Tuesday, 27 September 2016

Incentives and ethics in the economics of body parts

Repugnant markets are an relatively new area of economics - associated with the work of Nobel winner Alvin Roth - and one that many people find strange and unsettling but it is also one that has very important implications for people's welfare. And there is no more important area than the "market" for human body parts. This is an area where demand outstrips supply in a big way and we need ways to get more people to donate. But many people don't like the idea of using monetary incentives to increase donations.

In this new NBER working paper Nicola Lacetera looks at some of the economic and moral issues involved in organ markets.

The abstract of the paper reads:
Research shows that properly devised economic incentives increase the supply of blood without hampering its safety; similar effects may be expected also for other body parts such as bone marrow and organs. These positive effects alone, however, do not necessarily justify the introduction of payments for supplying body parts; these activities concern contested commodities or repugnant transactions, i.e. societies may want to prevent certain ways to regulate a transaction even if they increased supply, because of ethical concerns. When transactions concern contested commodities, therefore, societies often face trade-offs between the efficiency-enhancing effects of trades mediated by a monetary price, and the moral opposition to the provision of these payments. In this essay, I first describe and discuss the current debate on the role of moral repugnance in controversial markets, with a focus on markets for organs, tissues, blood and plasma. I then report on recent studies focused on understanding the trade-offs that individuals face when forming their opinions about how a society should organize certain transactions.

Sunday, 25 September 2016

GBBO and the nature of the firm

For those not in the know GBBO stands for the Great British Bake Off which is a very popular (not at all sure why) television programme in the UK which until recently as on the BBC but has now been bought by Channel 4.

What has this to do with the theory of the firm? Chris Dillow at the Stumbling and Mumbling blog writes,
As you all know, Mary, Mel and Sue [3 of the 4 presenters of the show] will not be joining the show when it moves channel, which has prompted everyone to claim that Channel 4 have spent £75m on a tent and a fat scouser – something they could have got in Millets Liverpool’s branch for rather less.

This highlights a general fact – that firms are often not merely collections of physical assets, intellectual property and explicit contracts. Their value often lies in key employees, and if these leave they can take a lot of corporate value with them. If viewers boycott the new GBBO because there’s no Bezza, then the GBBO is indeed not as valuable as Channel 4 thought.
While it it clearly true that many firm have employees who are of great value to them its not clear that this fact changes the theory of the firm. Even when workers/managers are of value to a firm non-human assets (physical assets, intellectual property rights, location etc) still play a role.

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

For GBBO while presenters are important there is also the need for non-human capital - cameras, sound equipment, editing equipment, ovens etc - which are not owned by the presenters. These non-human assets can keep the firm together.

Whether these are enough to keep GBBO together, or will it go the way of Top Gear after its three presenters left, only time will tell. But if human capital is super important to the show, as it seems to have been for Top Gear, and it fails then this would just make Hart's point, human capital only (or largely human capital) firms are unstable.

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

When antitrust runs amok: bulletin board material

Timothy Taylor at the Conversable Economist blog posted this cartoon from Dale Everett at the Anarchy In Your Head website in 2008:


An interesting cartoon given this quote from 1981 about why Ronald Coase gave up teaching antitrust:
“Ronald [Coase] said he had gotten tired of antitrust because when the prices went up the judges said it was monopoly, when the prices went down they said it was predatory pricing, and when they stayed the same they said it was tacit collusion.”

–William Landes, “The Fire of Truth: A Remembrance of Law and Econ at Chicago”, JLE (1981) p. 193.

Saturday, 24 September 2016

Why you shouldn't take economic advice from a comedian.

From CBCNews.ca comes this news story:
One of the hottest comedians in show business is warning fans not to buy or resell overpriced tickets to his upcoming shows — because he might just cancel the tickets.

Louis C.K. announced Tuesday that the West Coast city would be the only Canadian stop so far on his forthcoming North American tour.

The award-winning funny man will play the 6,000 seat Thunderbird Arena for two nights on Dec. 7 and 8. And once again he was capping prices well below average for a top notch show.

"As always, I'm keeping the price of my tickets down to an average of $50, including all charges," he said in an email blasted out to fans to announce the dates. "I know that's not nothing. But it's less than more than that."

Somewhat predictably, tickets were sold out with minutes, leaving desperate fans searching online for seats at the show.

And that's where the warning comes in.

It turns out C.K. has a long-standing beef with scalpers and resellers, and he takes personal pride in jamming their attempts to profit from his shows.

"Regarding ticket resale: we take great efforts and have many methods of finding out what inventory is being sold on broker sites like Stubhub and Vivid Seats and immediately invalidating those tickets," he declared on his website.
Now this guy may be great at being a comedian but he is a crap economist. If the quantity demand is greater than the quantity supplied the price rises to clear the market. Now Louis C.K. may not like this bit of basic economics but that doesn't stop it from being true. The reason that you see scalpers is simply that the ticket price is below the market equilibrium price. So if he wants to prevent scalping he just needs to increase the price of tickets.

But from the above you see that he wants to keep "the price of my tickets down to an average of $50". Low price implies below equilibrium pricing which in turn implies scalping to get tickets into the hands of those who value them most. That is, his own pricing policy creates scalping. An insolvable problem?

What to do? If he won't increase the ticket price does he have live with scalping? Actually no, there is a very obvious solution to this. All he has to do is increase supply. As supply increases the price will be driven down. So to get a $50 price with no scalping all he has to do with play a bigger venue or put on more shows, or both. These things will increase the supply of tickets which will decease the price until, if he gets the supply just right, the equilibrium price is $50. And, of course, there will be no scalping. Problem solved!

Is California's $15 minimum wage law a good idea?

California has passed a law that will raise the state's minimum wage to $15/hr by 2022. Does this law make economic sense? Is it a sound policy in pursuit of social justice? Don Boudreaux, Professor of Economics at George Mason University, and Mike Konczal, fellow at the Roosevelt Institute debate the issue at an event sponsored by the University of San Diego's Center for Ethics, Economics, and Public Policy.

Which countries have the greatest economic freedom?

From the Economic Freedom of the World: 2016 Annual Report comes these rankings of economic freedom. The ratings are for 2014, the most recent year for which comprehensive data are available.

New Zealand is in at 3. Hong Kong is at 1 and Singapore 2.
For the record the 10 lowest-rated countries, not shown, are: Iran, Algeria, Chad, Guinea, Angola, Central African Republic, Argentina, Republic of Congo, Libya, and lastly Venezuela. Yes the Socialist paradise that is Venezuela made it to 159 out of 159. But to be fair to Venezuela, North Korea is not in the rankings and if they were Venezuela may only be second to bottom.

Friday, 23 September 2016

How to regulate CEO pay (and how not to do it)

In the good old days political campaigns were about silly things like taxes, government spending, and foreign policy etc whereas today there about important things like CEO compensation and how government can regulated it to make the world a better place. In a column at VoxEU.org Alex Edmans considers the various arguments for regulating CEO pay and questions whether it is a legitimate target for political intervention. Some arguments for regulation are shown to be erroneous, and some previous interventions are shown to have failed. While regulation can address the symptoms, only independent boards and large shareholders can solve the underlying problems.

A obvious first question to ask is, Is regulation necessary? Our politicians don't ask this question they just assume it is. After all there are votes in say regulation is needed.
A contract is a private agreement between an employer and an employee. It is shareholders who bear the direct costs of the contract, and so it’s unclear whether the government should intervene.

A common argument is that pay has indirect costs – it causes CEOs to take actions (such as risk-taking) that affect society. However, there is very limited causal evidence that pay does have these effects. Even if it did, it is not clear why the government should regulate pay rather than these actions themselves. Firms take many other decisions that have far larger effects on society – firing workers, restructuring, or making large investments – which are rarely regulated. Thus, calls to regulate pay may be driven by envy, rather than pay actually being a critical social decision (Murphy 2012).

Moreover, we have remedies for bad decisions – private equity firms and hedge funds take large stakes in underperforming companies. They are certainly not in the CEO’s pocket, and they’re not afraid to make major changes – they even fire the CEO in many cases. But, they very rarely cut CEO pay (Brav et al 2008, Cronqvist and Fahlenbrach 2013). Thus, while large investors see many things to fix in a firm, the level of pay doesn’t seem to be one.
If we do what politicians don't and look at all the evidence, what do we find?
Public opinion is typically informed by a few high-profile examples of egregious compensation. The media will only report the worst cases because these are the most newsworthy. But, it is important to assess all the evidence – and that’s the role of academic research. Indeed, the large-scale evidence is that pay is highly linked to performance:
  • A 1% fall in the stock price reduces CEO wealth by $480,000 (Murphy 2013);
  • CEOs with high stock compensation deliver superior long-run stock returns of 4-10% per year (von Lilienfeld-Toal and Ruenzi 2014);
  • Firms with high income inequality exhibit superior operating and stock performance (Mueller et al 2016).
So what is the role of the policymaker?
A policymaker should exhibit similar caution to a doctor. The Hippocratic oath is "first, do no harm", i.e. to ensure that any intervention doesn’t worsen the problem. Murphy (2012) describes how the entire history of compensation regulation is filled with unintended consequences. The forced disclosure of perks in 1978 increased perks as CEOs could see what their peers were receiving; the 1984 law on golden parachutes catalysed the adoption of golden parachutes by alerting some CEOs to their existence; and Bill Clinton’s $1 million salary cap led to CEOs below the cap raising their salaries to above it, and those above merely reclassifying salary as a bonus.

Indeed, regulation is often driven by political agendas – by politicians’ desire to be seen as tough, rather than to create social value. Far more important than taking action is taking the right action.
What to do? Two common ideas are pay ratios and employee voting. But
The motivation behind capping pay ratios is sound – to ensure the CEO is not paid for poor performance, and to improve equality. But, to ensure the CEO is paid for performance, we should compare pay to her performance, not the pay of the median employee. One argument is that a well-performing CEO should share the spoils with her workers – she wasn’t the only one responsible for her firm’s success. But, the flipside of bonuses for good performance is they allow punishments for poor performance – former JC Penney CEO, Ron Johnson, suffered a 97% pay cut when the stock price tumbled. Workers pay didn’t fall – and it shouldn’t have.

Moving to equality concerns, a focus on pay ratios can actually increase inequality. A CEO can lower the pay ratio by firing low-paid workers, converting them to part time, or increasing their cash salary but reducing their non-financial compensation (such as on-the-job training and working conditions).
and
Employees rarely wish to weigh in on a pharma company’s R&D policy, since this should be left to the experts – the scientists. But everybody believes that they are an expert on CEO pay, even though economics and finance requires as much expertise as science.

An employment contract is an extremely complex issue and cannot be whittled down to a simple number such as a pay ratio. How should we best filter out industry performance? Indexed options? Indexed stock? Options on indexed stock? Stock with indexed performance vesting thresholds? Confused? Well, so might the general public be – as they were during the UK’s EU referendum, so the debate was narrowed to simple dimensions and driven by misinformation.

To get past a vote, a board may focus on the ‘optics’ of pay (e.g. a low ratio) and ignore more important dimensions, such as performance targets being long-term rather than short-term. The median size of a Fortune 500 firm is $20 billion, and median pay is $10 million. Thus, even if a CEO was paid double what she deserves, that costs 0.05% of firm value. If a CEO’s pay is tied to short-term performance, she might take myopic actions that reduce firm value by several percentage points (Edmans et al. 2015).

Employees often come up with ingenious ideas. But, companies already have incentives to consult workers – without any need for regulation – and many often do. In Edmans (2011), I find that firms with high employee satisfaction – for which consultation is key – beat their peers by 2-3% per year. Even if boards only cared about shareholder value, they should consult employees. We want to push the message that employees and executives are in partnership, rather than employee consultation destroying value so we have to pass laws to ensure it happens.

And, there is a big difference between consulting employees and putting them on the board. Firms do market research by consulting customers, but don’t put them on the board. Otherwise, every corporate decision would become a political process. Indeed, Gorton and Schmid (2004) found that worker representation on German boards is associated with lower profitability and firm value.
So the big question, What should be done?
Should we do nothing? Far from it. But we should leave the decisions to major shareholders, who have the expertise and incentives to get these decisions right. High CEO pay comes straight out of shareholder returns, and if the contract causes the CEO to take bad decisions – or demoralises employees and customers – shareholders suffer the consequences. Unlike regulation, which is one-size-fits-all, shareholders can decide what the optimal pay package is for that particular firm.

And things are being done. Eleven countries have passed ‘say-on-pay’ legislation since 2002; Correa and Lel (2016) show that it reduces pay and increases pay-performance sensitivity. Interestingly, advisory votes are more effective than binding votes – in contrast to politicians’ desire to take the toughest possible action. We have also seen innovation in other dimensions of pay, such as lengthening vesting horizons to encourage the CEO to think long-term (Gabaix and Edmans 2009), and paying with debt rather than just equity to dissuade excessive risk-taking (Edmans 2010).

Moreover, when pay is inefficient, it is often a symptom of an underlying governance problem brought on by conflicted boards and dispersed shareholders. Addressing pay via regulation will solve the symptoms; encouraging independent boards and large shareholders will solve the problem. That will improve not only pay, but other governance issues.

What about equality? Kaplan and Rauh (2010) showed that high CEO pay has actually not been a major cause of the rise in inequality – it has risen much more slowly than pay in law, hedge funds, private equity, and venture capital. If inequality is truly the concern, it may be better addressed by income tax. This will address inequality resulting from all occupations (including sports, entertainment, and trust funds); it is not clear why CEOs should be singled out.

The bottom line is that, to the extent that pay is a problem, it should be shareholders, not politicians or employees, who fix it. The electorate will be more impressed by a politician halving pay than extending the vesting horizon from three to seven years, even though the latter will have greater impact. The goal of policy shouldn’t be to write headlines, but to create long-term value for society.
We can conclude that one size does not fit all and the shareholders of a firm have the best information and incentives to get CEO pay right. So why not let them?

Thursday, 22 September 2016

How computer automation affects occupations: technology, jobs, and skills

James Bessen deals with this issue in a new column at VoxEU.org. A common argument you see with regard to computers and employment is that computer automation leads to major job losses. A modern version of the Luddite story. Bessen argues that this line of argument, however, ignores the dynamic economic responses that involve both changing demand and inter-occupation substitution. Using US data, he explores the effect of automation on employment growth for detailed occupational categories. Computer-using occupations have had greater job growth to date, while those using few computers suffer greater computer-related losses. The major policy challenge posed by automation is developing a workforce with the skills to use new technologies.

Bessen looks at estimates of employment demand growth.
Taking these considerations into account, I estimate a simple model of occupational demand across industries that allows for changing demand and inter-occupation substitution within industries. As my key independent variable, I measure the extent of computer use by workers in each occupation and industry. These data come from supplements to the Current Population Survey. I assume that occupations that use more computers will have a higher degree of task automation, all else equal. The dependent variable is the relative growth of employment in occupation-industry cells.

The estimates contradict popular assumptions about the impact of computer automation. First, computer-using occupations tend to grow faster, not slower. At the sample mean, computer use is associated with a 1.7% increase in occupational employment per year. In other words, the bank teller example may be typical rather than exceptional.

Second, there is a strong substitution effect between occupations. Occupations tend to have declining growth to the extent that other occupations in the same industry use computers. That is, the story is not about machines replacing humans; rather it is one of humans using machines to replace other humans, as graphic designers with computers replaced typesetters.

The substitution effect largely offsets the growth effect. Counting both, at the sample mean, computer use is associated with positive employment growth but the effect is small, 0.45% per year. This association is not necessarily causal—perhaps some other factor caused computer-using occupations to grow. But this finding does show that computer automation is not associated with major job losses.
The last sentence is the takeaway result. Computer automation is not associated with major job losses meaning our modern day Luddites have less to worry about than they first thought.

A downside to increasing computer use is that while the evidence suggests that computers are not causing net job losses, low wage occupations are losing jobs, likely contributing to economic inequality. The policy problem is how to get the workers effected the new skills they need in order to transition to new, well-paying jobs. Developing a workforce with the skills to use new technologies is the real challenge posed by computer automation.

Are firms that discriminate more likely to go out of business?

This question is asked in a paper by Devah Pager at Sociological Science. The answer is yes.

Alex Tabarrok explains the basic logic of the argument that discrimination will be punished by the market and discriminating firms will be driven under.
Discrimination is costly, especially in a competitive market. If the wages of X-type workers are 25% lower than those of Y-type workers, for example, then a greedy capitalist can increase profits by hiring more X workers. If Y workers cost $15 per hour and X workers cost $11.25 per hour then a firm with 100 workers could make an extra $750,000 a year. In fact, a greedy capitalist could earn more than this by pricing just below the discriminating firms, taking over the market, and driving the discriminating firms under.
Pager's article is one of the first to test this idea directly. The paper's abstract reads:
Economic theory has long maintained that employers pay a price for engaging in racial discrimination. According to Gary Becker’s seminal work on this topic and the rich literature that followed, racial preferences unrelated to productivity are costly and, in a competitive market, should drive discriminatory employers out of business. Though a dominant theoretical proposition in the field of economics, this argument has never before been subjected to direct empirical scrutiny. This research pairs an experimental audit study of racial discrimination in employment with an employer database capturing information on establishment survival, examining the relationship between observed discrimination and firm longevity. Results suggest that employers who engage in hiring discrimination are less likely to remain in business six years later.
The results of the paper show that 36% of the firms that discriminated in hiring failed but only 17% of the non-discriminatory firms failed over the six year time period studied. So if you discriminate the market will comeback and bite you.

One up for Becker.

Tuesday, 20 September 2016

How copyright improved Italian opera

Petra Moser explains that copyright protection for 19th century Italian operas led to more and better operas being written, but the evidence also suggests that intellectual property rights may do more harm than good if they are too broad or too long-term.

So the takeaway from this video is that intellectual property rights should be narrow and short-lived. Unfortunately when you look around you you see that there is increasing pressure, mainly from the US, for copyrights to be extended and made wider. Its not clear that such expansions are socially beneficial.

The video come from The CORE Project (http://core-econ.org).

NZ as Olympic host? No!

For some very strange reason Laura McQuillan, at Stuffdiscuses the idea of New Zealand hosting the Olympics. So much stupid here.
Nothing says "we're a world-class city" like hosting the Olympic Games - but could New Zealand ever do the honours?

Pulling off the world's largest sporting event - whether the Summer or Winter Games - is a lot of hard slog that brings mountains of debt, international criticism, and often not a lot of benefit.

But International Olympic Committee boss Thomas Bach reckons New Zealand has what it takes to play host.

In anticipation of that day arriving, here's a look at the New Zealand cities and councils best equipped to host the Olympics.
The most important thing in the above quote is "often not a lot of benefit" bit. The research on hosting events like the Olympics tells us the costs are much greater than the benefits.

In a recent issue of the Journal of Economic Perspectives (Vol. 30, Issue 2 Spring 2016) Robert A. Baade and Victor A. Matheson discuss Going for the Gold: The Economics of the Olympics.

The abstract reads,
In this paper, we explore the costs and benefits of hosting the Olympic Games. On the cost side, there are three major categories: general infrastructure such as transportation and housing to accommodate athletes and fans; specific sports infrastructure required for competition venues; and operational costs, including general administration as well as the opening and closing ceremony and security. Three major categories of benefits also exist: the short-run benefits of tourist spending during the Games; the long-run benefits or the "Olympic legacy" which might include improvements in infrastructure and increased trade, foreign investment, or tourism after the Games; and intangible benefits such as the "feel-good effect" or civic pride. Each of these costs and benefits will be addressed in turn, but the overwhelming conclusion is that in most cases the Olympics are a money-losing proposition for host cities; they result in positive net benefits only under very specific and unusual circumstances. Furthermore, the cost–benefit proposition is worse for cities in developing countries than for those in the industrialized world. In closing, we discuss why what looks like an increasingly poor investment decision on the part of cities still receives significant bidding interest and whether changes in the bidding process of the International Olympic Committee (IOC) will improve outcomes for potential hosts. (Emphasis added)
So no, New Zealand should never even think about doing something as stupid as trying to host the Olympics.

Kevin Murphy interviews Edward Lazear

Edward P. Lazear is a labour economist and a founder of the field known as personnel economics. His research centers on employee incentives, promotions, compensation and productivity in firms. In this episode, Lazear and Kevin Murphy talk about the legacy of human capital and labor economics at the University of Chicago, as well Lazear’s experience crossing from academia to the Council of Economic Advisers

The Kindle edition of the greatest book ever written is now available

I have just noticed that the Kindle edition of the greatest book ever written, aka The Theory of the Firm: An overview of the economic mainstream, is now available.

The big advantage of this edition is the price, US$43.53 compared to US$135.20 for the hardback. Still not exactly cheap but it is cheaper, by a reasonable amount, than the hardback.

I have also, unfortunately, had to update the errata section on the webpage for the book.

Monday, 19 September 2016

Why you shouldn't copy your classmates

Students beware, if you rely too much on your classmates, you all suffer.


The takeaway for students is stick together, but not for too long.

Does the division of labour matter?

The short answer is yes.

Adam Smith argued that the an increasing division of labour was a driver of technological improvement, increases in output and reductions in the prices of goods and services. But was Smith right?

According to a paper recently accepted by the Quarterly Journal of Economics the answer is yes.

The paper Adam Smith, Watch Prices, and the Industrial Revolution is by Morgan Kelly and Cormac Ó Gráda. They set out to evaluate Smith's claim that watch prices - watches were one of the first mass produced consumer goods and were Smith's prime example of technological progress - may have fallen by up to 95 per cent over the century preceding Smith.

The paper's abstract reads:
Although largely absent from modern accounts of the Industrial Revolution, watches were the first mass produced consumer durable, and were Adam Smith’s pre-eminent example of technological progress. In fact, Smith makes the notable claim that watch prices may have fallen by up to 95 per cent over the preceding century; a claim that this paper attempts to evaluate. We look at changes in the reported value of over 3,200 stolen watches from criminal trials in the Old Bailey in London from 1685 to 1810. Before allowing for quality improvements, we find that the real price of watches in nearly all categories falls steadily by 1.3 per cent per year, equivalent to a fall of 75 per cent over a century, showing that sustained innovation in the production of a highly complex artefact had already appeared in one important sector of the British economy by the early eighteenth century.
The authors also note that,
If we assume modest rises in the quality in silver watches, so that a watch at the 75th percentile in the 1710s was equivalent to one of median quality in the 1770s, we find an annual fall in real prices of 2 per cent or 87 per cent over a century, not far from what Adam Smith suggests.
One wonders how Smith obtained his estimate. He didn't have right fancy econometrics to help him.