## Wednesday, January 29, 2014

### Tribes, Gods, Indeterminancy, Property, Capitalism

The title of this post reflects the tone of my casual reading list for about the last month. I wanted to provide a brief comment on some of the books in the hope it may guide others.

Big Gods: How Religion Transformed Cooperation and Conflict
Ariel Norenzayan

The book opens by introducing the eight interrelated principles that summarise the book’s core arguments.
1. Watched people are nice people
2. Religion is more in the situation than in the person
3. Hell is stronger than heaven
4. Trust people who trust in God
5. Religious actions speak louder than words
6. Unworshipped Gods are impotent Gods
7. Big Gods for Big Groups
8. Religious groups cooperate in order to compete
These principles appear to describe religion as a formalised system of reward and punishment for within-group cooperation, allowing groups or tribes to out-compete other tribes. So far this is completely consistent with much of the experimental economic work on group cooperation and punishment, much of which contradicts game theoretic predictions of a lack of cooperation.

Folk theorems also get a mention, thankfully.

In all this is a good explanation of the rise, fall, of amorphous conceptions of religion and gods. Read it.

I recommend this book for those who want to start thinking about morality and justice. Unfortunately I could sum up the book with the following: Utilitarianism is good, but ultimately impractical for determining morality, and for solving the more pressing problem of conflicting inter-group morals.

The thing this book does well is put in one place a coherent explanation of the evolved moral drivers for cooperation. Such moral drivers allow often astonishingly coordinated feats to be achieved by single groups - I'm think of the pyramids, or extensive military operations during wartime - while at the same time producing conflict between groups that at first glance appears immoral.
Morality evolved to enable cooperation, but this conclusion comes with an important caveat. Biologically speaking, humans were designed for cooperation, but only with some people. Our moral brains evolved for cooperation within groups, and perhaps only within the context of personal relationships. Out moral brains did not evolve for cooperation between groups (at least not all groups). How do we know this? Because universal cooperation is inconsistent with the principles of natural selection. I wish it were otherwise, but there's no escaping this conclusion.
This snippet of evolutionary moral theory sits at the heart of so many economic problems - the maintenance of peace, facilitation of trade between groups, nations, etc, tax morale and the willingness that masses conform to common laws, and more.

While I loved the discussion and explanation of moral challenges, Greene doesn’t seem to offer much to help resolve these challenges. Perhaps there are no solutions.

Owning the Earth: The Transforming History of Land Ownership

This is kind of a historical story-telling book about experiments with different types of land ownership around the world, linked with philosophical discussion and anecdotes about key characters in these historical stories. Very much worth reading if you want understand the social product that is property rights, and how these need to be balanced between rights for individual owners and for society at large.

Average Is Over: Powering America Beyond the Age of the Great Stagnation
Tyler Cowen

Tyler Cowen wrote a whole book about inequality and long term labour market trends facilitated by labour-saving technology without once mentioning William Baumol. And for the life of me I just can’t understand how anyone, especially this respected economist, can waste so many words justifying inequality of labour market outcomes in terms of Solow’s unexplained residual.

As if by inter temporal magic, Cowen uses examples of 2000’s era tech startups to explain labour market trends that began in the 1970s.

What stares you in the face is the glaring omission of any policy discussion - it’s as if the changing nature of production technology occurred in a ceteris paribus world of unchanging policy. When in doubt label the residuals some kind of eminent flux of ideas rather than intentional incremental policy changes in favour of the asset-owning class.

A refutation of Cowen’s analysis of the impact of technology on the labour market and on income distribution simply needs to comprise an example of a period of extensive residual (technology) change that was not accompanied by rising inequality and labour market dysfunction. In the west we have a good recent example of the post war boom of the 1950s and 60s, where rapid commercial adoption of military technology was taking place. The only differences between then and now are institutional structures that produce more unequal outcomes.

After all, income distributions are a policy choice regardless of technology. I like Matt Bruenig’s take on this point.
If we had wanted to make sure median incomes continued to rise, we could have done that. We would have just needed different distribution policy.
This book is a big distraction.

Economic Indeterminancy: A personal encounter with the economists’ peculiar nemesis
Yanis Varoufakis

This is a terrific book aimed at the economic profession (it gets quite technical) about the tribal nature of economics and its attachment to determinacy and finding single ‘solutions’ to the issues they analyse.

Varoufakis takes us through much of his work on whether there is a rational economic theory of conflict, which I found very interesting.

The introductory chapter really summarises the way economists limit their analysis by adopting the ‘dance of the meta-axioms’ that defines neo-classical economics. He explores the way the core of economics was challenged multiple times only to recoil from the ‘wall of indeterminancy’ and either ignore critiques or slightly modify their theory in order to regain their determinant solution, even if they have to defy logic to do so.

One good example is the capital controversies, which essentially state that you can’t measure capital. This would absolutely crush the core production theories. Alas, although the UK Cambridge won the battle, they lost the way, and these crucial debates are now routinely ignored.

Recommended for frustrated economists.

23 Things they don’t tell you about capitalism
Ha-Joon Chang

Which could be called '23 common sense things people know but economic training beats out of them’. I want to briefly note some of my personal favourite ‘Things’ Chang writes about.

There is no such thing as the free market
This point cannot be stated enough in the libertarian wild west of the blogosphere. Legal institutions and enforcement, especially regarding the protection of contracts and private property, are the foundations of market exchange. Prices are facilitated by a monetary and banking system supported by decades, if not centuries, of institutional development.

Free market policies rarely make poor countries rich
I recommend Chang’s book Bad Samaritans to cover this point in more detail. Essentially, every developed country, including the newly developed, followed policies that are routinely opposed by economic theorists and policy advisors in the west. Government-backed export industries and infrastructure investment are usually critical ingredients, whether they occur through government owned corporations or other cooperative partnership with private sector companies.

We do not live in a post-industrial age
The declining share of economic activity occurring in agriculture and manufacturing is often interpreted as some kind of ‘decoupling’ of the economy from activities involving the transformation of material goods. What we usually forget is that these measurements are typically the result of a) a limit to agricultural demand, and b) Baumol’s cost disease, whereby productivity growth in any sector passes through to higher wages in other sectors. Thus it is only because there is a highly efficient agricultural and manufacturing sector that high wage tertiary services sectors can exist.

More education is not going to make a country richer
A simple thought experiment can make it obvious that education is not the crucial ingredient, and that education need only be ‘matched’ to the available real capital for countries to prosper. Chang uses the example of Switzerland’s low rates of tertiary education, and its more vocational post-school training which delivers competent workers with the skills necessary to complement high tech production equipment.

The general rule here is that education is only valuable if the physical capital exists to complement the know-how in genuine production activities. Many economists are often unable to comprehend this obvious point.

Big government makes people more open to change
The argument here is that a strong welfare state allows the private sector to be more dynamic since workers are less threatened by losing their job and are therefore more eagerly adapt to corporate change. This allows companies to be more dynamic and innovative. Chang explains that the US approach of employer-facilitated welfare in the form of health insurance creates a massive fear of losing one’s job, and hence creates tensions between workers and owners of a business seeking to reorganise. In countries where healthcare is publicly provided and not linked to employment, and where decent unemployment benefits and job transition arrangements are available, workers need not fear corporate owner’s decisions.

Finally, good economic policy does not require good economists. Nothing more to add to that!

## Sunday, January 26, 2014

### Why is return-seeking optimal?

In my rather long introductory post on the new theory of the firm (now published here) I developed with Brendan Markey-Towler, I listed many important characteristics of our model. I now want to invest some time expanding on these points in a series of posts.

The first characteristic of our model is the way we relaxed assumptions about market conditions. Rather than the unrealistic free entry and exit and perfect knowledge conditions that define most models, our model world is simply defined by a scarcity of resources.

In the paper we make a peripheral link between return-seeking firms and maximising the value of a firm’s real option to invest. We do this because real options analysis also relaxes many assumptions about market conditions compared to the mainstream model, which leads to a rather different firm objective. But I believe there is a closer link.

Dixit and Pindyck showed that under the realistic situation where firms face uncertainty about the future, and where costs incurred in production are irreversible and able to be delayed, that the value-maximising strategy of the firm is to jointly maximise 1) their current profit, and 2) the rate of change in firm value. As time reaches its infinitesimal limit the flow off current profits is zero and firms simply maximise the rate of change of firm value over time.

In our model the foundation assumption is the maximisation of profits divided by costs, which we show maximises the rate of change of profit per dollar of cost.

Is there a consistency here between a change in firm value per period of time, and per dollar of cost? Time is money isn’t it?

The logic behind this connection rests on the principle that there is a finite amount of resources available per period of time to utilise in order to increase firm value. Resources are scarce after all. Thus the practical expression of firm value maximisation that emerges from conditions of real resource constraints is return-seeking, or attempting to maximise the rate of return on all costs.

Where our model differs to analysis under real options is that we make no claims about the path of firm values over time. In our model the path of firm value is a result of active choices by firm managers rather than some assumed process.

We now show more concretely how the process of continuous capital investment choices in our model of return-seeking firms results in investment and output choices that conflict with traditional models.

Consider the optimal planned output level for a new investment in a production unit of some sort (call it capital if you will). For a firm requiring a particular threshold rate of return on their new investment (commensurate with its perceived risk and the alternative investment options for these resources), the output level for that production unit that will first justify its investment will be the output level that maximises the rate of return on all costs.

Let me just repeat that. When a firm is assessing a new investment of any kind, they will commit to it when the maximum rate of return exceeds their hurdle rate.

Look at the diagram above showing the traditional firm cost and demand curves for some discrete investment choice. At time t=1 the demand curve, p(q)1, is below the average total cost curve at all points. Thus there is no positive return to be gained from this potential investment.

At time t=2 however, demand has shifted so that there is now a point (at q2) where investing in this new capital will provide a positive rate of return. The timing of this new investment will be when the maximum rate of return exceeds the hurdle rate reflecting the perceived risk in that market.

Finally, at t=3 this firm will produce a slightly higher output at the greatly increased price if they remain on this cost curve. If other cost curves are available then a firm will expand output by ‘jumping’ to the next available cost curve at the point that maximises the rate of return on costs (also remember that the capital, or production unit, space exists only as discrete set of curves).

Capital investments are made on the basis of planned production at the point on their cost curve that maximises their rate of return.

Traditional economic analysis has no agreed method for dealing with the process of capital investment - either capital is fixed, or it has already perfectly adjusted to the ‘long run’. The active choice of capital and the output for which it is designed to be utilised, is not a consideration.

In our more realistic model world capital choices are being continually made. Therefore in normal operation of markets, where expectations are reasonably good on average, capital will be utilised at the point that maximises the rate of return on all costs.

Our setup of capital input choices as cost curves existing in a discrete space also allow firms to continually invest in new operations. In order to analyse firm price, output and investment choices in the model we have no need to invoke arbitrary time periods where some arbitrary inputs into production are fixed or flexible.

Our firm decision rule is therefore one that firms can use to make investment choices to most rapidly grow their firm value in a world of scarce resources.

## Sunday, January 19, 2014

### Time for a new theory of the firm

I don’t know how best to say it, so here it goes - the current mainstream theory of the firm is dodgy. Real dodgy. Put simply, the theory of the firm that we all know and love tolerate, is a neat mathematical construction contrived to support an already established, but flawed, theory of markets.

If we want to make real progress in economics we need a new theory of the firm upon which we can build a theory of markets; fully informed by empirically observation and able to generate realistic predictions about production, trade and prices.

Is that too much to ask?

I stumbled into this challenge. In first year economics when the supply curve was shown as upward sloping, the annoying undergraduate in me asked: Why? When we get on to exactly why the supply curve is upward sloping, lo and behold, it is simply a representative firm’s marginal cost curve. Amazing!

But wait. If that’s true then firms operate at a point where there are diseconomies of scale. Yet didn’t most goods come down in price as output increased? What happened to the whole idea of economies of scale?
Oh what’s that? You’re getting confused between the short, medium and long run young grasshopper, of course there’s economies of scale, but we don’t lose anything from the analysis by assuming they exist only in the long run.
Tell me more Obi-Wan.

It was far too ad hoc for my liking. The contrived concept of short, medium and long run, is to all accounts quite inconsistent, since all periods of time must be part of all ‘runs’. But as a good economist-in-training I shoved my doubts back into the suppressed deviant skeptic part of my mind and accepted that marginal costs probably slope up. Surely the chaps with all those PhDs must have some empirical insight about this ‘fact’.

Except they didn’t. And they don’t. Alan Blinder made that clear after surveying firm managers about their cost structures and operations. He said
The overwhelmingly bad news here (for economic theory) is that, apparently, only 11 percent of GDP is produced under conditions of rising marginal cost.
… firms typically report fixed costs that are quite high relative to variable costs. And they rarely report the upward-sloping marginal cost curves that are ubiquitous in economic theory. Indeed, downward-sloping marginal cost curves are more common…
If these answers are to be believed … then [a good deal of microeconomic theory] is called into question…
There are numerous other studies showing this to be the case - that flat or rising marginal costs are the exception rather than the rule.

So do I trust the contrived theory of the firm? Or do I trusted the empirical record? Personally, I prefer to start from observation, so I’m siding with the empirical record.

Which altogether leads to another conundrum - the heart of economic theory, that equilibrium is found where marginal cost equals marginal revenue, can no longer be accepted. Some other mechanism must be at play in the determination of prices generally.

My own experience in business, and the repeated challenges to the theory of the firm, finally revealed to me what was missing from the theory.

Returns.

It’s strange to think how in economic commentary the rate of return and profit are terms used almost interchangeable. Even Milton Friedman did this from time to time, saying that ‘firms behave as if they were seeking to maximise their expected returns’. He did a poor job of clarifying what he meant by returns, only that he uses the term profits as the realised ex post version of the ex ante expected profits, which he labels returns. Strange but true.

The foundation of economic theory is actually centred on profit-maximisation, being the maximisation of revenue minus costs. Returns, by every definition apart from Milton Friedman’s, are profits divided by costs. Colloquially, profits are ‘bang’, and returns are ‘bang for your buck’ - and I’ve never heard of anyone trying to get the best bang without trying to economise on the buck.

Just think of Milton Friedman assessing a production plan before a company board:
MF: This project will earn a return of $10m! Board member: Great! But a return of$10m on what?
All the more strange is that Avinash Dixit and Robert Pindyck made the astute observation twenty years ago that in the real world of uncertainty, and where investments in new businesses and expansions are risky and costly (meaning firms have a real option to delay incurring costs to increase production levels), that maximising the growth rate of firm value is akin to maximising its present value. In a world of scarce resources, maximising the growth in value can be achieved by maximising the rate of return on those resources.

So if maximising the rate of return is ubiquitous in financial analysis, and has strong foundations in economic analysis under realistic market conditions, why hasn’t our theory of firm production been updated to address this?

Well, today it has.

We - myself and co-author Brendan Markey-Towler - have released a working paper outlining a new theory of return-seeking firms (now published here). And to our surprise, what seems a rather minor change in the firm’s objective function leads to a variety of results consistent with the empirical record, and with many alternative theories of firm production and pricing (such as mark-up pricing).

What did we do?

First, we relaxed the assumptions about market conditions. Rather than the unrealistic free entry and exit and perfect knowledge of the future which define most models, in our world firms face uncertainty, have irreversible costs, and can delay investment to future time periods. As per real options theory, these conditions give rise to our firm objective of return maximisation.

Next, we allow competition to enter the model via the shape of the firm-specific demand curve in the manner of monopolistic competition. The firm specific demand curve can be specified to include the supply of other firms producing substitute goods, and the parameters of the curve can be varied to reflect differing intensity of competitive pressures.

We do this because the usual model condenses similar products into a single market, yet there are almost no examples of markets where the goods produced by different firms are perfectly interchangeable. Hence, competition is a process of return-seeking between firms competing in close substitute goods. This conception of competition also predicts non-price competition which aims to reduce the price sensitivity of customers, such as loyalty schemes and other incentives, and of course, product differentiation.

Because of the way market competition is conceived in our new model, there is no need for the arbitrary conceptual leap between a downward-sloping market demand curve, and a horizontal curve faced by a firm in a competitive market. All firms operate in their own markets, whose demand schedule is influenced by the offerings in substitute markets.

One thing that is consistent with the traditional model of markets is that the more competitive a market the firm faces, in terms of having a flatter demand curve (more price sensitive customers who have more substitutes available), the greater their output with a specific level of capital.

I show this in panel (c) of the figure below, where competitive (q*c) and monopolistic (q*m) outputs are chosen when the same firm faces a competitive demand curve, p(q)c, or a monopolistic-type demand, p(q)m, using the same capital inputs.

 Comparison of profit-maximising and return-seeking firm choices

Third, firms choose their inputs and output level to maximise their rate of return. This means that the price is above the marginal cost (and above average cost) such that mark-ups over cost are a feature of firm accounting structures. It also means that there must exist some economies of scale for firms to produce at all.

In the special case reflecting a traditionally perfect market (firms face a horizontal demand curve), return-maximising firms do not respond to changes in demand. They produce at the point of minimum cost at all times, as long as prices are above costs (shown as point q* in panel (a) of the above figure). Hence there is no supply curve as such in this market.

Indeed, even under imperfect markets, where firm-specific demand curves are downward sloping, the path of a firm’s supply response to a change in demand depends both on the shape of their cost curve and the shape of their demand curve. Hence, there is no supply curve, merely a response to changing market conditions conditional upon a firm’s cost structure. This has implications for long run trends in the relative prices of different goods. For example, goods limited natural supply, such as land and mineral resources, will increase in price relative to manufactured goods where economies of scale dominate.

In panel (d) we show that the emergent supply response can lead to what some might call a downward sloping demand curve (following a rightward shift of the demand curve from p(q) to p(q)delta).

Fourth, we make the input and output space of the firm discrete, meaning firms can only produce goods in discrete quantities, or batches, and can only choose capital inputs in discrete amounts. This is highly relevant to the capital debates, which demonstrated the inadequacy of capital aggregation. In our model firms face discrete choices in their capital investment, allowing ‘lumpy’ capital units, and various production techniques to be exclusive choices for firms.

The discrete nature of firm choices also means that firms are almost never going to be at their optimal point - they will be seeking to get there but typically they will be unable to because the optimal point is between two discrete choices. Hence we call the model one of return-seeking, rather than maximising, firms.

Such a disequilibrium approach allows for interactions between investment paths of firms across the economy as each firm’s slightly imperfect decisions cascade into those of other firms, resulting in a business cycle driven by capital investment choices. For example, a large firm in a region undertakes a capital project, thereby increasing the income of the workers, who in turn increase the revenues of other businesses, who in turn undertake return-seeking capital investment choices based upon expectations of continued growth in revenue.

Fifth, in our model there is no need to invoke a ‘normal’ rate of return on costs, since all real returns are driven by investment and output decisions in markets. Rates of return emerge from the market, rather than being fed into the market and emerging from some deep group psychology.

Sixth, the existence of a firm relies on both economies of scale and uncertainty - both of which must feature in our model. This shouldn’t be a surprise, since some rather hard-hitting economists have also made this point. Here’s Ronald Coase - “It seems improbable that a firm would emerge without the existence of uncertainty.” And not forgetting Frank Knight - “Its [the firm’s] existence in the world is a direct result of the fact of uncertainty”. We simply add that economies of scale are also necessary, since output would be infinitesimally small for any firm if that wasn’t the case.

Lastly, we need not invoke any special notions of short, medium or long run to understand markets. At all points in time firms are investing in new capital - it is a continuous process in the macro economy, even if at a firm level these lumpy capital investments are undertaken intermittently.

Phew.

We never expected that the small changes we made to ‘what firms do’ in a model would capture so many features of reality that had so far been treated in an ad hoc manner.

One important question concerns the value in this new theory. What can it tell us that existing theory cannot?

I’ve thought about this a lot, and the answer is a great deal. It may take a number of posts to cover the important ones, such as; regulation of private monopolists, analysis of competition and market structures, the dynamics of market power and innovation, the ability to define economic rent broadly, the impact of regulations on competitiveness, competition via market share, and more. But let me just give you an example that I think is extremely important.

Housing supply.

The usually approach is to suggest that rising home and land prices have some connection to town planning regulations that determine location and density limits for new housing. If prices are rising, then according to our mainstream theory there must be a regulatory or physical constraint on the ability to shift the supply curve.

But the theory of return-seeking firm suggests that for many land owners the optimal choice is to withhold their land from development. Because there is an ability to delay investment, deferring capital improvement maintains the option value to develop at a later date to a much higher density. It may currently seem optimal to develop a 3 storey apartment building, but if I delay investing, I might be able to develop a 10 storey building in five years time and increase my return on the land.

In fact land development is a core example in real options theory.

If a government wanted to intervene in this market to increase housing stock compared to the status quo under existing regulations, our theory of return-seeking firms suggests that any policy that reduces the rate of return of the land owner when they delay will be effective at bringing housing investment forward in time. One idea is to announce a future restriction on development density, or implement a land value tax, which will reduce the potential rate of return from delaying investment.

Again, the working paper is here for those who wish to review our approach. I appreciate all responses and criticisms.