Month: October 2009

What this Nobel prize means

It's a nod in the direction of social science, rather than economics per se.  It's another homage to the New Institutional Economics and also to Law and Economics.  It's rewarding larger rather than smaller ideas, practical economics rather than abstract theory.  It's a prize somewhat outside of the mainstream.  As you probably know by now, Ostrom is a political scientist and she has spent much of her career at Indiana University.

I was delighted to hear of Ostrom winning (which I had not expected) but frankly it makes the omission of Gordon Tullock all the more glaring.

Here are interviews with Elinor Ostrom (recommended).  On Elinor Ostrom, here is Peter Boettke and on Williamson and Ostrom here is Lynne Kiesling.  Here are varied reactions.  Here is an excellent list of long links on Ostrom.  Here is Henry on Elinor Ostrom.

Check out Ostrom's cites on Google Scholar.

Oliver Williamson and asset specificity

That's his greatest contribution (see Alex on this same point, and Jeff Ely).  Let's say you privatize a water system in Africa and write a 30-year contract with a private French company to run the thing.  As the contract nears its end, and if renewal is not obvious, the company has an incentive to "asset strip," or at the very least not maintain the value of the pipes.  Alternatively, the government might signal, in advance, that it has every intention of renewing the contract.  The company then has the incentive to lower quality to consumers, since it expects renewal a and faces weaker competitive constraints.

In other words, franchise bidding, or "ex ante" competition for the market doesn't always resolve monopoly issues  The key problem is the existence of a fixed investment in the pipes and that the value of the pipes depends on investments from both the government and the company.  It can be hard to write a contract for a good solution, since any allocation of the residual rights creates some distortion or another.  This has in fact been a very real problem with privatization around the world in many settings.  Oliver Williamson outlined these arguments in his debate with Harold Demsetz over privatizing cable TV.  Much of the literature on "mechanism design," such as David Baron's pieces, picks up on this problem and extends Williamson's work.

Williamson is a truly important economist.  If you read him, especially in his later work, he also has lots of taxonomy and verbiage.  The key is to cut through to the substance, which is plentiful.

Here is John Nye on the Prize

the unusual economics of the film industry part II

Another aspect of the economics of the film business that I don't believe is common elsewhere is that you often find vast price difference for the same commodity.  In fact, if I'm not mistaken in most industries it's illegal to sell the same product at different prices to different buyers.  Yet actor salaries can vary drastically between productions, and I'm talking about prices for the same actor.  For example Jim Carrey routinely gets paid $20M to act in a big studio comedy, but will take a fraction of that amount for a edgy, thoughtful, smaller indie like "The Eternal Sunshine of the Spotless Mind".  I use Carrey as one example, but almost all of the major film stars routinely engage in the same practice.

What has always surprised me about this is not that motivation of the stars which I completely understand.  They want to stretch, do something more daring, take creative risks, put themselves in a film that could be an award winner, etc.  They don't need the money, so they are motivated by other factors.  What surprises me is that the studios accept the price differential so easily.  I have never heard of a studio executive saying, 'Wait a minute Mr Sandler, you say you want $20M for 'You Don't Mess with the Zohan' yet the entire budget of 'Spanglish' was less than that, how does that work?"  To be sure, there are constant negotiations between the studios and agents over star salaries, and this current recession has shown that even the top stars as are susceptible to the general economy as the rest of us.  However those negotiations are aways centered around how big the star's last picture 'opened', and previous pay scale precedents do not come into play.  A star taking a much reduced payday to appear in a smaller indie production doesn't seem to weaken their bargaining power.  There appears to be no risk to their next 8 figure pay check by very publicily taking a huge pay cut in the interim.  I think this is a good thing, especially for the indie filmmaker community, but it's curiosity to me nontheless.

Oliver Williamson and the pin factory

In Adam Smith there is the pin factory and the market and from that beginning we trace the long literature in economics focused on the twin questions, What price to set?  How much to produce?  Following Coase, Williamson asks different questions, Why a pin factory?  Why are the 18 steps to make a pin performed by a single firm rather than two or more?  Why are there many firms instead of one large firm?  Why does the pin factory not vertically integrate upwards to buy the steel factory and downwards to buy the retail hardware shop?

Williamson’s answers rest on the notions of bounded rationality, contract incompleteness, asset specificity and opportunism. Start at the end, asset specificity and opportunism.  When a deal has been sealed the parties typically move from having many potential partners to being locked in.  That’s bad because it raises the possibility of opportunism–one party can exploit the other.  But it’s also good because when the lock-in is credible each party may be more willing to invest in assets which are extra-productive but specific to the relationship.

Marriage, for example, takes away some possibilities but it adds others.  With marriage, for example, comes a greater willingness to invest in children (n.b. asset specificity, the child is of extra value but only to the specific parties involved in the marriage) but that very benefit also means that one of the parties has the leverage to be opportunistic.  Knowing all of this when they enter the contract the parties bargain ex-ante, they exchange promises and make investments (the ring), they establish rules for ex-post bargaining or decide on the background rules to apply in that eventually (pre-nup, no fault divorce, covenant marriage).  The rules are never perfect and the contacts are always incomplete.

Transaction cost economics is all about applying these ideas in different settings to figure out the best governance structures (marriage, vertical integration etc.) in different circumstances. How does one deal with expensive investments (such as highly
individual dies or plant construction) that are specific to a given
trade and put the investor at risk yet which increase productivity? Williamson analyzes how firms
come to rely on long term contracts or vertical integration or other
seemingly non-competitive solutions to enhance market productivity.
Early generations of antitrust enforcers often saw these as
monopolistic dealings, but scholars such as Williamson helped us
understand how these are essential to the workings of the invisible

Williamson’s paper, The Economics of Governance (working version) published in the May 2005 AER is an excellent recent summary of his views in the area.

Williamson’s work is notable for inspiring a large body of empirical and theoretical work in modern industrial organization and having influence in law, political science, and management. His work has been widely cited, and by some counts he was the most widely cited economist in the world.

I especially thank John Nye who contributed to this post.

Elinor Ostrom and the well-governed commons

Elinor Ostrom may arguable be considered the mother of field work in development economics.  She has worked closely investigating water associations in Los Angeles, police departments in Indiana, and irrigation systems in Nepal.  In each of these cases her work has explored how between the atomized individual and the heavy-hand of government there is a range of voluntary, collective associations that over time can evolve efficient and equitable rules for the use of common resources.  

With her husband, political scientist Vincent Ostrom, she established the Workshop in Political Theory and Policy Analysis in 1973 at Indiana University, an extraordinarily productive and evolving association of students and professors which has produced a wealth of theory, empirical studies and experiments in political science and especially collective action.  The Ostrom's work bridges political science and economics.  Both are well known at GMU since both have been past presidents of the Public Choice society and both have been influenced by the Buchanan-Tullock program.  You can also see elements of Hayekian thought about the importance of local knowledge in the work of both Ostroms (here is a good interview).  My colleague, Peter Boettke has just published a book on the Ostrom's and the Bloomington School.

Elinor Ostrom's work culminated in Governing the Commons: The Evolution of Institutions for Collective Action which uses case studies to argue that around the world private associations have often, but not always, managed to avoid the tragedy of the commons and develop efficient uses of resources.  (Ostrom summarizes some of her findings from this research here).  Using game theory she provided theoretical underpinnings for these findings and using experimental methods she put these theories to the test in the lab. 

For Ostrom it's not the tragedy of the commons but the opportunity of the commons.  Not only can a commons be well-governed but the rules which help to provide efficiency in resource use are also those that foster community and engagement.  A formally government protected forest, for example, will fail to protect if the local users do not regard the rules as legitimate.  In Hayekian terms legislation is not the same as law.  Ostrom's work is about understanding how the laws of common resource governance evolve and how we may better conserve resources by making legislation that does not conflict with law.

Nobel Prize day

Whoops!  Usually today I'm supposed to stay home and cover the winner of the economics Nobel Prize.  But I'm on a plane home from Paris as the prize is announced and I am not landing for many hours.

Alex may well provide coverage of his own, but in the meantime please leave your discussion and analysis here in the comments.

I remember last year when one reporter at a prominent newspaper said to me: "If it's Lars Hansen you *are* going to explain to us what he did in plain English, right?"  Well…if Lars is going to win it, here's hoping that this is the year.

*Replenishing the Earth*, by James Belich

How is this for a real estate bubble?

At peak in 1888, over 80 per cent of Victorian private investment went into Melbourne buildings.  Expenditure on housing was even greater than that on rail, and many houses were built without people to live in them, or without jobs for those who did.

In the 1890s Melbourne was an impressive place.  With 500,000 people, it was eighty percent bigger than San Francisco and nine hundred percent bigger than Los Angeles.  Three hundred trains a day serviced the suburbs.  The city had three hundred buildings with elevators and Melbourne was reputed to have more large public buildings than any British city outside of London.  There were plans to build a replica of the Eiffel Tower.

That is all from James Belich's Replenishing the Earth: The Settler Revolution and the Rise of the Anglo-World, 1783-1939.  I'll discuss this book more soon, but I'll tip my hand and say it is one of the very best non-fiction books of the year.  Imagine Jared Diamond or Greg Clark (albeit more measured, in each case) but applied to the settlement of the colonies rather than to Europe itself.  This book also has perhaps the best explanation as to why the Argentina growth miracle fell apart.

*Misadventures of the Most Favored Nations*, by Paul Blustein

The subtitle is Clashing Egos, Inflated Ambitions, and the Great Shambles of the World Trade System and the author is Paul Blustein.

I've enjoyed Blustein's books in the past and this one covers the WTO.  It has interesting portraits of Dani Rodrik, Bob Zoellick, Pascal Lamy and others.  Maybe I was in too analytic a mood when I read this book but still I recommend it; there's not nearly enough on the topic, even if I might have wanted something more wonkish on this topic.  I would have liked more discussion as to whether the WTO matters at all (the Andrew Rose debate), or whether some countries should simply stay out for as long as possible, or a public choice take on how unbiased (or not) the whole thing really is.  To be sure all these issues pop up, but I'd like to see Doug Irwin write this book too.

Referees get worse as they age

They titled the piece "Older but not Wiser."  Here is the summary result:

Michael Callaham, editor-in-chief of the Annals of Emergency Medicine in San Francisco, California, analysed the scores that editors at the journal had given more than 1,400 reviewers between 1994 and 2008. The journal routinely has its editors rate reviews on a scale of one to five, with one being unsatisfactory and five being exceptional. Ratings are based on whether the review contains constructive, professional comments on study design, writing and interpretation of results, providing useful context for the editor in deciding whether to accept the paper.

The average score stayed at roughly 3.6 throughout the entire period. The most surprising result, however, was how individual reviewers' scores changed over time: 93% of them went down, which was balanced by fresh young reviewers coming on board and keeping the average score up. The average decline was 0.04 points per year.

"I was hoping some would get better, and I could home in on them. But there weren't enough to study," says Callaham. Less than 1% improved at any significant rate, and even then it would take 25 years for the improvement to become valuable to the journal, he says.

I thank Michelle Dawson for the pointer; I wonder when the editor who ran the study, Callaham, thinks he should resign.  He's totally gray.