad degree in the subject you want to do grad work in is normally assumed so there is a more direct link between undergraduate degrees and graduate degrees in the New Zealand system. This means moving universities is more difficult since your undergrad training may not integrate easily into the grad programme you are moving to. This gives students an incentive to do their undergrad and grad work at the same university. For some subjects this may not matter much since an undergraduate degree is the terminal degree, e.g. engineering,  but for others, e.g. clinical psychology or economics, where an advantaged degree is necessary for employment it matters more.

So if you only teach undergrads you have to teach in such a way as to have your students be able to move to any other university in the country for their graduate work. This is not a simple issue to deal with given the differences in what is assumed about students backgrounds in different graduate programmes. Knowing that student have to leave their current institution to do graduate work gives other institutions an incentive to head-hunt the best of the local students thereby damaging the local undergraduate programme.

Thus there are push factors making students want to leave an institution without a postgrad programme and there will be pull factors as well as other universities try to attract good undergraduate students. If this results in a falloff in undergraduate students, certainly it will not help undergraduate numbers, it could be to the point where the undergraduate programme is also seen by management as unsustainable.

Knowing this can a move by university administrators  to close a department's graduate programme just be seen as a signal that they want an excuse to close the department itself?

Do entrepreneurs matter? - The Dismal Science

Apr 23, 2013

According to Sascha O Becker and Hans K. Hvide over at VoxEU.org the short answer is yes.

Becker and Hvide write

Governments try to boost competitiveness through a vast array of policies. Newly founded firms have the potential to give new impetus to an economy. The question arises: what matters more, the horse (i.e. the products) or the jockey (i.e. the owner-manager) in the life of young firms? Do entrepreneurs matter and should they be encouraged by economic policy? Few empirical studies focus on how entrepreneurs affect the performance and value of firms (see Syverson 2011). If entrepreneurs personally embed a major part of the value of the firm, it will be difficult to pledge the value of the firms to outside investors, which in turn leads to liquidity constraints and underinvestment in entrepreneurial firms (as in Hart and Moore 1994).
Brynjolfsson (1994) and Rabin (1993) are additional papers which highlight the problems that reliance on human capital can have for the development of firms. While the Brynjolfsson model is distinct from the Rabin model, they are complementary. The relationship between information, ownership and authority is central to both papers. Rabin works within a framework utilising an adverse selection model and shows that the adverse selection problems can be such that, in some cases, an informed party has to take over the firm to show that their information is indeed useful. The Brynjolfsson model is a moral hazard type framework which deals with the issue of incentives for an informed party to maximise uncontractible effort.

Brynjolfsson argues that the increased importance of information technology will result in reduced integration and smaller firms insofar as this increased reliance on IT leads to better informed workers, who need incentives; enables more flexibility and less lock-in in the use of physical assets, and allows direct coordination among agents, reducing the need for centralised coordination. On the other hand, the Brynjolfsson framework suggests that more integration will result from information technology where network externalities or informational economies of scale support the centralised ownership of assets, and it facilitates the monitoring, and thus contractibility, of agent’s actions. Clearly in any given case more than one of these phenomena may be important.

Within the Rabin framework it is suggested that firms are more likely to trade through markets when informed parties are also superior providers of productive services that are related to their information. But if, on the other hand, information is a firm’s only competitive advantage, it is likely to obtain control over assets, possibly by buying firms that currently own those assets.

Becker and Hvide argue that human capital/personalities are important for firms. Looking into the death of a firm’s founder during the first ten years of a company’s existence, the data suggest that entrepreneurs matter – they are the ‘glue’ that holds a business together.
We expected businesses that experienced the death of a founder-entrepreneur to have some kind of a dip in performance immediately after the death owing to the upheaval, but we anticipated there would be a bounce back. However, the results were quite surprising. Even four years after the death, most firms show no sign of recovering and the negative effect on performance appears to continue even further beyond that, [...]

A simple explanation for our findings could be reverse causality: poor firm performance leads to entrepreneurs having a higher probability of dying. To deal with this possibility, we look at whether there are pre-treatment differences between treated and matched controls. We do not find evidence of pre-treatment effects, [...]. This suggests that reverse causality is not a major force behind our findings.

For how long in a firm's life does the entrepreneur matter? The very youngest companies suffered most after the founder’s death, but significant effects were still felt by companies that were up to ten years old. The degree of ownership the founder had retained matters. The death of a founder with a 50% stake had about half the impact of losing a founder who had retained a majority shareholding. The level of formal education of the founder also showed a strong correlation with the damage that person’s death could have. Those with the most highly educated founders experienced the largest drops in sales performance after the founder’s death. There was no difference between the results for family and non-family companies, between rural and urban businesses, or when comparisons were made between different sectors.

It could simply be that the founder was a fantastic sales person who generated a disproportionately high level of sales. On the other hand, it could be down to a leadership effect, where the founder-entrepreneur inspires the employees to perform as best they can and without the presence, that drive slips away.

Possibly, entrepreneur death induces a voluntary shutdown by heirs of unprofitable firms that provided the entrepreneur with private benefits, so that there is no social loss. Using quantile regressions, we find strong negative effects of entrepreneur death on sales and assets also among successful firms. The bankruptcy code in Norway is similar to Chapter 7 in the US bankruptcy code, i.e., bankruptcy is associated with creditors taking control and is not 'voluntary' as in Chapter 11 in the US bankruptcy code. We find that firms where the entrepreneur dies have twice the probability of going bankrupt. This, again, is evidence supporting that entrepreneurs create value.

Another concern is that many firms in our database are very small, and possibly motivated by providing tax or private benefits to the entrepreneur.

Fortunately, a substantial fraction of firms in our database are not tiny, even in the first year – the 75th percentile for book value of assets and number of employees in the first year of operations is about $400,000 and four, respectively.
The conclusions of the article are
All our results are consistent with a simple mechanism: entrepreneurs personally embed a major part of the value of the firm, and the entrepreneur vanishing has a large negative impact. The death of the founder appears to shift the firm outcome distribution to the left. For firms in the lower part of the outcome distribution, the consequence is a higher probability of closing down, while for firms higher up in the quality distribution, the effect will be a significant reduction in firm growth.
Refs:
  • Brynjolfsson, Erik (1994). ‘Information Assets, Technology, and Organization’, Management Science, 40(12): 1645-62.
  • Hart, O and J Moore (1994), 'A Theory of Debt Based on the Inalienability of Human Capital', Quarterly Journal of Economics, 109, 841-879.
  • Rabin, Matthew (1993). ‘Information and the Control of Productive Assets’, Journal of Law, Economics, and Organization, 9(1) Spring: 51-76.
  • Syverson, C (2011), “What Determines Productivity?”, Journal of Economic Literature 49, 326-365.

Adam Smith: a man of the left or right? (updated) - The Dismal Science

Apr 18, 2013

I shall put aside the obvious response that since the left/right distinction developed from the political divisions of the French Revolution and Smith died in 1790 it is somewhat pointless to think about Smith in terms that had no meaning in his time and concentrate instead on the recent trend in Smith studies that concerns itself with the extent to which Smith’s ideas can be distanced from the more vociferous of his free market admirers such as Milton Friedman, James Buchanan and F.A. Hayek. In the field of political economy there has developed a line of argument that sees Smith’s ideas associated not with the right or liberal (or libertarian for any Americans reading this) concerns but with the contemporary left’s concerns with fairness, equality and social justice.

In a forthcoming article (“Adam Smith: Left or Right?”) in the journal Political Studies well-known Adam Smith scholar Craig Smith writes

Amartya Sen (2009) has drawn inspiration from Smith in developing his own theory of social justice and Samuel Fleischacker (2004) has made the case for reading Smith as a precursor of modern notions of social justice. Iain McLean (2006), on the other hand, makes the stronger claim that Smith’s true legacy lies, not with the libertarian economists of the Adam Smith Institute, but rather with the social democrats of the John Smith Institute. In all three cases the broad claim is that there are grounds for associating Smith with the modern egalitarian idea of social justice understood as the state-backed redistribution of wealth to ameliorate the effects of poverty.
Smith expands on this by saying,
Fleischacker offers perhaps the most detailed version of the argument under consideration. He admits that Smith wrote in a period prior to the modern notion of distributive justice and that this leads Smith to consider justice in the commutative sense favoured by the natural law tradition, but he goes on to argue that Smith helped to point the way towards the notion of distributive justice that animates the contemporary left (Fleischacker, 2004, p.213).Fleischacker accepts that there are both libertarian and egalitarian themes in Smith’s work and that he can thus be read as providing a legacy fo both contemporary positions (Fleischacker, 2004, p. 19), but in his view Smith’s abiding concern for the poor brings him closer in spirit to the contemporary left (Fleischacker,2004,p.265). Fleischacker’s argument is based on the idea that Smith does not operate with an absolute and pre-social, moralised notion of property rights and that as a result of this Smith has no principled reason to consider it unjust to use ‘redistributive taxation to help the poor’ (Fleischacker, 2004, p. 145). What replaces the principled objection in this reading is a case-by-case assessment of the likely success of particular government attempts to alleviate poverty with a presumption against the likely success of such activity drawn from Smith’s distrust of the political process. This leads to a‘Smithian’state which,while unlikely to be as extensive as the modern welfare state (Fleischacker,2004,p.236),is nonetheless open to the use of politics to pursue the goals of egalitarian distributive justice. Fleischacker then argues that the contemporary left has much to learn about the pursuit of its goals from Smith’s criticism of state bureaucracies and his stress on competition.
Craig Smith argues against those who would claim Adam Smith for the left, in terms of an adherence to social justice, by explaining,
[...] that not only would Smith have been dubious about the modern conception of social justice, but that he actually takes care to draw a conceptual distinction between his notion of justice and the sort of redistributive and welfare programmes that we understand under the vague catch-all notion of social justice. My point is not that Smith was unconcerned with the situation of the poor; it is rather that he makes a quite clear philosophical distinction between this concern and the concept of justice. I want to claim that we should not dismiss this distinction as merely a feature of the language that Smith inherited from his predecessors. Instead I want to take his attempt at conceptual clarity seriously and suggest that the normative distinctions Smith draws might prove to be a further lesson for the contemporary left in addition to the empirical and social theoretical points that Fleischacker concedes (Fleischacker, 2004, p. 226). Put another way, for the purposes of this article it does not matter how much of a role Smith allowed for deliberate attempts to ameliorate the effects of poverty; what matters is that he does not conduct this discussion in terms of justice.
In the conclusion to his paper Smith argues that in Adam Smith's ideas we see the existence of a sphere of devolved (local level) human activity distinct from the political concerns of the state. Craig Smith continues,
The proper conceptual vocabulary for this sphere then is clearly distinct from the vocabulary both of justice and of beneficence. Justice has its place in Smith’s vision of society, but that place is specific and limited and this must surely give us pause in attempting to relate Smith’s thought to modern conceptions of social justice. Indeed, at least one conclusion that might be drawn from the reading presented here is that, far from offering us a theory or even an inspiration for a theory of social justice, Smith actually gives us good grounds to want to keep some conceptual distance between ideas of justice, police and beneficence. That he is wary of any automatic reliance on the political process and the state to pursue our social objectives is admitted even by those such as Fleischacker who want to reclaim Smith for the left. As Fleischacker (2004, p. 241) also admits, this points us toward a presumption against the state and a presumption in favour of private action by voluntary associations of individuals. But if this is the locus for the exercise of beneficence and the provision of public works then we are dealing with something very different from the modern debates about intra-national transfers or even international transfers and distributive patterns.
Craig Smith goes on to say that what this implies for a ‘Smith-based’ notion of distributive or social justice is clear,
we should take more seriously Smith’s silence on modern distributive justice, his desire to place conceptual distance between beneficence and justice, his distrust of the political process and his temperamental distaste for utopianism. And we should pay more attention to his localist, prudential category of police and his desire to press a normative distinction between strict principles of justice and political or beneficent decisions guided by expediency. These are not accidental aspects of Smith’s thinking, however imperfectly they are carried over into his own policy prescriptions. They suggest a very different understanding of the normative ideal of justice and one that might actually give us good reasons to doubt the efficacy of thinking about our moral obligations to the poor and welfare provision in terms of social justice.
When thinking of our moral obligations a related question about Adam Smith’s thinking is raised by Maria Pia Paganelli in a chapter forthcoming in the Oxford Handbook on Adam Smith. Paganelli asks why Smith promotes free markets and argues that he promotes them for at least two reasons: efficiency and morality. In terms of morality Paganelli argues that Smith thought that markets can foster morality just as much as morality can foster markets. Paganelli concludes her chapter by noting,
Adam Smith favours commerce on grounds of both morality and efficiency. Commerce is intertwined with morals, it supports moral development and at the same time it is supported by it. Commerce requires morals for its functioning and gives the conditions under which people can live, can live freely, and can live morally.
Returning to the question of whether Adam Smith was “left or right” James Otteson writes in the epilogue to his 2011 book Adam Smith,
He [Smith] was instead an old-fashioned liberal: favoring individual liberty, endorsing state institutions to protect this liberty, and, where they conflicted, favoring the individual over the state as a default. But he was also a sceptical empiricist. He favored free trade, free markets, and a government robust but limited to the enforcement of a few central tasks not because they comported with a priori principles but because they seemed to work.
It is worth noting that this sceptical empiricist approach to markets, trade and government rather than an a priori principle approach would most likely disqualify Smith as a libertarian, at least of the Radian or Nozickean kind.

Otteson goes on to say,
Smith’s concern with the poor leads some commentators to suggest that he must have been a proto-“progressive” liberal, since, as some believe, only progressive liberals care about the poor. Samuel Fleischacker, for example, argues that Smith’s concern for the poor is one reason to see him as “left-leaning” rather than “right-leaning” . Concern for the poor is, however, hardly the exclusive provenance of the political left. And Smith’s strong arguments in favor of decentralization of power, competition, and free markets would seem to put him rather on the right of today’s political spectrum than on the left.
Otteson's conclusion is that Smith is a classical liberal, which is consistent with the arguments made above, but if accepted this does mean Smith is not a man of the left.

Update: Adam Smith scholar Gavin Kennedy comments on this post at this Adam Smith's Lost Legacy blog.

Local authority chief executives are boosting their pay packets by “empire-building” - The Dismal Science

Apr 18, 2013

The following link is to a TV3 news item in which Dr Glenn Boyle, professor of finance at Canterbury University, discusses his recent paper in which he shows that that some local authority chief executives are boosting their pay packets by "empire-building". Boyle found that councils which collect the most revenue per ratepayer also pay their chief executives the most. The pay rate is not related to things the amount of infrastructure the councils controls but is related to the additional hiring of bureaucrats.

http://www.3news.co.nz/Empire-building-CEOs-boost-pay/tabid/370/articleID/294292/Default.aspx

Scoop reports,

A new study by UC finance professor Glenn Boyle and former UC student Scott Rademaker found councils which collect the most revenue per ratepayer pay their chief executives the most.

``While this could indicate that chief executives with more revenue to manage have more complex jobs, and hence deserve to be paid more, it turns out that the additional revenue is primarily used to employ additional council personnel,’’ Professor Boyle says.

"The more bureaucrats a council chief executive is able to employ, relative to the size of their ratepayer base, the greater the remuneration he or she is able to extract on average. Chief executives who have increased personnel costs the most during the 2005-10 period have, on average, received the biggest pay rises during that time. In short, council chief executives are being rewarded for good old-fashioned empire building.

Unemployment is bad for employment 2 - The Dismal Science

Apr 16, 2013

I have made the point that the longer you are unemployment the less likely it is that you will become employed before but more evidence confirming it comes from this article in the Washington Post:

Here’s one big reason why America’s unemployment crisis may be here to stay. Thanks to the lasting effects of the recession, there are currently 4.7 million workers who have been out of work for at least 27 weeks. And new research suggests that employers will almost never consider hiring them.

Matthew O’Brien reports on a striking recent experiment by Rand Ghayad of Northeastern University. He sent out 4,800 fake resumes at random for 600 job openings. And what he found is that employers would rather call back someone with no relevant experience who’s only been out of work for a few months than someone with more relevant experience who’s been out of work for longer than six months.

In other words, it doesn’t matter how much experience you have. It doesn’t matter why you lost your previous job — it could have been bad luck. If you’ve been out of work for more than six months, you’re essentially unemployable. Many companies won’t even consider you for a job.
One obvious question this raises is, Are companies irrationally discriminating against the long-term unemployed or do they have good reasons for screening out these applicants? The Washington Post article writes,
Privately, many employers worry that someone who’s been out of work for six months “may have outdated skills, or may be a short-timer who is desperate enough to take any work now but will leave when something better comes along.”
One worry with this is that the current cyclical unemployment problems could become structural and very long-lasting.

Margaret Thatcher’s economic legacy - The Dismal Science

Apr 12, 2013

From VoxEU.org comes a couple of articles looking at Margaret Thatcher’s economic legacy. John Van Reenen argues:

Margaret Thatcher’s economic legacy lives on. This column provides a markedly balanced assessment of her mistakes and achievements. Most pressingly, Thatcherism left the UK failing to properly think about long-run investment, especially in infrastructure, in the skills of those at the lower end of the ability distribution and in innovation. The UK is addressing some of these problems, but this failure to invest in prosperity is the main challenge we face as a nation over the next 50 years.
while Nicholas Crafts explains that
The policies of the Conservative governments led by Margaret Thatcher between 1979 and 1990 remain highly controversial more than 20 years later. In many respects, they represented a sharp break with the earlier postwar period and this was certainly true of supply-side policies relevant to growth performance. Reforms of fiscal policy were made including the restructuring of taxation by increasing VAT while reducing income-tax rates and, notably, by indexing transfer payments to prices rather than wages while aiming to restore a balanced budget. Industrial policy was downsized as subsidies were cut and privatisation of state-owned businesses was embraced while deregulation, including most notably of financial markets with the ‘Big Bang’ in 1986, was promoted. Legal reforms of industrial relations further reduced trade union bargaining power which had initially been undermined by rising unemployment. In general, these changes were accepted rather than reversed by Labour after 1997.

In fact, before, during and after Thatcher, government policy moved in the direction of increasing competition in product markets. In particular, protectionism was discarded with liberalisation through GATT negotiations, entry into the European Community in 1973, the retreat from industrial subsidies and foreign-exchange controls in the Thatcher years, and the implementation of the European Single Market legislation in the 1990s. Trade liberalisation reduced price-cost margins. The average effective rate of protection fell from 9.3% in 1968 to 4.7% in 1979, and 1.2% in 1986 (Ennew et al. 1990), subsidies were reduced from £9bn (at 1980 prices) in 1969 to £5bn in 1979 and £0.3bn in 1990 (Wren 1996), and import penetration in manufacturing rose from 20.8% in 1970 to 40.8% by 2000.
Van Reenan sees Thatcher's polices as a failure.
Nevertheless, there are many important economic and social failures that are part of the Thatcher legacy. First, there was a tremendous growth of inequality both in pre-tax incomes and through changes to tax and benefit policies that favoured the rich. [...]. Some of this inequality was addressed by the Labour governments through tax credits and the minimum wage, but the share of income going to the top 1% continued to rise inexorably, driven by the financial sector. This was the second failure – excessive deregulation of financial services starting with the Big Bang in 1986, but continuing until the eve of the 2007 crisis. Even free markets need to be properly regulated. Third, her early years were marked by a failure to understand that the public employment service needs to be active in helping people find jobs. A major mistake was splitting benefit offices from job centres and pushing many unemployed onto disability benefits (which are much harder to escape from) in an effort to massage down the unemployed claimant count statistics. Unemployment claims peaked at over three million in 1986 when Restart was launched – a policy that finally put more effort into getting the unemployed searching for work and was deepened under the New Deal policies after 1997.

Finally, and perhaps most importantly, there was been a failure of long-run investment: in infrastructure, in the skills of those at the lower end of the ability distribution, and in innovation. The UK addressed some of its problems, but this failure to invest in prosperity is the main challenge we face as a nation over the next 50 years. The LSE Growth Commission has put forward some proposals to deal with this – let’s hope the current generation of political leaders takes heed.
Crafts concludes by saying,
In sum, Thatcherism was a partial solution to the problems which had led to earlier underperformance, in particular, those that had arisen from weak competition (Crafts 2012). The reforms encouraged the effective diffusion of new technology rather than greater invention and worked more through reducing inefficiency than promoting investment-led growth. They addressed relative economic decline through improving TFP and reducing the NAIRU. At the same time, the short-term implications were seriously adverse for many workers as unemployment rose and manufacturing rapidly shed two million jobs while income inequality surged, to no small extent as a result of benefit reforms.

Indeed, any judgement on Thatcherism turns heavily on value judgements concerning the relative importance of income distribution and economic growth as policy objectives. The 1980s saw a very rapid increase in the Gini coefficient by about nine percentage points, which has turned out to be largely permanent. Ultimately, the Thatcher experiment was about making a liberal market economy work better. There will be those who think a German-style coordinated market economy is preferable. That was not really an option available to Mrs Thatcher but in any event it was hardly a vision of which she approved.

David Farrar just doesn’t get it. - The Dismal Science

Apr 03, 2013

With regard to the mixed ownership model David Farrar writes,

This is the model that the unions and their allies have tried to destroy.
Everyone is a winner – the Bay of Plenty Regional Council and its ratepayers, Port of Tauranga’s minority shareholders and the company itself.

It is totally inappropriate to look at partial privatisation as a zero sum game, a game where there must be a loser for every winner. Partial privatisation can lead to a substantial increase in value and income for a regional council, or the government, if the listed company is well governed and managed.
Absolutely. There can be no argument that privately owned and managed companies do better overall than wholly owned public ones. By this I do not mean no private companies fail and no public companies succeed. Of course not. But if you look at decades of economic data across OECD countries, the difference is stark.
Yes and if you look at the economics literature you will also find that fully private companies outperform mixed ownership firms. Some insight on this 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 partial 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.)
When you look at the performance of mixed ownership firms they don't do as well as fully privately owned firms. For example, Aidan Vinning and Anthony Boardman in "Ownership and Performance in Competitive Environments: A Comparison of the Performance of Private, Mixed, and State-Owned Enterprises", Journal of Law and Economics vol. XXXII (April 1989) conclude
'The results provide evidence that after controlling for a wide variety of factors, large industrial MEs [mixed enterprises] and SOEs perform substantially worse than similar PCs [private corporations].'
So fully private firms out-perform mixed ownership firms. Thus if Farrar followed his own logic he would be arguing for 100% privatisation of SOEs.

A case study in privatisation - The Dismal Science

Apr 03, 2013

At the IEA blog Wayne A. Leighton discusses the telecom reforms undertaken in Guatemala. He writes,

In 1996, Guatemala adopted one of the most market-oriented telecom reforms in the world. The benefits to the country followed quickly as coverage expanded, competition surged, and prices plummeted.
He then asks the question, So, what is special about the Guatemalan experience? His answer:
Firstly, Guatemala’s reform was based solidly on market principles. Secondly, it was a huge success, providing greater consumer benefits than reforms in most other countries.

One of the most significant aspects of the Guatemalan experience is that the market was opened to competitors before the state-run telecom monopoly was privatised. Most countries did the opposite, selling the government’s monopoly phone company at a high price and promising to open the market at a later date. While such an approach put a lot of funds in these governments’ treasuries, it also created a private monopoly with the incentive to lobby for slow and cautious market liberalisation. By contrast, in Guatemala the buyer of the state phone company would have no special privileges and its competitors would face no special restrictions.
An interesting point here is that opening the telecom market to competition before privatisation highlights the importance of a point I have made before that getting the highest possible price when selling an SOE isn't always the best policy. Selling the SOE as a monopoly would have generated more money for the government but would have, as Leighton notes, slowed, or even stopped, the liberalisation of the telecom market and thus stopped the benefits that flowed to consumers from the privatisation and liberalisation.

In addition,
The other key aspect of reform is that it fostered a free market in the airwaves (electromagnetic spectrum). Guatemala created what are essentially property rights to the spectrum. This matters greatly, because access to spectrum is needed for wireless communications, and in low-income countries wireless is the most cost-effective way to extend service.
and
Significantly, the right to use spectrum in Guatemala for commercial purposes was not defined as a licence, as is the case in many other countries. Rather, usufruct titles were issued, which grant much more flexibility to determine how the spectrum will be used, subject to very basic restrictions on interference and international agreements. This closely approximates a property right. It creates greater certainty for wireless providers and greater potential for the spectrum to be put to its highest valued use.
The message here: getting property rights right matters.