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.

Eminent domain (updated) - The Dismal Science

Jul 27, 2015

A couple of days back I downloaded the Kindle version of Ilya Somin new book on the problems with eminent domain, "The Grasping Hand: 'Kelo v. City of New London' and the Limits of Eminent Domain". This has turned out to be very timely given that The Productivity Commission has come up with the most appalling policy idea I have seen in I don't know how long, that is, the idea that there is a potential role for compulsory property acquisition in assembling large-enough land parcels for achieving proper economies of scale in construction of housing as a way of dealing with problems to do with the supply of land for homes.

Fortunately not all of New Zealand is as crazy as the Commission. Eric Crampton makes the case against the Commission's idea in an excellent post over at The Sand Pit blog.

Eric writes

Hold-out problems are the usual justification for use of eminent domain. Suppose that you’re a property owner. You get wind that a big developer is planning something substantial for the neighbourhood – and that it would include your property. If you know that everybody else has sold their rights to the developer, well, you could charge a price that would have you get a pretty substantial chunk of the developer’s profits. Or, suppose you got wind of where the government was planning on putting in a roading project. If you bought up the properties ahead of the government, and if you knew the government didn’t have other options for the route, you could hold the government to ransom for that property. And so the threat of eminent domain expropriation guards against this kind of strategic behaviour that can threaten the viability of beneficial projects.

But is it the only way of solving hold-out problems? And are hold-out problems even the binding constraint here?

I have been a fan of option contracting as a way around hold-out problems. Suppose you’re the same property owner above. The developer comes to you and offers you a deal. The deal is this. He’ll pay you $10,000, right now, for the option to buy your house in a year’s time at a price that looks fair to you. Whether or not he buys the house in a year, you get to keep the $10,000. He says he’s putting together land for a development but he isn’t quite sure where he wants to put it yet – it could be here, it could be someplace else. You can’t tell whether you’d be the hold-out as you neither know whether your neighbours have signed up, nor whether your property would wind up being used anyway. If the developer is clever, he’ll have identified a couple of sites that could work reasonably well for the project and would be buying options over both sites. You can’t do better than taking the $10,000 in hand, if you think the price is fair. If you don’t, the sale would be inefficient anyway.

Hold-out is pretty cheap in an environment with ever-escalating land costs due to stupid zoning rules. You lose nothing by just sitting on the land and waiting for the capital gains. Some developers have told me that, in hindsight, they should never have bothered trying to put housing up in some parts of Auckland – the costs of dealing with Council meant that they’d have earned a much better return by just landbanking rather than developing. But that changes where the other policy recommendations from ProdComm come into play. When far more land can be put to its most productive use, you can’t expect that your little plot will forever appreciate. Another offer to develop might not come because the development will have gone elsewhere.

Is land assembly through option contracting feasible? It worked where I grew up. Manitoba Hydro wanted to put in wind turbines. Before they did the wind mapping, they bought options from all the farmers where they might have wanted to place the turbines. Where they had options over a long enough ribbon of land where the wind turned out to be right, they exercised those options and put up the turbines. Nobody could hold-out because nobody knew where Hydro would want to put the turbines and because there were multiple potential options. Some people didn’t sell Hydro the option because they didn’t think that the price that Hydro was offering for access to the turbine site was worth the hassle it would cause in the field – and fair enough. But in an eminent domain version, every one of them would have been considered a hold-out and forced to sell.

Think about how this eminent domain proposal would pan out in New Zealand practice. ProdComm talks of using it in a Urban Development Agency (UDA) for Master-Planned developments. In practice, that would mean the UDA in partnership with a big developer strong-arming homeowners to sell out, on threat of forced sale, in order to put up a new subdivision or higher-density development.

Think too of all the land assembled under threat of compulsory purchase in Christchurch. How much of that is now in more productive use? Was small owner hold-out the main problem there? Really?

As alternative, the UDA could instead maintain a register of the owners of the fragmented property holdings and pass along option contract offers to the owners, lowering the transactions costs of assembling the land. They could also pass along declined offers to Council, that Council might update its land valuation figures. If you’ve turned down a million dollar offer on a site that’s rated at $500,000, well, the rating is probably too low.
A question I wonder about with eminent domain is, How do you know that a person who is not willing to sell is in fact holding-out? After all a refusal to sell could just mean they value their property more than the price they are being offered. There may be nothing strategic in what they are doing at all. Especially when it comes to homes or businesses. They may just want to live or work where they are. Consider that they could have sold their property for the market price at anytime but they haven't. I would assume this is because they don't think the market price is high enough to compensate them for the loss of the property. So how is forcing them out efficient?

Note: I have changed a number of "hold-ups" to "hold-outs" in the quote from Eric's post just because I'm a pedant!

Update: At the Not PC blog the point is made that the Productivity Commission pisses on property owners while Michael Reddell comments on The Productivity Commission on land supply.

EconTalk - The Dismal Science

Jul 26, 2015

Michael O'Hare of the University of California, Berkeley talks with EconTalk host Russ Roberts about the management of art museums. O'Hare suggests a number of changes that would allow museums to be more effective and to justify their non-profit status...

Government takes over Serco-run Mt Eden prison - The Dismal Science

Jul 24, 2015

That is the headline on an article at stuff.co.nz. In the article Aimee Gulliver writes,

Corrections Minister Sam Lotu-Iiga announces that the government is taking over Serco-run Mt Eden prison as of Monday.

The government is taking over the management of Mt Eden prison as of Monday, following serious allegations of prisoner mistreatment at the Serco-run facility.

Serco staff will remain on site but a management team will be put in place to oversee the day to day running of the facility.

The decision comes after a series of serious allegations at the Mt Eden prison, where inmates are claimed to have been thrown off balconies in a practice known as "dropping", and physically assaulted.
A question I would ask is, Should we be surprised at this outcome? One reason for saying no comes from the literature on privatisation, in particular the paper 'The Proper Scope of Government: Theory and an Application to Prisons' by Oliver D. Hart, Andrei Shleifer and Robert W. Vishny, "Quarterly Journal of Economics", 112(4) November: 1127-61, 1997. The paper considers the question as to which goods or services the government should provide, with an emphasis on prison services.

The HSV model considers the choice between in-house production and contracting out. The provider, government or private, can invest in improving the quality of service or reducing cost. Given incomplete contracts, the private provider has a stronger incentive to engage in both quality improvement and cost reduction than a government employee has. However, the private contractor's incentive to engage in cost reduction is typically too strong because he ignores the adverse effect on noncontractible quality. Cost are always lower under private ownership but quality may be higher or lower under a private owner.

Hence the focus of the HSV model is on quality. Here quality has a broad interpretation. It can stand for how well prisons treat prisoners, how clean utilities keep the water, how well schools educate their pupils, how long it takes for a letter to reach a remote area or how innovative car makers are etc. The basic idea is that the provider of the service, whether it be the government or a private firm, can made an investment to increase the quality of the service or a investment to reduce the cost of the service. It is important to note that quality is reduced by any cost reductions. Neither of these two investments are ex ante contractible. But to implement either of the innovations requires the agreement of the owner of asset. The asset can be thought of as, say, a school or a hospital or a prison. If the owner of the asset is the government then the provider of the service, who will be a government employee, requires the approval of the government to invoke either investment since, in this case, the residual control rights reside with the government. As a result, the employee will receive just a fraction of the returns to either innovation, even if implemented.

If on the other hand the provider is a private sector contractor, then the contractor has the residual control rights and thus does not need the government's agreement for a cost reduction. However, if the contractor wishes to improve the quality of the service and receive a higher price for it, then they have to renegotiate with the government since the government is the purchaser of the service. Under the assumption that the contractor is successful in obtaining an increase in price they capture all such gains. Thus a private contractor will generally face stronger incentives, than a government employee, to improve quality and reduce costs but the incentive to reduce costs can be too strong since the contractor ignores the negative impact this has on quality.

HSV examined the conditions that determine the relative efficiency of in-house provision versus outside contracting of government services. Their theoretical arguments suggest that the case for in-house provision is generally stronger when noncontractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem. In contrast, the case for privatisation is stronger when quality reducing cost reductions can be controlled through contract or competition, when quality innovations are important, and when patronage and powerful unions are a severe problem inside the government.

They then apply this analysis to several government activities using the available evidence on the importance of various factors. They conclude that the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for privatisation is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools.

With regard to prisons HSV write (p. 1152-4)
Prisons seem to fit reasonably well into our framework. Although in some respects prison contracts are very detailed, they are still seriously incomplete. There are significant opportunities for cost reduction that do not violate the contracts, but that, at least in principle, can substantially reduce quality. Moreover, from the available evidence we have the impression that the world may not be far from the assumptions of Proposition 4. First, the welfare consequences of quality deterioration might be of the same magnitude as those of cost reduction (b(e) and c(e) are comparable). Second, the opportunities for quality innovation are limited (beta(i) is small). Under these conditions, Proposition 4 suggests that public ownership is superior.

Would ex post competition between prisons for inmates strengthen the case for privatization? One possibility is that convicts themselves choose the prison in which to serve their sentences, but this is probably a bad idea, since prisoner choice would encourage contractors to attract customers by allowing gangs, drugs, and perhaps even easy escapes. A more plausible alternative is to have judges choose a private prison to send a convict to, with the idea that judges would send more inmates to higher quality prisons and fewer to lower quality prisons. Private contractors would then have the appropriate incentives to invest in quality improvements, and to avoid excessive cost reductions, to bring in more business. At the moment, such schemes have not been tried, in part because there is a shortage of prison capacity in the United States, but it is possible that they could be tried in the future. One potential disadvantage of such judge choice is that some judges might actually choose lower quality prisons because they want the inmates to get a stiffer penalty, whereas other judges might choose prisons that are soft on inmates. Contractors would then cater to the preferences of the judges, which need not coincide with social welfare.

Finally, the choice of whether to privatize prisons depends on the importance of corruption and patronage. Patronage does not appear to be a huge problem in prison employment in the United States, since the union premium as of this writing is not large. Corruption appears to be a greater concern, at least judging from the available anecdotal evidence. To begin, private prison companies are very active politically. For instance, ESMOR evidently lobbies politicians and makes political contributions to receive contracts {The New York Times, July 23, 1995}. The wife of Tennessee governor Lamar Alexander invested early and profitably in the stock of Corrections Corporation of America, which subsequently got involved very deeply in the privatization of Tennessee prisons with the governor’s endorsement {The New Republic, March 4, 1996, p. 9}.

A related problem is that contract enforcement cannot be taken for granted. The INS report concludes that ESMOR’s changes in policies “hindered INS ability to effectively perform its oversight functions.” The report also notes that ESMOR told its guards not to share information with the INS officials working on the premises, and in one instance encouraged the INS to reassign an officer who complained about the performance of the Elizabeth, New Jersey, facility several months prior to the riot. The report indicates that ESMOR violated the contract in some instances, and also pursued policies preventing the INS from enforcing the contract. But it is also clear from the report that the INS did not do what it could to enforce this contract. The INS report vividly illustrates how a government bureaucracy with relatively weak incentives has trouble enforcing a contract with a private supplier determined to reduce its costs, even if this involves violations of the contract and not just the issues on which the contract is silent.

In sum, our model suggests that a plausible theoretical case can be made against prison privatization. This case is weakened if competition for inmates can be made effective, but strengthened by the relevance of political activism by private contractors. One instance in which the case against prison privatization is stronger is maximum security prisons, where the prevention of violence by prisoners against guards and other prisoners is a crucial goal {The New York Times Magazine 1995}. In many cases, the principal strategy for preventing such violence is the threat of the use of force by the guards.We have shown that it is difficult to delineate contractually the permissible circumstances for the use of such force. Moreover, hiring less educated guards and undertraining them—which private prisons have a strong incentive to do—can encourage the unwarranted use of force by the guards. As a result, our arguments suggest that maximum security prisons should not be privatized so long as limiting the use of force against prisoners is an important public objective. Consistent with this view, only 4 of the 88 private prisons in Thomas’s {1995} census of private adult correctional institutions in the United States are maximum security. In contrast, private half-way houses and youth correctional facilities, where violence problems are less serious, are common {Shichor 1995}.
So there is a case to be made for private prisons, but it may not be as strong as for other services currently provided by the government, and it is at its weakest for the case of maximum security prisons. Thus seeing Mt Eden prison back under government management may not be that surprising. Maximum security prisons are an area where government provision can be more effective.

Cool book and website - The Dismal Science

Jun 18, 2015

There is a cool new book and website available on the work of F. A. Hayek designed for the general reader.The book is the The Essential Hayek by Donald J. Boudreaux.The chapters in the book are:1. How we make sense of an incredibly complex world2. Know...

The Austrian tradition in economics - The Dismal Science

Jun 03, 2015

From the Free Thoughts series at Libertarianism.org comes this interview with Professor Peter J. Boettke of George Mason University in which he talks about "The Austrian Tradition in Economics".


Boettke traces the school’s history from Carl Menger through Eugen Böhm-Bawerk and Joseph Schumpeter, Ludwig von Mises, Friedrich Hayek, and Murray Rothbard to contemporary economists such as Israel Kirzner, Vernon Smith, and Mario Rizzo. He explains what Austrian economics does and does not do, and distinguishes between what he calls “mainline” economics and “mainstream” economics.

What distinguishes Austrian economics from other schools of thought in economics? How did the Austrian school come to be known as the free market school?

Harford on inequality - The Dismal Science

May 06, 2015

At his blog Tim Harford has been writing on The truth about inequality. He says,

How serious a problem is inequality? And if it is serious, what can be done about it?

Myths abound. Many people seem to believe that Thomas Piketty’s Capital in the Twenty-First Century showed that wealth inequality is at an all-time high; instead, his data show that wealth inequality has risen only slowly since the 1970s, after falling during the 20th century. In Europe we are thankfully nowhere near the wealth inequality of the past.

Another common belief is that the richest 1 per cent of the world’s population own half the world’s wealth (almost true) and that their share is inexorably increasing (not true). The richest 1 per cent had 48.2 per cent of the world’s wealth in the year 2014, according to widely cited research from Credit Suisse, but that share has fallen and risen over the past 15 years. It is lower now than in 2000 and 2001.

Neither is it clear that global inequality is rising. Average incomes in China and India have risen much faster than those in richer countries; this is a powerful push towards equality of income. But inequality within many countries is rising. Research from Branko Milanović, author of The Haves and the Have-Nots, suggests that the two forces have tended to balance out roughly over the past generation.

One final myth is that inequality in the UK has risen since the financial crisis. In fact, it has fallen quite sharply. “Inequality remains significantly lower than in 2007-08,” said the Institute for Fiscal Studies last summer. That conclusion is based on data through April 2013. The IFS did add, though, that “there is good reason to think that the falls in income inequality since 2007-08 are currently being reversed.”
Harford then makes an important point about the need to take income redistribution into account when looking at inequality.
The UK already redistributes income extensively. As Gabriel Zucman of the London School of Economics points out, the UK’s richest fifth had 15 times the pre-tax income of the poorest fifth, but after taxes and benefits they had just four times as much.
I would think that if we were to look at consumption, which to me seems the important thing, the gap between "rich" and "poor" would decrease even more.

Of course there are those who would have the government redistribute even more but my previous post on To eat the rich, first they must stay still should act as a warning as to what could happen when the top income rates are raised.

I would suggest there is one addition question Harford did not ask: Is inequality a problem at all? Only after having answered that question yes should we ask how big the problem is and what can we do about it.

Risk aversion and the firm - The Dismal Science

May 03, 2015

A bit over a week ago in the comments to a post James asked,

Can I make a request for a topic? Since you're the resident expert on the theory of the firm, can you write something about any work that's been done on risk averse firms? (I.e. in contrast to the standard assumption about risk neutral firms). Does the risk neutrality assumption have any major implications for standard economic theory?
I've been away but now I'm back at home I can attempt a rough answer. Better late than never, I hope.

Back in 1974 when discussing the topic of 'risk, uncertainty, and the firm' Michael Crew wrote,
Like growth theory of the firm, the theory of the firm under uncertainty is not highly developed. Much of it is speculative.
And not much has changed since then, the theory still isn't that well developed. Knightian uncertainty rather than risk has become more important to the modern theories of the firm.

While little has been written on the topic of risk and uncertainty to do with the firm, the amount is not zero. Back in 1970, for example, Lintner wrote a paper in which pricing decisions of the firm are made on a fully rational profit maximising basis subject to risk aversion with respect to the uncertain profits involved. Assume the uncertainty is due to uncertainty to do with demand. It is uncertainty about the quantity that will be sold. Under the assumptions Lintner makes he can show, not surprisingly, that for a given price change the higher the degree of risk aversion the greater is the increase in expected profits profits requires by a firm (decision maker) in order to induce it to accept greater profits uncertainty. Also the effects of risk aversion on price and output are such that prices are lower when (1) the greater the uncertainty and (2) the greater the risk aversion the closer the price gets to marginal cost and thus the further a firms gets from the monopoly outcome. In addition Lintner can show that the greater the uncertainty about sales and volumes and the greater the risk aversion of the decision maker the greater will be the expected quantity sold.

Different forms of uncertainty can deliver different results. If uncertainty is about realised prices, rather than quantities, then Day, Aigner and Smith show that price is set higher than the monopoly outcome, the greater the degree of risk aversion.

Marcus Asplund has a 2002 paper on 'risk-averse firms in oligopoly'. Does risk aversion lead to softer or fiercer competition? This paper provides a framework that accommodates a wide range of alternative assumptions regarding the nature of competition and types of uncertainty. It shows how risk aversion influences firms' best-response strategies. Only in the case of marginal cost uncertainty does higher risk aversion make competition unambiguously softer. The risk-averse best response strategies depend on the level of fixed costs. This fact is used to analyse strategic investments in capacity and the importance of accumulated profits. The paper concludes with a discussion of ways of empirically testing for risk-averse behaviour in oligopoly.

In more modern approaches to the firm the work of Frank Knight on risk and the firm has been developed. The standard view of Knight’s rationale for the existence of the firm doesn't depend on profit, but on risk, or more accurately, risk distribution. The entrepreneur forms a firm as a way of specialising in risk-taking. Employees receive a stipulated income and the entrepreneur takes the residual income of the firm and thereby bears most of the risk associated with uncertainty about the future. The advantage of the firm, according to the standard view, is that there are gains to be made from this distribution of risk between the entrepreneur and the firm’s employees. The profit and loss consequences of fluctuations in the business outcomes can be better absorbed by the entrepreneur than the employees. The entrepreneur contracts to pay a fixed wage to workers, thereby protecting them from the fluctuations in business outcomes. Knight sees this as efficient since the entrepreneur is less averse to bearing risk. Presumably, risk is not handled as well without firms.

Other views of Knight have been put forward in papers by Barzel and McManus. Each puts forward a moral hazard explanation for the Knightian firm. The firm arises here because, for certain kinds of risks, the functions of risk taking and management are inseparable due to the prohibitively high costs of enforcing constraints that would induce one individual, the manager, to maximise the wealth of another, the risk-taker. As noted in the distribution of risk story above, firms are one way of specialising in risk-taking. Knight was aware of contractual and insurance arrangements as alternatives to the firm as ways of specialising in risk-taking but thought, because of the moral hazard problems, they were particularly costly to enforce in the case of risks of enterprise and hence the need for the creation of a firm. Presumably monitoring the manager is easier for the risk-taker in a firm that it is on the market.

In 1991 Holmström and Milgrom made two observations to do with the firm and its (risk-averse) employees. First, they note that there are a number of ways that an employee can spend their time, many of which can be of value to an employer. But if these multiple activities compete for the worker’s attention then the incentives offered for each of the activities must be comparable. Otherwise, the employee will put most effort into those things that are most well compensated and put less effort into the others activities. The second observation relates to the provision of strong incentives to a risk-averse employee. Providing strong financial incentives is costly because it loads extra risk into the worker’s pay. In addition, the cost is greater the more difficult it is to measure performance. This means that, other things being equal, tasks where performance is hard to measure should not be given as intense incentives as ones that are more accurately observed. But having low-powered incentives means that the employer needs to be able to exercise authority over the use of the employee’s time, since the employee will not have the proper incentives to be productive.

The above are all partial equilibrium models but a general equilibrium approach is taken in a 1979 paper by Kihlstrom and Laffont. They construct a theory of competitive equilibrium under uncertainty using an entrepreneurial model with historical roots, again, in the work of Knight in the 1920s. Individuals possess labour which they can supply as workers to a competitive labour market or use as entrepreneurs in running a firm. All entrepreneurs have access to the same risky technology and receive all profits from their firms. In the equilibrium, more risk averse individuals become workers while the less risk averse become entrepreneurs. Less risk averse entrepreneurs run larger firms and economy-wide increases in risk aversion reduce the equilibrium wage. A dynamic process of firm entry and exit is stable. The equilibrium is efficient only if all entrepreneurs are risk neutral. Inefficiencies in the number of firms and in the allocation of labour to firms are traced to inefficiencies in the risk allocation caused by institutional constraints on risk trading. In a second best sense which accounts for these constraints, the equilibrium is efficient.