Category: Economics

The benefits of outsourcing

Virginia Postrel has been blogging up a storm on outsourcing, click here for a sterling post. In addition Her latest NYT column offers an excellent historical tale of outsourcing:

In the late 1980’s, Asian manufacturers began turning out basic memory chips, undercutting American chip makers’ prices and inciting a fierce policy debate. Many industry leaders argued that the United States would lose its technological edge unless the government intervened to protect chip makers.

In a famous 1988 Harvard Business Review article, Charles Ferguson, then a postdoctoral associate at the Center for Technology Policy and Industrial Development at M.I.T., summed up the conventional wisdom: “Most experts believe that without deep changes in both industry behavior and government policy, U.S. microelectronics will be reduced to permanent, decisive inferiority within 10 years.”

He denounced the “fragmented, chronically entrepreneurial industry” of Silicon Valley, which was losing market share to government-aided Asian businesses. “Only economists moved by the invisible hand,” he wrote, “have failed to apprehend the problem.”

Those optimistic economists were right. The dire predictions were wrong. American semiconductor makers shifted to higher-value microprocessors. Computer companies bought commodity memory chips and other components, from keyboards to disk drives, abroad. Businesses and consumers enjoyed cheaper and cheaper prices.

Far from an economic disaster, the result was a productivity boom. As global manufacturing helped to reduce the price of information technology sharply, all sorts of businesses, from banks to retailers, found new, more productive ways to use the technology.

“Globalized production and international trade made I.T. hardware some 10 to 30 percent less expensive than it otherwise would have been,” Dr. Mann estimates in an institute policy brief. (Her paper, “Globalization of I.T. Services and White-Collar Jobs: The Next Wave of Productivity Growth,” can be downloaded at

As a result, she estimates, gross domestic product grew about 0.3 percentage point a year faster than it would have otherwise, adding up to $230 billion over the seven years from 1995 to 2002. “That’s real money,” she said in an interview.

By building the components for new integrated software systems inexpensively, offshore programmers could make information technology affordable to business sectors that haven’t yet joined the productivity boom: small and medium-size businesses, health care and construction.

I link to Doug Irwin’s excellent outsourcing piece at The Volokh Conspiracy. Daniel Drezner covers the debate in his usual quality fashion. Arnold Kling offers good comments as well. Here’s hoping that this swell of intellectual support for free trade continues. Here is a more ambivalent Glenn Reynolds.

Mall facts

1. At last count there were 1,175 large regional enclosed malls in the United States. Such malls account for about 14 percent of all U.S. retailing, or about $308 billion in sales.

2. The average mall customer spends 22 seconds looking at a mall map, and often leaves the map baffled.

3. The spaces near mall entrances typically yield lower rents and lower valued items. The shopper, upon entering the mall, is still disoriented and is not yet ready to buy something. That is why hair cutteries are so commonly found near mall entrances.

4. Men are more interested in people watching at malls, whereas women are more interested in shopping. Men also like the non-retail parts of malls, such as food courts, which do not require them to price shop or try on anything.

5. Bookstores have much higher “conversion rates” when they are outside of malls. Bookshops in malls are thought of as places to browse while waiting or marking time, but not places to buy books. Plus it is harder to bundle a mall bookshop with a cafe, which is often the most profitable place in the bookshop. For these reasons, bookshops are leaving malls in droves.

These assessments are from Paco Underhill’s new Call of the Mall. Underhill is arguably the leading expert in the anthropology of shopping, also read his views on selling real estate. This interview presents his views on web retailing.

How it is for me: To enjoy a mall trip, I need one fixed destination, combined with a firm plan to buy something. Add on a free hour to spare, and the desire to eat somewhere in the area or in the mall. The new Chipotle at Tysons Corner Mall is a big draw for me, since they have the freshest Mexican food in my rather sorry neighborhood. I would love a movie theatre at my mall but civilization in Northern Virginia is not yet so advanced. Beyond that, I want enough space in the mall to stretch my legs freely when walking. Given those preconditions, I will buy something for sure, once I have gone. Unlike Alex, I don’t treat sunk costs as sunk. Once I decide to do something I follow through, if only to discipline my choice of original commitments. That is how I make my highly rational, economically calculated, expected utility-maximizing shopping decisions.

Taking expected utility theory seriously, or, A story about Tyler

In the post immediately below, Tyler writes that Robert Rubin sounds like a brilliant person whom he would like to meet. He especially likes the description of how Rubin thinks probabilistically. Readers may like this story:

I once had to choose between two different career paths and I was torn about what to do. I asked Tyler for his advice and he turned to me and said “calculate the expected utility of both choices.” At first, I was flabbergasted. Was he joking? I’d always thought of expected utility theory as a descriptive theory of how people behave not as a normative theory of how they should behave. Certainly, I’d never tried to use the theory to guide my own choices. Tyler remarked that even most economists don’t take expected utility theory seriously but most people could nevertheless benefit by quantifying their choices. So I took his advice and sat down to think hard about the probabilities and utilities. Surprisingly, I found this very helpful. Once I had some numbers on paper it became clear which was the better choice and I made that choice confidently and without feeling conflicted. As it turned out, the choice was good ex-post as well as ex-ante. Thanks Tyler!

Addendum: As you may recall, I now take sunk costs seriously too.

Patent theory versus patent law

According to the economic theory of patents, patents are needed so that pioneer firms have time to recoup their sunk costs of research and development. The key element in the economic theory is that pioneer firms have large, hard to recoup, sunk costs. Yet patents are not awarded on the basis of a firm’s sunk costs. Patent law says the subject of a patent should be novel, useful and non-obvious but nowhere does it say the original idea should have required extensive costs of research and development as the economic theory would predict.

The disconnect between the economic theory and what patent law actually requires suggests that patent law could be improved by bringing it into greater conformity with economic theory. Why, for example, should every patent get 20 years of protection regardless of costs? Why not have patents of shorter length for those ideas that required little R&D? (Amazon’s one-click shopping patent comes to mind). I think that such a system is possible and discuss it further in the following paper.

Tabarrok, Alexander. 2002. Patent Theory versus Patent Law (subs. required or email me). Contributions to Economic Analysis & Policy 1 (1), Article 9.

In defense of choice

Here are some brickbats for my economist and libertarian readers:

†¢ Sheena Iyengar and Mark Lepper, psychologists at Columbia and Stanford respectively, have shown that as the number of flavors of jam or varieties of chocolate available to shoppers is increased, the likelihood that they will leave the store without buying either jam or chocolate goes up. According to their 2000 study, Ms. Iyengar and Mr. Lepper found that shoppers are 10 times more likely to buy jam when six varieties are on display as when 24 are on the shelf.

†¢ In a study that Ms. Iyengar, Rachel Elwork of Columbia and I are working on, we found that as the number of job possibilities available to college graduates goes up, applicants’ satisfaction with the job search process goes down. This is particularly true for job seekers whose aim is to get the “best possible” job – while people in this group receive more and better job offers than those who are aiming for “good enough” jobs, they also tend to be less satisfied with their career decisions than their less demanding counterparts. They are also more anxious, pessimistic, disappointed, frustrated and depressed.

†¢ In another study under way, Ms. Iyengar found that as the number of mutual funds in a 401(k) plan offered to employees goes up, the likelihood that they will choose a fund – any fund – goes down. For every 10 funds added to the array of options, the rate of participation drops 2 percent. And for those who do invest, added fund options increase the chances that employees will invest in ultraconservative money-market funds.

†¢ Carl Schneider, a law professor at the University of Michigan who specializes in medical ethics, has reported that patient satisfaction goes down when the choice of pharmaceutical and medical treatment goes up.

One illustration of the mismatch between how choice appears in theory and how it feels in daily life comes from a 1992 study by Lesley F. Degner and Jeffrey A. Sloan in The Journal of Clinical Epidemiology. People were asked if they would want to be in charge of their treatment plan if they had cancer. For those who had never had cancer, 65 percent answered “yes.” For those who had already had cancer, only 12 percent said that they would want to oversee their own treatment.

Here are eight letters in response. Consider this one:

As a neophyte shoe salesman, I was told never to show customers more than three pairs of shoes. If they saw more, they would not be able to decide on any of them.

My take: No doubt, choice confuses the hell out of us, much of the time. That being said, the question is not whether more or less choice is good. Instead the question is what kind of choice-restricting and choice-regulating institutions we wish to have. Markets, in reality, are the best known institutions for limiting our choices as well as expanding them. When I go into a (good) restaurant, I like to simply tell the waiter that I don’t want to look much at the menu, and he should simply bring me what is best. If he asks what that means by “best,” I (sometimes) respond by telling him I am an aesthetic Platonist and that best is best. Or I will ask the waiter to imagine it is his last meal on earth and to bring me the relevant dishes he would order. Other times, such as when I am buying classical compact discs, I wish to survey all the available information before buying Freddy Kempf’s stunning Transcendental Etudes, composed by Franz Liszt. Have I mentioned it is the sixth recording of those pieces in my collection?

What if you asked people the following: do you wish to choose your own means of limiting your (subsequent) choices, or do you wish to let someone else, perhaps the government, do the work? I suspect the answers would overwhelmingly favor the former option, namely voluntary choice at the meta-level. And if you reexamine the experiments mentioned above, they are all about ways in which people voluntarily limit their own choices. Maybe you don’t wish to run your own cancer treatments, but you wish to choose the doctor who will.

I am indebted to Daniel Akst for the pointer to the link and topic. By the way, check out his old column on whether you are free-riding if you buy and hold a broad stock index. He is one of the most interesting financial journalists around, in addition to being an accomplished novelist.

A famous economist paints

Here are some paintings by economist William Baumol. Baumol has done much notable work, my personal favorite is his recent The Free-Market Innovation Machine on how oligopolistic competition drove the innovation behind the Industrial Revolution. Unlike many others, Baumol has never called it quits. He is still going strong at 81 years of age and producing some of his best work.

Thanks to Greg Delemeester for the pointer.

Econometric Poetry!

I am teaching econometrics this semester and am thinking about putting the following poem by the American poet, J.V. Cunnigham on the final exam and asking students to prove. Yes, it is fun being a professor! 🙂 Hat tip to Aaron Haspel at God of the Machine.

Meditation on Statistical Method

Plato, despair!
We prove by norms
How numbers bear
Empiric forms,

How random wrong
Will average right
If time be long
And error slight;

But in our hearts
Curves and departs
To infinity.

Error is boundless.
Nor hope nor doubt,
Though both be groundless,
Will average out.

–J.V. Cunningham

A readable treatment of current macroeconomics

Is there a new consensus about macroeconomics? Read this recent essay by Perry Mehrling.

Mehrling makes the following points:

1. Macroeconomists are more optimistic than before, in part due to the 1990s extended, low-inflation boom.

2. Monetary policy has replaced fiscal policy as the preferred instrument of stabilization.

3. The current consensus would look remarkably familiar to many of the pre-Keynesian monetary theorists, such as Ralph Hawtrey.

4. The more concerned we are with price stabilization, the more our economies take on properties of commodity money standards. Money is moving again toward the notion of a “promise to pay.”

Read the whole article for a stimulating treatment of further critical issues. If you would like a more technical and theoretical treatment, for macro nerds only, try Michael Woodford’s recent Interest and Prices: Foundations of a Theory of Monetary Policy. Fans of Wicksell (notice the title) and the conundrums of Fischer Black will enjoy Woodford’s work, which reexamines the central assumptions of monetary theory. Think of the book as the 21st century version of Don Patinkin’s Money, Interest, and Prices. And what are we told in practical terms? The price level is best controlled through interest rate policy.

Thanks to Daniel Davies for the pointer to Mehrling’s home page.

It’s simple, part II

“For the past two years our farmers have struggled with historically low milk prices,” said Senator James Jeffords, an Independent from Vermont who often votes with the chamber’s Democrats. “The last thing we need right now is a flood of imported milk products that could drive prices even lower, perhaps permanently.

Imagine the horror, permanently low prices! And what is the political context?

Senators from dairy states like Vermont fear that a proposed US-Australian Free Trade Agreement could mean “undue hardships” for American milk producers…More than 30 senators signed a letter to President Bush last week that said the proposed trade agreement “would have dire consequences for several of America’s agricultural industries including the dairy industry…

By the way, current U.S. tariffs on Australian dairy products average about 100 percent. The above facts are from the Sunday Boston Globe, the article is not currently on-line.

Are you wondering what the title of this post means? Here is “It’s Simple” [part I], in case you missed it a few days ago.

Risk Regulation

The Economist has a nice survey on risk. Here’s one chart on the cost per life saved of various regulations. Bottom line: the cost per life saved of many regulations is absurdly high and we are often required to buy more safety than we want. John Morrall, whose study the Economist bases its figures on finds that almost half of the regulations that he studied do not pass a cost-benefit test.

Thanks to Zev Safran for the pointer.


Why 99 cents per song?

Apple’s iTunes charges 99 cents for every song downloaded. Why? Is Outkast’s “Hey Ya” really worth no more than a creaky Pat Boone ballad?

Some artists object to this “one price fits all” model. A star may feel it cheapens the value of her wares, or that she simply deserves a higher return.

An alternative business model asks users to donate to the artist, depending how much they like the song. For one service, you can pay as little as $5 but it is suggested that you pay more. The average payment is running at $8.93, though this is a small and self-selected group using the service. In any case not all songs go for the same final price. The service is called Magnatune: We Are Not Evil, check out their web site.

Yet another idea would use an auction system. Listeners could bid for song downloads, with the price determined periodically by supply and demand. We would then expect the songs in highest demand to bring the highest price. Note also that when bands sell their concert recordings on-line, they don’t generally all charge the same prices.

Alternatively, songs may be like books. You charge a low price at first, to stimulate a snowball of fan demand. Bestsellers sell for less, per page, than academic books. (Imagine a professor boasting “Stephen King’s books sell for a mere $6.99; my books sell for a royal $75 a piece.”) In this case the supplier would flood the downloads market with copies, so that the price of the more popular song would be less, not more, despite higher demand.

Different movies sell for the same prices. Either Return of the King or the latest bomb both go for $8.50 at the same theater. This practice has long puzzled me. Perhaps the low price satisfies a fairness constraint, and also helps generate a snowball of fan demand, as with books. It might make more sense to expand the number of screens for the movie rather than raise the price. And hit movies pull people into movie theaters more generally, which spills over into demand for other movies.

The big change may come when downloads are used as advertising. Pepsi is expected to give away up to one million downloaded songs, through iTunes, in connection with the Super Bowl. Coca-Cola may be entering the market as well. Keep in mind that the recorded music industry is small in size relative to corporate advertising budgets. Perhaps corporations will become patrons of music, giving away songs wrapped in an advertisement.

The bottom line: iTunes is just one business model, and it has yet to prove itself. Apple is making money off the hardware, not the songs. Returns will plummet once the hardware business becomes more competitive. It remains to be seen how the downloads market will evolve, but do not expect a mere extrapolation of current trends.

It’s simple

Atrios writes:

I’m basically a “free trader,” but it’s time we stop pretending it’s that simple.

Try this highly complex story on for size:

The US Commerce Department has said it may impose tariffs of up to 123% on Chinese, Malaysian, and Thai plastic shopping bag producers.

The Commerce Department said it would continue its investigation and reach a final decision in June.

The US imported about 100 billion plastic bags in 2002, worth more than $127m, and China supplied about 30%.

The list of items causing trade tensions between the US and Asian countries already includes Vietnamese cat fish and Chinese-made bras and colour TVs.

The Commerce Department issued its preliminary ruling after complaints from US packaging firms, including Sonoco Products and Interplast Group.

They say unfairly cheap Asian plastic bags are losing them $300m in sales a year.

Strain your mind, can you figure this one out? And I am a free trader, not a “free trader.” Thanks to Don Boudreaux for the link.

How does high fashion turn a profit?

The most expensive dresses can sell from anywhere from $15,000 to $100,000. They are popular for weddings in the United States and the Middle East, but otherwise do not garner large numbers of orders. Note also that the sector is highly regulated and in typical French fashion:

The Chambre Syndicale de la Haute Couture, the governing body that oversees the couture business in France, enforces archaic and unyielding regulations–defending tradition and, in the process, driving most practitioners out of business. To receive official designation as haute couture from the Chambre Syndicale, a fashion house must employ 20 or more full-time skilled technicians in France and produce a minimum of 50 new designs for day and evening wear in each of the two fashion seasons, although the conditions are somewhat looser for new houses that wish to start producing couture.

How then do the designers make money?

…couture…serves two other purposes for the houses that produce it. One is that couture represents what the designer John Galliano called the “laboratory of ideas,” where the act of creation is given free rein. Many who watch the coverage of the couture shows marvel that anyone could be possibly expected to wear the extravagant and seemingly uncomfortable designs on display, but couture is not really designed to be worn; rather, it affords an opportunity to try out cuts and styles that can then be incorporated, in more modest form, into wearable prêt-à-porter.

Couture also serves to create a brand identity that rubs off on the perfume, cosmetics, and leather goods–few of them high-design products in themselves–where the profit margins are fat and the real money is to be made. Ironically, many people will buy a $150 bottle of perfume to participate in the lifestyle suggested by the $15,000 couture dress they cannot afford, while in reality the dress was produced in large part to seduce them into paying too much for the perfume.

Here is a list of papers on the economics of fashion, but the topic remains underexplored. So much of economic activity is about buying dreams, and we don’t yet have to analytical tools to analyze this kind of problem.

How free market is the Chilean miracle?

The major economic successes of Chile are commonly considered to be a free market miracle. To be sure, there is much truth to this characterization. The Pinochet regime engaged in extensive privatization and deregulation and moved to free trade. Agriculture, services, copper mining, and telecommunications all boomed. The Chilean economy has been the envy of Latin America for some time now. The country also has few problems with corruption.

The reality nonetheless is more complex than a simple market story may imply, read this thorough account. The Chilean state has grown stronger as the Chilean economy has prospered. In the 1990s, Chile has doubled corporate taxes, almost doubled its minimum wage, and more than doubled spending on health and education. Here is another account of how social spending has gone up during the 1990s. Chile also has maintained tight capital controls on foreign investment until 1999. The vaunted Chilean social security privatization in fact superimposed a system of private accounts on an already-existing governmental system, which did not disappear. Yet in the 1990s the country continued to prosper. Chile grew by an average of 5.9 percent a year.

The bottom line: The world has seen massive liberalizations over the last twenty-five years and all for the better. But with few exceptions these reforms have strengthened rather than overturned welfare states. New Zealand, for instance, also has not cut its welfare spending. Welfare states are, in part, the price we pay for public order, whether or not they always make economic sense. When it comes to economic development, the question is not state vs. market. Rather poorer countries need both stronger markets and stronger (as distinct from more tyrannical) states. Chile is generating strong institutions across the board, in both private and public realms. In contrast, look at Mexico, where government taxation takes only 12 percent of gdp. In Mexico the problem is not to cut the absolute size of government per se (although I can think of some obvious and good steps in this direction, such as introducing more electricity competition) as to reduce corruption and improve the quality of governance. Until market-oriented reformers understand this basic distinction, we will continue to give bad advice and generate only mixed results for market-oriented ideas.