Tuesday, February 25, 2014

What does affordable housing mean?

In my submission to the Senate Inquiry on Housing Affordability I wrote the following

Home ownership and reducing housing costs are not necessarily related policy goals. Housing can be cheap with extremely low rates of home ownership, and expensive with high rates of ownership. Clarity about what housing affordability means as a social policy goal is necessary.

There is usually an implicit stance in the housing affordability debate in Australia that a high rate of home ownership is a desirable policy goal. For some reason, a renting society is frowned upon. I put this down to tradition.

In Switzerland and Germany for example, around 60% of households rent. In Denmark and Austria it is around 50%. In Australia 30% of households rent.

We must remember that affordability of buying homes is not the same as making housing cheaper. Making housing cheaper means focussing on rental prices and their share of household income. If rents fell by 25% but prices didn’t, surely we would say housing has become more affordable. And vice-versa, if home prices increase 25% but rents were flat, we should say that housing has become less affordable.

A home is a financial asset that produces a place to live. Why do we care about owning the financial asset that produces our housing, but we don’t care about owning the assets used to produce our food, clothing and other goods? No one ever talks about a BHP share affordability problem!

The exact meaning of affordable housing is a crucial question to consider before any constructive housing policy can be developed.

Some may argue home ownership is about security. Home owners can put down roots because they know they won’t be evicted by a greedy landlord. But security of tenure can equally apply to rental housing, as it does in many countries. We just choose not enact the regulation to enable this to happen. Maybe readers have other reasons that home ownership is socially desirable.

For my part, I believe it is actually counterproductive to tackle housing affordability by encouraging greater home ownership.

Here’s why.

High home-ownership rates imply that most of the electorate has a financial interest in keeping prices high. This implies an interest in keeping rents high in order to maintain those prices. Thus, the interests of the home owner and the investor are aligned against the interests of the renter. 

When the bargaining power of renters is curtailed it merely enables investors to extract the full share of rents - that is, they are able to charge the maximum that renters are willing to pay. Any reduction in rents is merely a transfer of wealth from investors and home owners to renters.

With a higher proportion of rental households governments would be forced to improve conditions for tenants, and by doing so, increase their bargaining power.

Buying a home in Australia currently costs between 1.5 and 2 times more than renting, meaning that few rental households have an outside option of buying. They rent because they have to.

We can improve the bargaining power of renters either though changes to rental regulations, or through improving the home-buying outside option. This means that the very act of reducing prices, via LVR restrictions, removing the FHOG, and limiting CGT discounts and negative gearing, means that home buying will reduce in cost compared to renting, allowing buying to be a financially viable alternative to more currently renting households.

For more discussion on the issue I recommend this paper, which contains a wealth of data on rental housing in the OECD, and reasonable discussion about these important issues, including rent controls and the need to shift bargaining power towards tenants to reduce housing costs.

Once we focus on the rental price of housing, and not the price of the financial asset of residential property, we get a very different picture of the housing affordability debate. In fact, we get a picture where housing affordability has remained relatively stable in Australia over the past 20 years. And one where home ownership may even be a policy goal at odds with the goal of affordable rental housing.

But that doesn’t mean we can’t change the situation if we wanted to. We just have to accept that doing so involves a massive transfer of wealth.

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Monday, February 24, 2014

Inequality is a capital vs labour story

I was in a seminar recently where the presenter explored some trends in income inequality in Australia, Canada and the US over the past century. While there was much to like about economists trying to unravel this issue, including the repeated reminders that representative agent models cannot deal with this problem, I had some niggling doubts that the whole story was being considered. I thought this presenter was sticking to only the issues deemed acceptable to discuss in the economics community, while ignoring the more important political issues.

First the good parts. Education is not a solution to income inequality. Canada and the US in particular are very highly educated countries, whose average educational attainments have soared for the past 30 years - the exact period that also saw huge growth in inequality. 

It was acknowledged that the greater the degree of inequality, the easier it is to buy favours within political processes, further entrenching the income divide. It was nice to see economists raise these political points, but equally it highlighted how much of a disgrace it is that economists (and economic theory) play such a key role in capturing political processes for the 1%. 

Now to the issue I believe is the crux of the income equality debate.

I was informed in the presentation that the inequality story of the past 20 years is not about the division of income between capital and labour. Labour incomes in the top 1% are increasing very rapidly too. Sure. But we know that CEO and executive pay is more closely linked to capital returns than ever before, following the wide acceptance of the principle of incentive pay and aligning executive pay to share market performance. 

When I look at the data from the Henry tax review, I find that in fact that the distribution of income from capital is far more distorted towards the upper end than income alone. 

I’ve borrowed the chart below from the Henry Review website. What we see is that the top 5% of income earners in Australia get half of total national income from owning capital assets. While they only get 15% of the wages. 

We can even see that the bottom 20% are making capital losses (capital gains and dividends), highlighting the process by which the poor are becoming more dependent on labour income. 

Many researchers do in fact note that decreasing labour share, and therefore increasing capital share, of national income has been a global trend since the 1970s. What few say however is that this is trend is a result of policy choices informed by neoliberal ideology. We certainly could have avoided this trend if we desired. It was simply a matter of different policy choices. And to reverse the trend is also very simple, should be desire to do so. 

There is no 'natural' outcome when it comes to inequality.

In a mere technical sense, reversing the trend couldn’t be easier. Off hand I can think of dozens of policies; from inheritance taxes, greater public transparency of personal income data (including trusts), land taxes, improving the power of shareholders in the determination of executive pay, grants of land or capital for public service, and more. The options are limitless. 

The barrier to change is modern realpolitik. Those at the top have captured the political process, partly by capturing the media. Any change will entail a massive redistribution of wealth from those who bankroll the political parties, to those with the least resources, the least education and the least interest. 

This is the heart of the matter, and one we repeatedly avoid discussing.

Sunday, February 23, 2014

Pretending to care about housing affordability

Australia is embarking on another Inquiry into housing affordability. In the past decade almost every government body, at every level of government, that has any function related to any aspect of housing policy, has conducted similar inquiries. With zero results.

Is it time we stopped pretending to care?

I made a submission (pdf here) to the inquiry, not because I think things will change, but to highlight the 'big picture' considerations in any housing policy. You know, the ones we don't talk about because the Overton window has been slammed shut by decades of well-funded propaganda by wealthy interest groups. Just look at the content of other submissions to see how they miss the big picture, either simply promoting their own financial interests or preserving their reputation by reiterating arguments deemed acceptable in polite company.

My main point is this - any policy that successfully reduces housing rents, and subsequently home prices, entails a massive redistribution of wealth from the richest to the poorest. I wrote the following in my submission.

At current prices Australia’s total housing stock is valued at around $5 trillion. If a policy successfully reduced rents and prices by 20% it would wipe $1 trillion of value from this market. Purchasing power of around $40 billion per year would be redistributed from the almost 6 million current home owning households and 1.8 million residential property investors, to the 2.8 million renters, along with future home buyers and owners of other non-residential domestic assets. 
There is no win-win scenario. Housing affordability is almost completely a question about the distribution of wealth in society. 
To understand the magnitude of potential redistribution from successful policy to improve housing affordability, a reduction in housing rents by even as little as 10%, would lead to possibly the largest redistribution of wealth from the richest to the poorest in Australia's recent history.

Politically it makes sense to pander to the majority. And while the majority of households still own their own home, absolutely nothing will be done to reduce rents and home prices. Even the ridiculous fig leaf of the First Home Owners Grant is actually a subsidy to existing home owners. It's the most fantastical piece of doublespeak to not call it what it really is - the Current Home Owners Grant.

This is the elephant in the room on housing policy. Here. Right here. I'm pointing at it.

Watch me be ignored.

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Thursday, February 20, 2014

The 140 year cycle in macroeconomic thought

I am reading Progress and Poverty: An Inquiry into the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth: The Remedy by Henry George (free ebook available here)
I’ve been fascinated so far that the economic debates that occurred during the long recession of the 1870s are almost identical to those still occurring during the great recession. I would have expected more progress in macroeconomic thought in 140 years.

Here’s George describing the utter disarray of the economic elite of that time in explaining how the depression had arisen, and where to look for a remedy.

This is shown by the widely-varying attempts to account for the prevailing depression. They exhibit not merely a divergence between vulgar notions and scientific theories, but also show that the concurrence which should exist between those who avow the same general theories breaks up upon practical questions into an anarchy of opinion.  
Upon high economic authority we have been told that the prevailing depression is due to over-consumption; upon equally high authority that it is due to over-production; while the wastes of war, the extension of railroads, the attempts of workmen to keep up wages, the demonetisation of silver, the issues of paper money, the increase of labour-saving machinery, the opening of shorter avenues to trade, etc., etc., are separately pointed out as the cause by writers of reputation.

The modern equivalents are

1870s excuses                      2000s excuses
over-consumption           → excess household debt
over-production              → excess housing construction
wastes of war                  → government waste or regulation
high wages                      → high wages
currency debasement       → currency debasement
labour-saving machinery → robots

I found even more interesting the debates about the nature of capital and wealth that occurred at the time. George criticised the writers of common textbooks for not being specific in their definitions which caused much confusion when applying economic reasoning to the problems of the day. It seems an awful lot like the Cambridge Capital debates of the 1970s and reminded me of debates (or indeed lack of debate) around foreign investment that appear to have subsided in the past few decades. 

Here’s a snippet, which shows George would firmly be on the side of Cambridge, England, in the capital debates, and would be firmly of the position that foreign investment is merely a transfer and is not wealth-creating. 
As commonly used, the word " wealth " is applied to anything having an exchange value. But when used as a term of political economy it must be limited to a much more definite meaning, because many things are commonly spoken of as wealth which in taking account of collective or general wealth cannot be considered as wealth at all.

Increase in the amount of bonds, mortgages, notes, or bank bills cannot increase the wealth of the community, that includes as well those who promise to pay as those who are entitled to receive. 
The enslavement of a part of their number could not increase the wealth of a people, for what the enslavers gained the enslaved would lose. Increase in land values does not represent increase in the common wealth, for what land owners gain by higher prices, the tenants or purchasers, who must pay them, will lose. 
And all this relative wealth, which, in common thought and speech, in legislation and law, is undistinguished from actual wealth, could, without the destruction or consumption of anything more than a few drops of ink and a piece of paper, be utterly annihilated.  
By enactment of the sovereign political power debts might be cancelled, slaves emancipated, and land resumed as the common property of the whole people, without the aggregate wealth being diminished by the value of a pinch of snuff, for what some would lose others would gain.  
There would be no more destruction of wealth than there was creation of wealth when Elizabeth Tudor enriched her favourite courtiers by the grant of monopolies, or when Boris Godoonof made Russian peasants merchantable property. 
All things which have an exchange value are, therefore, not wealth in the only sense in which the term can be used in political economy.  
Only such things can be wealth the production of which increases and the destruction of which decreases the aggregate of wealth. If we consider what these things are, and what their nature is, we shall have no difficulty in defining wealth. 

What amused me is that George looked for answers in political economy

It must be within the province of political economy to give such an answer. For political economy is not a set of dogmas. It is the explanation of a certain set of facts. It is the science which, in the sequence of certain phenomena, seeks to trace mutual relations and to identify cause and effect, just as the physical sciences seek to do in other sets of phenomena.

Maybe it’s time to follow his lead, again, and look outside of sterile economic theory to resolve problems of macroeconomic instability.

Monday, February 17, 2014

Open borders: A morality play by the 1%

Alex Tabarrok, who I rarely agree with, has recently argued his moral position on open borders here. There is no doubt that most moral frameworks also support his position. As do I in the mere theoretical sense. As Tabarrok argues

How can it be moral that through the mere accident of birth some people are imprisoned in countries where their political or geographic institutions prevent them from making a living?

I have argued before that redistribution of wealth from the world’s richest to the world’s poorest should be at the top of the policy agenda for any economist who believes in the utilitarian foundations of their discipline. Open borders is an indirect method for pursuing similar goals of increasing wellbeing for the poorest, and usually promoted by those who fall on Mankiw’s side of the political spectrum; by those who typically argue that the rich ‘deserve’ their wealth (counterargument here).

Open borders is merely the logical outcome of any type of ‘natural rights’ approach to moral reasoning. People should have the opportunity to flourish irrespective of the patch of Earth they were born. Yet the idea boils down to being the policy you support when you want to help the world’s poor but don’t support actually giving them money. Tabarrok’s argument equally applies within borders between the rich and poor, and I paraphrase his comment to make this point. 

“How can it be moral that through the mere accident of birth some people are imprisoned in towns and suburbs where their financial and geographic constraints prevent them from making a living?”.

That open borders within countries does not automatically eliminate poverty reminds us be skeptical of claims that opening borders between them will reduce poverty automatically.

It helps to identify the potential winners and losers from opening borders in order to better understand the motivations of its proponents. If open borders works, and large scale migration occurs, the net effect is that the poorest in the world’s richest countries would have their wages reduced due to competition for unskilled jobs. By contrast, the richest individuals in rich countries, whose incomes are derived mostly from owning capital, would increase due to the greater demand for their domestic assets (such as land) following high levels of immigration. 

Even the wildest proponents of open borders agree that

…open borders could not on its own eliminate poverty and that international migration could only help the relatively better off among the global poor

The rich get richer; that we know with some degree of confidence. The poor get, well, we don’t know. Probably poorer in relative terms, maybe richer in absolute terms. We just don’t know. But we can be fairly certain that the poorest in the world are unlikely to walk away from their homes and straight into the most exclusive enclaves of New York and London. Indeed, one suspects that the most highly educated from the poorest countries will be the first to leave (as they often are now).

Open borders in a global sense is therefore likely to be a game that benefits the richest from the poorest countries and still leaves the poorest with few options to improve their economic fortunes.

Putting this raw economic analysis to one side for a moment, one question seems completely overlooked by proponents of open borders. Why do borders exist in the first place? If we can’t satisfactorily answer that question we won’t get far understanding the many important social issues that would accompany open borders.

A very brief and abstract story of borders is as follows. National borders typically exist as a result of previous wars, or the negotiations that took place between competing interests under the threat of war. These borders now serve as moral boundaries, whereby we see those within our border as part of our tribe. Tribes reinforce their internal cohesion through social signals, customs and rituals which foster stability. This process, however, can distance them from other tribes (countries).

It is these tribal and moral values of borders that make integrating tribes quite difficult. Immigration is always contentious not because of the existence of a line on a map, but because of these deeper social customs, norms and rituals are often in conflict. It takes a mighty will for immigrants to adapt to their new countries, and for citizens of destination countries to patiently accept new people with often conflicting customs and beliefs in their towns and suburbs. I generalise here probably a little too much, but the point I hope to make is that social integration is not automatic and is an extremely complex issue that needs to be properly considered in arguments for open borders.

While I don’t have a disagreement with open borders on moral principles, I disagree on practical grounds that they should be promoted as a first-best way to improve the lives of the world’s poorest. Any economic success from such a fantastical global open borders policy would come at cost of social challenges arising from what I’ve described as ‘tribal integration’. The greater the economic benefits to the, the higher the social costs at both source and destination countries. 

In many ways open borders is the type of policy you support to display street cred in the company of the economically rational, particularly when discussions turn to inequality and, god forbid, redistribution. Making the poor richer is as simple as giving them money and therefore access to resources, whether they are fellow citizens of your country, or your planet.

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Tuesday, February 11, 2014

Economics is applied morality

The ignorance of many highly experienced economists to the moral foundations of their work is quite alarming. As a group, economists typically internalise the utilitarian morality embedded in their methodology to such a degree that they are happy to promote economic theory and practice as an objective scientific approach.

To set a more honest course for the discipline I pushed hard during the development of Australian Learning Standards in Economics to include criteria for the teaching of moral foundations, in addition to professional ethics. Indeed, I have argued previously for adopting standards of professional ethics in economics. You know, to cover the usual expected standards of professionalism such as not making comments in public forums without disclosing financial interests. 

I couldn’t get the actual words morals and ethics into the new learning standard. But the result was very good I think, with the fifth learning standard being called Reflection, and containing the following
Bachelor graduates will be able to reflect on the:
  • nature and implications of assumptions and value judgments in economic analysis and policy
  • interactions between economic thinking and economic events, both historical and contemporary
  • responsibilities of economists and their role in society.
You wouldn’t believe it, but one concern was that there may be insufficient expertise within the cohort of university professors to achieve this standard. So in the interests of raising awareness, I want to provide a very brief comment on the moral foundations of economics.

Utilitarianism is the moral foundation of economics. The idea of the greatest good for the greatest number is intuitively appealing. But applying a utilitarian framework relies on value judgments about the desires, and a comparable measure of their intensity, of every individual. Some of the defining debates in economics over the past century have centred around the measurement and comparability of utility between individuals.

Thus any application of economics requiring estimation of costs or benefits is applying a judgment about the worthiness of competing desires of the population at large. That judgment is necessarily a moral one.

Further, most economic analysis applies utilitarianism in an ad hoc manner, by considering only the population within national borders. Unless you are a ‘national utilitarian’ (a distinct moral position), it can never be appropriate to consider domestic policy in terms of the utility of local residents while ignoring effects on the utility of those abroad. 

A truly utilitarian analysis must always and everywhere adopt a global perspective, which would make it exceeding difficult to justify any domestic policy in the developed world that didn't entail a massive redistribution from that country’s wealthiest to the world’s poorest. 

Then there’s the moral position that only the utility of humans counts.

Other times economic analysis is more clearly a case of applied morality. In analysis of public health economists usually appeal explicitly to the idea of utils, or some metric of quality-adjusted life years. The adoption of this metric relies on a moral judgement, for it implies that the elderly are less deserving of health resources than the young. But an equally valid moral position is that the elderly are more deserving as a repayment for their lifetime of work contributed to the community. Another moral position is that the young are easily and cheaply replaced, while the wisdom held in those elderly bodies has a high value and is costly to replace.

In more general terms we face the morality problem when measuring progress. Economists prefer GDP because their utilitarian framework implies that more consumption leads to greater utility. Apart from the obvious problem that GDP only includes goods traded in markets, ignores household production and externalities, it also contains a compositional problem.

What I mean is that many of the ‘goods’ that people trade are actually what we would call precautionary spending and increase utility only because they compensate for a loss of utility arising from outside of the market. Home security is one example.

Isn’t it better to not need to have home security, than for people to feel the need to spend 5% of their income on security, including locks, alarms, surveillance, insurance and so forth?

Other measures of progress have been proposed to overcome these issues. Each of these simply reflects and alternative moral judgment.

Lastly, there are the moral positions surrounding the degree of wealth distribution, the degree of community support to offer the unemployed, the elderly, and so forth that are perennially topical. These are all moral judgements, which are easy enough to see when we get down to the nitty-gritty debate and words such as worthy come out.

There is of course much more to the story of morality in economics than can be covered in this short post. One important thing to remember is that in practice utilitarianism can be, and has been, applied to justify almost every policy position.

What we need to remember is that you can’t escape morality in economics. But understanding the moral foundations of economics is the best way to properly grasp the limits of economic reasoning. It is my hope that the next generation of economists will learn to discuss and criticise the moral foundations of economics, and by doing so see policy debates as far more complex than is typically realised when alternative moral perspectives are ignored.

Thursday, February 6, 2014

Organ markets and the problem of real options

The fanfare surrounding organ markets within the economics community is often extreme. For many it is the last frontier of market fundamentalism, with some even promoting a futures market in organs.

For others however, organ markets are so obviously ethically and morally questionable that these ‘non-economic’ concerns override their otherwise vigorous support for market solutions.

One purely practical consideration is whether markets for organs will fulfil their promise of increasing supply at all, especially from living donors. Will the ‘intrinsic’ motive of one’s moral commitment be crowded-out by the ‘extrinsic’ incentive of financial compensation?

The crowding-out hypothesis is supported by evidence of reduced blood donations in areas that pay for blood compared to those that don’t. In a classic study on conflicting motivations between financial incentives and social incentives, the introduction of a fine for late pick-ups at a selection of Israeli day-care centres actually increased the number of late pickups. The social motive to do the right thing by the centre was replaced with a financial relationship, where the fine became a fee for longer day care.

Medical professionals are much more cautious in their approach to organ markets. This survey of 739 individuals from the transplant-related medical community found that while 70% support indirect compensation for organ donation, 66% opposed direct compensation, while 84% approved of the role of next-of-kin in this decision. Other studies have found that 85% of families of donors reject any payment at all. Clearly there is more to the story that financial incentives.

I offer here a more standard economic reason why most estimates of increased organ supply from establishing a market for organs, especially by live donors, are massively overestimated. Typically organs are treated as commodities in the abstract sense used by neoclassical models of demand and supply. But in reality, organ donation is a once off irreversible and costly event for each individual, and therefore has the characteristics of a real options problem. 

Potential donors have a real option to delay donation for a better price in the future. Yep, the same constraint that determines the rate of housing development occurs in this situation, where donors face decision of when to exercise their one-shot option to donate. 

If the price of organs is rising rapidly, it will pay for potential donors to withhold their organs till a future time. Perhaps ultimately till their death, at which time they may exercise their option and bequeath the earnings to their heirs. Or they may not, since there is no financial motivation any longer (apart from bequeath motives, which are actually similar to the ‘intrinsic’ motives discussed earlier).

How such financial dynamics will effect the market for organs (including from live donors) is a concern for policy makers seeking stable reliable supply. There is clearly scope for organ price bubbles to occur, which will compromise the medical intentions of the policy in the first place.

Attempted legal markets for organs are generally compromised by unscrupulous behaviour and high levels of donations by the poorest in society, meaning potential organ donation success typically comes with associated social costs.

Non-market organ donation policies have proven to have great benefits. Setting the national default to opt-in to organ donation, rather than opt-out, seems to generate significant (usually 20-30%) increases in donations, although raising its own moral and ethical dilemmas.

My personal view is that the default option appears worthwhile and should be on the table for public discussion. But the moral controversy surrounding organ donation seems to suggest that developments in lab-grown organs will be a more attractive, potentially medically and morally. This a complex area of social policy and I am no expert. Simply offer yet another argument to quell the enthusiasm of the market zealots, and point interested readers to the variety of challenges, both moral and practical, in this area of policy.

Wednesday, February 5, 2014

Poverty is always a relative concept

This post was sparked by a piece over at The Drum (ABC) by the CIS’s Matthew Taylor. My first mistake was to misunderstand the piece as an attempt at logic, rather than an attempt at well-funded propaganda by the CIS.

Live and learn I guess.

Taylor’s argument, which is repeated by many others of similar political disposition (such as Adam Creighton) is that relative poverty doesn’t matter, only ‘absolute’ poverty. If the poor are getting richer in real terms, then it doesn’t matter if the rich are getting richer at a faster rate. 

Such absolutism on this important social issue is not helpful. This is easy to see with a very brief thought experiment. Imagine a world where half the population of 1 million people live a loaf of bread and a cup of milk per week, live in leaky shacks, and have generally poor health and short life expectancy. The other half dine on a variety of meats, vegetables and fruits, and live in luxurious mansions. 

The poverty line is drawn a 1 lot of bread and 1.5 cups of milk a week. Hence 50% of the people live in relative poverty.

Now imagine that over a period of time incomes rise for the wealthy half of the population. The best estimates put the increase in real incomes around 80% over a 10 year period. 

The bottom half are then given an extra 500mL of milk per week and absolute poverty is eliminated.

Strange as it may seem, this is exactly the argument used by Taylor and Creighton (and I’m sure many others) about how absolute poverty is decreasing. They take a relative poverty measure at one arbitrary point in time, and as long as there is an absolute gain from that starting point, absolute poverty is being diminished, and they are happy.  

They see no moral dilemma surrounding the distribution of resources in this imaginary society, either in the first instance, or after the income growth, so long as the incomes of the poorest increase over time. But the distribution of resources in society is always and everywhere a moral choice, and poverty is always and everywhere measured relative to standards of non-poverty. 

It was a moral choice to construct institutions to allow the great divergence in wealth in our imaginary society, just as it is in reality. Clearly I have in mind something like slavery in my thought experiment. In the Taylor-Creighton world, the poverty caused by slavery would be of no consequence as long as the incomes of slaves increased at any rate greater than zero. 

Now, they may appeal to moral arguments about human rights in the case of slavery - that the slaves had no opportunity to determine their own destiny. But the same argument equally applies to arguments surrounding poverty in general; those born into the poorest households had little choice about their own destiny either. Conversely, those born into the wealthiest households benefit from the most opportunities to choose the economic destiny. 

As a society we make choices about which institutions to create and enforce in order to get the outcomes we desire. I’ve noted before the moral foundations underpinning these institutions before, specifically in the case of government-supported parental leave schemes. In this case the concept of poverty is always relative, and our policy approach to poverty is always morally grounded, whether people choose to see it this way or not.

Tuesday, February 4, 2014

The firm existence puzzle and how we solve it

One of the more coherent criticisms of our new theory of return-seeking firms is that it’s not really about firms and their organisation, but rather more about markets as a whole. Apparently modern theories of the firm no longer seek to answer questions about inputs, outputs and prices, but instead look for answers about why firms exist in the first place, what determines their boundaries, how they are internally organised and so forth.

From a scientific point of view it is quite strange to drop this question, perhaps ticking it off as satisfactorily answered, despite evidence to the contrary. I certainly agree that questions about the existence of firms are inadequately addressed, in fact assumed away, in the mainstream theory. But that doesn’t mean that the determination of inputs, outputs and prices is a distinct separate issue. Why shouldn’t these factors also be key determinants explaining firm existence, size and organisational structure?

In our theory of return-seeking firms we generate a prediction about firm size based on input cost structures. Returns to scale determine a minimum size of a firm or ‘production unit’ in general (however its internal organisation is structured).

To be clear, the decision in our model is a simultaneous choice of firm size, in terms of how many resource inputs to combine, prices to set, and subsequently output choices. Thus, be default our model makes the connection between production costs and firm size via economies of scale.

We can appeal to notions such as incomplete contracts and transaction costs to explain why owners of resources choose to coordinate into single entities of particular sizes. If combining resources generates returns to scale because of reduced transaction costs, these become simply an additional benefits from scaling within-firm production. It is optimal to continue to increase the size of a single firm’s operations until the rate of return is maximised. If costs can be reduced by shrinking the size of operations, such as by splitting resources in competing companies, then it will also pay to do so. Hence it seems obvious that firms will choose to avoid facing increasing unit costs by choosing their size, including capital investment, appropriately.

The intuitive story I have in mind to support this model prediction starts with imagining that every dollar of costs necessary for a firm to spend on production comes from a different investor. To expand output in the face of increasing cost you need to add more investors (who share profits in proportion to their contribution). You do this only if the overall rate of return on the total costs is increasing. Once you hit that maximum rate of return, adding additional investors to cover greater costs reduces both profits and returns, and hence the value of a share, for existing investors. In the extreme case of a flat firm demand curve, the resulting size of a firm is one that exhausts available economies of scale.

Thus we have a testable prediction about firm size, which is that economies of scale will almost never be exhausted at the firm level. The evidence in favour of this prediction is quite strong, with most surveys of firm costs structures showing increasing returns to scale with few exceptions.

In fact the much stronger prediction from our theory is that production never occurs in a single firm where strictly decreasing economies of scale exist. What this means in practice is that if producing one unit of a good within a single firm is more expensive than producing component parts in different firms, then the single firm will not emerge, and the smaller firms will produce where they exhibit economies of scale in production.

Additionally our model supports the well understood trade-offs that occur with firm mergers; between cost reductions and market monopolisation. If mergers reduce the possibility for competitors to emerge or expand, they may still be beneficial for consumers if cost reductions are large enough.

While the research agenda into a theory of the firm no longer sees cost structures as a key determinant of a firm’s existence, our theory suggests that the link is instead rather fundamental.

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