Friday, 25 July 2014

Urbanisation makes the world more unequal

A recent article, by Kristian Behrens and Frédéric Robert-Nicoud, at deals with the above issue and argues that large cities are more unequal than the nations that host them. The article contends that this is because large cities disproportionately reward talented superstars and disproportionately 'fail' the least talented. Cities should thus be the primary focus of policies to reduce inequality and its adverse consequences for society. Now the obvious question is Why should there be policies to reduce inequality? Are the authors attacking inequality when their real concern is with poverty?

The basic argument of the article is,
Large cities are more unequal than the nations that host them. For example, income inequality in the New York Metro Area (MSA) is considerably higher than the US average and similar to that of Rwanda or Costa Rica. Large cities are also more unequal than smaller towns. Figure 1 plots the relationship between population size and the Gini index of income inequality for a 2007 cross-section of US MSAs (solid line). The relationship is clearly positive. This holds true even when considering that large cities host more educated people on average (dashed line); income inequality cannot be entirely explained by higher educational attainment in large cities.

How can we then explain the size-inequality nexus? Researchers have proposed two main explanations so far, both of which have to do with city composition.

First, large cities may differ systematically in their industrial structure and the functions they perform. Large cities host, for example, more business services and the higher-order functions of finance and R&D, whereas small and medium-sized cities host larger shares of lower-order services and manufacturing. Consequently, larger cities are more skilled. However, industry composition explains only about one fifth of the observed skill variation across cities (Hendricks 2011). Furthermore, that variation cannot fully account for observed income inequality.

Second, large cities attract a disproportionate fraction of households at the bottom and at the top of the income distribution [ ... ]. Central cities of US MSAs attract, for example, poor households because they offer better access to public transportation [ ... ]. Large cities also attract rich households because they reward their skills more highly than smaller cities – a ‘superstar effect’ in ‘superstar cities’ [ ... ].

This is the second potential source to the positive relationship in Figure 1: returns to skill are increasing in city size [ ... ].
The argument for the second issue is that while larger cities increase the income of everyone, the top 5% benefit substantially more than the bottom quintile. The article continues,
In a recent study we propose a simple theory to explain why this happens [ ... ]. In our theory, large cities are places that disproportionately reward the most talented people (the ‘superstars’) and that disproportionately fail the least talented (‘selection’). In a nutshell, larger cities provide incentives for the most able to self-select into activities that offer high payoffs to the successful. However, the risk of failure associated with those activities also increases because workers in larger cities compete against more numerous and better rivals.

Disproportionate rewards for the most skilled – and failure for the less skilled – then drives income inequality. Both channels are stronger in larger cities, thus establishing the positive link between city size and inequality, even when abstracting from differences in industry composition and educational attainment.

The theory also predicts that increasing globalisation among global cities will translate into larger urban income inequality. Just as large cities provide large local markets to reward skills, larger global markets serve the same function. One novel aspect of our analysis is to emphasise the existence of both a direct effect of increasing globalisation on inequality (the ‘superstar effect’) and an indirect effect that goes through increasing urbanisation and the growth of cities. Cities are more ‘valuable places’ in a globalised world, which may serve to explain increasing urbanisation. The latter is positively linked to inequality, an aspect that has not been much analysed until now.
But perhaps the most interesting bit of the article are the caveats they put at the end.
We conclude with two words of caution. First, nominal income inequality (which is measured) is not equivalent to real income inequality (which is not directly measurable). Insofar as large cities offer a wider range of cheaper goods and services than small cities do, and if this pattern is especially pronounced for the least well off, then actual real urban inequality may be less severe than nominal inequality [ ... ]. Actually, Harvard economist Edward Glaeser claims that the large poverty rates of central cities are a testimony of their success, not their failure: they attract poor households by catering better to their needs [ ... ].

Second, fighting (urban) inequality does not require aggressive local redistributive policies, for such policies attract the poor and repulse the rich, leading to the bankruptcy of local governments, such as the fiscal crisis that hit New York City in the 1970s.
If inequality really is the issue then you may ask, Inequality of what? Is nominal/real income inequality what we should be worried about or is consumption inequality the real issue?

Thursday, 24 July 2014

Theoretical v. applied economics

"Then, as now, applied economists, “realitics”, as Sir John Clapham called them, and theoretical economists (‘analytics’) were often a race apart who neither properly understood nor appreciated each other’s roles and approaches. Then, as now, views differed on whether or not theory had to be directly applicable in explanations of ‘real world’ observations and much misunderstanding occurred because the separation between logically coherent ‘high theory’ in its own domain and, a separate issue, its direct applicability, was not made by protagonists in an argument. Or, if it were, one side would be concerned with the former, the other with the latter, without either making this understanding explicit."
(Stephanie Blankenburg and Geoffrey Harcourt (2007), ‘The Debates on the Representative Firm and Increasing Returns: Then and Now’ In Philip Arestis, Michelle Baddelely and John S. L. McCombie (eds), Economic Growth, New Directions in Theory and Policy, Cheltenham, UK and Northampton, MA: Edward Elgar Publishing, pp. 44–64.)

Wednesday, 23 July 2014

Housing affordability

Paul Cheshire - Professor Emeritus of Economic Geography at LSE, and twice visitor to the econ department at Canterbury - asks, What lies behind Britain’s crisis of housing affordability? His answer is that it is nothing to do with foreign speculators but decades of planning policies that constrain the supply of houses and land and turn them into something like gold or artworks. He also exposes myths about the social and environmental benefits of ‘greenbelts’.

Cheshire writes,
When things go wrong, it is always handy to blame foreigners and currently even the liberal press are blaming them for our crisis of housing affordability. The problem is not 50 luxury houses empty on London’s Bishops Avenue (as The Guardian reported in January) or foreign speculators buying luxury flats to keep empty in London. It is that we have not been building enough houses for more than 30 years – and those we have been building have too often been in the wrong place or of the wrong type to meet demand.
This is what explains the crisis of housing affordability: we have a longstanding and endemic crisis of housing supply – and it is caused primarily by policies that intentionally constrain the supply of housing land. It is not surprising to find that house prices increased by a factor of 3.36 from the start of 1998 to late 2013 in Britain as a whole and by a factor of 4.24 over the same period in London.
and he adds,
What also happens – and this is central to our ‘blame the foreigners and speculators’ scapegoating – is that houses are converted from places in which to live into the most important financial asset people have; and the little land you can build them on becomes not just an input into house construction but a financial asset in its own right.

In other words, what policy is doing is turning houses and housing land into something like gold or artworks – into an asset for which there is an underlying consumption demand but which is in more or less fixed supply. So the price increasingly reflects its expected value relative to other investment assets. In the world as it has been since the financial crash of 2007/08, with interest rates at historic lows and great uncertainty in global markets, artworks and British houses have been transformed into very attractive investment assets.
The more tightly we control the supply of land and houses, the more housing and housing land become like investment assets. In turn, the stronger the incentives for their owners to treat them as an option to hold in the expectation of future price rises.

So to blame speculators for housing shortages and rising prices is simply incorrect. It is our post-war public policy that has converted a good that is in principle in quite elastic supply into a scarce and appreciating asset.
And what of greenbelts?
Supporters of urban containment policies argue that Britain is a small island and we are in danger of ‘concreting it over’. But this is a myth: greenbelts in fact cover one and a half times as much land as all our towns and cities put together.
So the second myth about greenbelts is that they are ‘green’ or environmentally valuable. They are not because intensive farmland is not. Moreover, there is little or no public access to greenbelt land except where there are viable rights of way. Greenbelts are a handsome subsidy to ‘horseyculture’ and golf. Since our planning system prevents housing competing, land for golf courses stays very cheap. More of Surrey is now under golf courses – about 2.65% – than has houses on it.

The final myth about greenbelts is that they provide a social or amenity benefit. The reality is that a child in Haringey gets no welfare from the fact that five miles away in Barnet, there are 2,380 hectares of greenbelt land; or in Havering another 6,010 hectares.

What SERC research has shown is that the only value of greenbelts is for those who own houses within them. What greenbelts really seem to be is a very British form of discriminatory zoning, keeping the urban unwashed out of the Home Counties – and of course helping to turn houses into investment assets instead of places to live.
So the solution to our crisis of housing affordability is not to blame speculators or foreign buyers but to sort ourselves out. We need to allow more land to be released for development while protecting our environmentally and amenity-rich areas more rigorously than we do at present.

Building on greenbelt land would only have to be very modest to provide more than enough land for housing for generations to come: there is enough greenbelt land just within the confines of Greater London – 32,500 hectares – to build 1.6 million houses at average densities. Building there would also reduce pressure to build on playing fields and amenity-rich brownfield sites such as the Hoo Peninsula and improve the quality of housing.
Basic message: release more land for building houses. Now I wonder if any other country could learn from this idea.


Investor-owned firms as cooperatives

Having written a couple of posts recently on cooperatives, see here and here, I thought to compare cooperatives with investor-owned firms, the main form of firm in the economy. While investor-owned firms dominate the economy what is not often realised is that they can be seen as a form of producer cooperative. This argument is due to Henry Hansmann, "Ownership of the Firm", Journal of Law, Economics, & Organization, Vol. 4, No. 2. (Autumn, 1988), pp. 267-304.

Hansmann begins by noting that
In the discussion that follows it will be helpful to have a term to comprise all persons who transact with a firm, either as purchasers of the firm's products or as suppliers to the firm of some factor of production, including capital. Such persons—whether they are individuals or other firms—will be referred to here collectively as the firm's "patrons."

Most firms are owned by persons who are also patrons. This is conspicuously true of producer and consumer cooperatives.
He then notes that this is also true of the standard business firm, which is owned by persons who lend capital to the firm. In fact, Hansmann argues, the standard investor-owned firm is in a sense nothing more than a special type of producer cooperative—a lenders' cooperative, or capital cooperative.

To show this Hansmann starts by looking at the structure of a typical producer cooperative.
A representative example is a dairy farmers' cheese cooperative, in which a cheese factory is owned by the farmers who provide the raw milk for the cheese. The firm pays the members a predetermined price for their milk on the occasion of each sale. (In keeping with conventional usage, the term "member" will be used here to refer to the patron-owners of cooperatives.) This price is usually set low enough so that the cooperative is almost certain to make a profit from its operations. Then, at the end of the year, profits that have been earned from the manufacture and sale of the cheese are distributed pro rata among the members according to the amount of milk they have sold to the cooperative during the year. Voting rights are held only by those who sell milk to the firm, either on the basis of one-member-one-vote or with votes apportioned according to the volume of milk each member sells to the firm. Some or all of the members may have capital invested in the firm. In principle, however, this is unnecessary: the firm could borrow all of the capital it needs. In any case, even where members invest in the firm, those investments typically take the form of preferred stock that carries no voting rights and is limited to a stated maximum rate of dividends. Upon liquidation of the firm, the net asset value—which may derive from retained earnings or from increases in the value of rights held by the firm—is divided pro rata among the members, usually according to some measure of the relative value of their cumulative patronage.

In short, ownership rights are held exclusively by virtue of the fact, and to the extent, that one sells milk to the firm. On the other hand, not all farmers who sell milk to the firm need be owners; the firm may purchase some portion of its milk from nonmembers, who are simply paid a fixed price and do not participate in net earnings or control. (Consumer cooperatives are set up similarly, with net earnings and votes apportioned according to the amounts that a member purchases from the firm.)
Now what of the standard business firm?
A business corporation is also organized in this fashion, except that it is owned not by persons who supply the firm with some commodity, such as milk, but rather by some or all of the persons who lend capital to the firm. To see the analogy clearly, it helps to characterize the transactions in a business corporation in somewhat stylized terms: The members each lend the firm a given sum. For this they are paid a fixed interest rate, set low enough so that the firm has a reasonable likelihood of running at a profit. Then at regular intervals, or upon liquidation, the firm's net earnings (after all contractual expenses, including wages and the cost of materials as well as the fixed interest rate on the capital borrowed from the members, have been paid) are distributed pro rata among the lender-members according to the amount they have lent. The firm may also have lenders who are not members. These lenders, commonly banks or bondholders, simply receive a fixed market interest rate and have no share in profits or participation in control.

As it is, in a business corporation the interest rate that is paid to lender- members (that is, shareholders) is generally set at zero for the sake of convenience. Moreover, the loans from members are not arranged annually or for other fixed periods, but rather are perpetual; the principal can generally be withdrawn only upon dissolution of the firm. In the typical cooperative, by contrast, members generally remain free to vary their volume of transactions with the firm over time, and even to terminate their patronage altogether. This distinction is not, however, fundamental. Investor-owned firms can be, and sometimes are, structured so that the amount of capital invested by each member can be redeemed at specified intervals or even (as in a simple partnership) at will. Conversely, cooperatives can be, and often are, structured so that members have a long-term commitment to remain patrons. Electricity generation and transmission cooperatives, for example, commonly insist that their members (which are local electricity distribution cooperatives) enter into requirements contracts that run for thirty-five years.

Indeed, we can view business corporation statutes as simply specialized versions of the more general cooperative corporation statutes. In principle, there is no need to have separate business corporation statutes at all; business corporations could just as well be organized under a well-drafted general cooperative corporation statute. Presumably we have separate statutes for business corporations simply because it is convenient to have a form that is specialized for the most common form of cooperative—the lenders' cooperative—and to signal more clearly to interested parties just what type of cooperative they are dealing with. (All quotes, Hansmann 1988: 270-2. Footnotes deleted.)
So the standard business firm can be seen as a form of cooperative, a capital cooperative. Not that it is often thought of in this way.

Do large modern retailers pay premium wages?

An important question given the grow we have seen in larger retailers in New Zealand and around the world. The question is studied in this new NBER working paper Do Large Modern Retailers Pay Premium Wages? by Brianna Cardiff-Hicks, Francine Lafontaine, Kathryn Shaw. The abstract reads,
With malls, franchise strips and big-box retailers increasingly dotting the landscape, there is concern that middle-class jobs in manufacturing in the U.S. are being replaced by minimum wage jobs in retail. Retail jobs have spread, while manufacturing jobs have shrunk in number. In this paper, we characterize the wages that have accompanied the growth in retail. We show that wage rates in the retail sector rise markedly with firm size and with establishment size. These increases are halved when we control for worker fixed effects, suggesting that there is sorting of better workers into larger firms. Also, higher ability workers get promoted to the position of manager, which is associated with higher pay. We conclude that the growth in modern retail, characterized by larger chains of larger establishments with more levels of hierarchy, is raising wage rates relative to traditional mom-and-pop retail stores.
So the short answer seems to be yes, at least for the U.S., but to me the interesting thing is the sorting effect with better working employed at the bigger retailers. Is this a version of the Henry Ford $5 a day idea?
Henry Ford’s friend and general manager, James Couzens, came up with the innovative idea of paying the workers enough to keep them from leaving. $5 a day, said Couzens. Henry, himself a multimillionaire, countered that $3 a day was more than enough, then a few days later he grudgingly agreed to $4 before eventually caving in to Couzen’s insistence. Finally, in January 1914, Ford doubled the wages of his workers to an unheard-of $5 a day. Ford was swamped with job applications and absenteeism dropped from 10% to 0.5%.

Tuesday, 22 July 2014

Worker (and other) cooperatives

As I have posted before on when worker cooperative may be a viable governance structure, and when they won't be, I thought I would take a look at just how large a force they are in the economy. Data is a bit hard to get but I did come across this from the US Federation of Worker Cooperatives
Though we lack comprehensive data on the nature and scope of worker cooperatives in the U.S., researchers and practitioners conservatively estimate that there are over 350 democratic workplaces in the United States, employing over 5,000 people and generating over $500 million in annual revenues.
Given the size of the US economy, 5000 people is not many.

However if you look at all cooperatives things look a bit different. The International Co-operative Alliance states that there are
30,000 co-operatives [which] provide more than 2 million jobs
Of course cooperatives being big employers is nothing new for New Zealand given the size of Fonterra (17,300 employees as at 2012). But to put this into perspective Wal-Mart alone employs around 2.2 million people world-wide.

EconTalk this week

Chris Blattman of Columbia University talks to EconTalk host Russ Roberts about a radical approach to fighting poverty in desperately poor countries: giving cash to aid recipients and allowing them to spend it as they please. Blattman shares his research and cautious optimism about giving cash and discusses how infusions of cash affect growth, educational outcomes, and political behavior (including violence). The conversation concludes with a discussion of the limits of aid and the some of the moral issues facing aid activists and researchers.

A direct link to the audio is available here.

Monday, 21 July 2014

Why not worker control?

This question is asked by everyones third favourite Marxist Chris Dillow at his Stumbling and Mumbling blog. Chris writes,
"Workplace autonomy plays an important causal role in determining well-being" conclude Alex Coad and Martin Binder in a new paper. This is consistent with research by Alois Stutzer which shows that procedural utility matters; people care not just about outcomes but about having in having control, which is why the self-employed tend to be happier than employees.

This implies that a government that is concerned to increase happiness - as David Cameron claims to be - should have as one of its aims a rise in worker control of the workplace.
The first question you may ask is, If workers control is so great why does it need government help? If it really can out perform other governance structures it should be able to dominate these other structures without any government help. In fact doing so would prove that it is a better form of governance. A second question to ask is Why, if worker cooperative are so great, are there so many conversions to investor ownership?

But let me give an answer to Chris based on my paper Simple Models of a Human-Capital-Based Firm: a Reference Point Approach which is forthcoming in the Journal of the Knowledge Economy. The abstract of the paper reads,
One important feature of the knowledge economy is the increased importance placed on human capital, especially when dealing with the firm. We apply the reference point approach to contracts to the modelling of a human-capital-based firm. First, a model of firm scope is offered which argues that the organisation of a human-capital-based firm depends on the “types” of human capital involved. Having a firm based on a homogeneous group of human capital leads to a different organisational form than that of a firm which involves a heterogeneous group of human capital. Second, a simple model of a human-capital-based firm is discussed. Three organisational forms are considered: an investor-owned firm, a labour-owned firm and a market transaction involving the use of an independent contractor. Results are given that show when each of these forms is optimal. The effects of a firm’s size and scope on organisation are considered as is the question of why are there conversions from worker to investor ownership.
My basic argument is that worker control can work when the labour force is homogeneous but is less likely to work when the labour force is more heterogeneous. Let me illustrate the idea with an example from the conclusion of the paper. One place you may expect to see labour ownership is in situations where the skills of the work force is the major, if not the only, source of value added. An example of this is pirates. I write,
The labour-owned firm is more likely to be formed when the human capital is relatively homogeneous in its characteristics and faces a common set of incentives. The pirate example at the beginning of the paper is an (unusual) example of this
In the introduction to the paper I say,
To illustrate how having a firm based on knowledge workers—human capital—rather than physical capital can change the structure of the firm, consider the example of pirates (a human-capital-based firm) versus privateers (a more physical-capital-based firm).

Lesson (2009) argued that given the economic environment and incentives faced by pirates a “worker cooperative” type organisational form was found to be viable for “pirate firms” (ships), but as he also notes one size does not fit all and thus worker-owned firms are unlikely to be an exploitable organisational form for all firms, in all situations. Leeson’s point about different economic contexts resulting in different organisational forms for firms can be illustrated by comparing the organisational form of the privateers with that of pirates and considering the role that non-human capital (or the lack of it) plays in determining that form.

An important difference between privateers and pirates is that although they both practised maritime plunder, privateers were state-sanctioned. That is governments would commission privateers to attack and seize enemy nations’ merchant shipping during times of war.The most obvious piece of non-human(physical in this case)capital for both pirates and privateers was their ship. The role of investors in providing this capital was important to the organisational form that the pirates and privateers developed. Pirates had no investors; they simply stole the capital they needed. Privateers, on the other hand, as legal enterprises could not just go out and steal the capital they required; they needed external financiers to supply their capital requirements. This difference in capital supply resulted in very different organisational forms, the privateers having a more autocratic management system than pirates. Pirate crews were equal contributors and part owners of the firm they worked for. Having no need for investors, pirates did not need to develop mechanisms to protect the interests of the firm’s financiers as the privateers needed to do. This meant that incentive problems could be dealt with by developing a worker-owned firm with the crew (usually) sharing equally in “profit” and electing their leaders and having power dispersed among multiple members of the crew such as the captain and the quartermaster. In contrast, the privateer had investors and a management system designed to protect their investments. The investors appointed privateer captains and developed an organisational scheme that in some important respects mirrored the managerial organisation of (also investor backed) merchant ships.
Chris's point seems to be that we would be happier and more productive if we were pirates.

Well may be not I argue. In the conclusion I go on to say,
Another (more usual) example of a human-capital based “firm”, but one where labour-owned firms are seldom, if ever, found, is that of the professional sports team. The models developed above can explain this. Here we have a situation where human capital,talent at playing a particular sport, is the basis for the “firm” but ownership by the human capital, the players, is extremely rare since a worker-owned team would be at a disadvantage relative to a player-as-employee-based team.

Heterogeneity in playing talent—playing talent being the human capital here—and thus in earning potential is a disincentive to the formation of a worker cooperative, an organisation which normally involves (rough) equality in payment, 25 since those players with the greatest earning potential, the largest outside options, will transfer away from the cooperative to maximise their income stream. Thus,a worker-owned team would have few, if any, star players, a handicap in the winner-takes-all world of professional sports.

Another issue for a cooperative sports team is that while the star players may leave the team too soon, the “average players” may stay too long. The average players will have smaller outside options and thus less incentive to leave but as they are also owners of the team it would be more difficult to get rid of those who are not performing. It would be easier for an employee-based team to remove under performing players as they are not owners of the firm.

Also, to the degree that exit barriers are entry barriers, a worker-owned organisation is at a disadvantage. Such an organisation could hinder rapid transfers between clubs. Problems with transfers could arise, for example, if the conditions under which a player can exit the team have to be negotiated with the remaining player-owners at the time of exit. Or the remaining owners may be unable or unwilling to buy out the exiting player—under a “right of first refusal” or “right of first offer” scheme—or any of them could veto an incoming replacement player-owner. Also, there is the question of the value of a player’s interest in the team as well as the question of the time period over which an agreed upon value would be paid. These costs make exit more difficult than it would be under an employment contract and thus tend to lock-in the player-owner to the team. Such lock-in is a disincentive to forming, or joining, a labour-owned firm, especially for the best players. Many of these problems can, to a degree, be contracted around but this imposes additional negotiation costs at the time of entry into the team, which again is a disincentive to forming a worker-owned team. Utilising a worker-owned organisation would result in additional haggling costs, either ex ante or ex post, relative to a player-as-employee team.

Put simply, an employee can leave an organisation more quickly and easily than an owner and in the case of professional sports, transfers between teams, or at least a credible threat to transfer, are particularly valuable to the best players. Therefore, a player-owned team would be at a competitive disadvantage compared to teams comprised of employee players.

In the model in the section “a simple model of a human-capital based firm”, an independent contractor contract implies giving control over production decisions (choice of the widget in the model) to the consultant which in the sports team example would mean giving control to the players. This would create at least some of the same problems as player ownership. If the consultant’s (player’s) contract restricted the amount of control that players have, then it’s not clear what the effective difference between the independent contractor contract and an employee contract would be.
An alternative interpretation of the results in the paper is to say that they show that organisational form depends, in part, on the relative mix of the inputs used in production. For a largely human-capital-based firm, some form of labour-ownership may be feasible while for a firm with a greater (relative) use of non-human capital, a capital owned organisation is more likely. If you increase the relative importance of the non-human capital compared to the human capital, i.e. increase the amount of non-human capital the knowledge worker needs to be productive, you increase the ability of the non-human capital owner to "shade" and thus his ability to impose welfare losses. What we see is that when the firm is homogeneous in its inputs, in the sense that they consist largely of the efforts of the knowledge worker some form of worker-owned organisation is feasible. But as the relative importance of the non-human capital increases the firms begins to look more “traditional” in its input mix and thus begins to look more traditional in its organisational form in that a capital-owned firm becomes increasingly likely. If you are a computer scientist using a PC to design small business accounting software, then your firm being a partnership is feasible whereas if you are writing software for a super-computer you are more likely to be an employee of whoever owns/rents the computer.

So the argument which is based around the "reference point" approach to the theory of the firm suggests that when a firm's human capital is homogeneous, and thus there is little reason for "shading", worker ownership may work but when the human capital becomes heterogeneous or non-human capital starts to play a big role in the production of the firm, investor ownership becomes more likely.

I would suggest that the general thrust of my argument is similar to that of Henry Hansmann's discussion of worker cooperatives and why we see so few of them. Hansmann, for example writes,
[t]he most striking evidence of the high costs of collective decision making [for employee-owned firms] is the scarcity of employee-owned firms in which there are substantial differences among employees who participate in ownership. Most typically, employee-owned firms all do extremely similar work and are of essentially equivalent status within the firm. Rarely do they have substantially different types or levels of skills, and rarely is there much hierarchical authority among them.
[t]he preceding evidence implies that employee ownership works best where the employee-owners are so homogeneous that any decision made by the firm will affect them roughly equally, or where, though the employees differ in ways that cause the burdens and benefits of some decisions to be shared unequally, there is an objective and widely accepted basis for making those decisions. That is, employee ownership is most viable where either no important conflicts of interest exist among the employee-owners, or some simple and uncontroversial means is available to resolve the conflicts that are present

Sunday, 20 July 2014

Arnold Kling on macroeconomics

From Kling's blog askblog,
I remain concerned that macroeconomists have very elastic theories and empirical methods that can be used to confirm almost any story.

Saturday, 19 July 2014

Interpreting the "representative firm"

Marshall's notion of the representative firm is an idea I have never really understood. But, to be fair to me, I'm not sure anyone else understands it either. Take, for example, Michel Quere (Quere 2006) who has written
The representative firm is a key analyical device in Marshall's Principles of economics.
and compare this with Lionel Robbins's view that the representative firms was,
Conceived as an afterthought ... it lurks in the obscurer corners of Book V [of Marshall's Principles] like some pale visitant from the world of the unborn waiting in vain for the comforts of complete tangibility.
Its difficult to see how the notion can be both a key device and a pale visitant from the world of the unborn.

In fact it was Robbins along with Piero Sraffa who are largely to blame, or who deserve most of the credit, for the controversy that lead to the replacement of the representative firm with Pigou's equilibrium firm.

One of the problems with the representative firms is that it has at  least two interpretations. Quere writes,
On the one hand, long-run equilibrium and free competition have been mainly associated with static equilibrium and perfect competition. In line with this interpretation, Sraffa [...] demonstrated the inconsistency of the representative firm as an equilibrium firm, due to the role played by internal and external economics. However, as became clear afterwards, the originator of the representative firm as an equilibrium firm was Pigou [...] and not Marshall [...]. To put it more precisely, increasing returns (resulting in economics of production on a large scale) are incompatible with the requirements for the supply curve. Their effects are either too wide or too restricted. For example, internal economics can be seen as excessive because they rapidly become incompatible with competitive conditions. On the other hand, external economies are inconsistent with the conditions of the particular equilibrium of one commodity. In order to be compatible with the laws of returns, the representative firm requires a very particular context, namely one in which external economics are 'those economics which are external from the point of view of the individual firm, but internal as regards he industry in its aggregate' [...]. But that context is likely to be rather useless as 'it is just in the middle that nothing, or almost nothing, is to be found'[...]. Therefore, the likelihood of supply curves showing decreasing costs can only be very low. Moreover, Robbins [...] complemented Sraffa's attack by showing that the concept of a representative firm was inappropriate to a proper distribution theory, and very misleading. Thus, when Keynes arranged for the 1930 symposium, this interpretation of the theory of the representative firm was brought to an end, despite Robertson [...] - and, to a lesser extent. Shove's [...] attempt at a defence. In the end the symposium fully legitimated the importance of a framework of monopolistic competition.
So by around 1930 Marshall's representative firm was no longer represented in economic theory.

But in the 1950s there was a renewal of interest in the idea. But with this new interest came a new interpretation of the notion. Here the representative firm is seen as a device to blend theory and facts in a proper fashion. Quere again,
First, the representative firm is a central device for bridging the contents of Book IV and Book V of the Principles. It also has a pivotal role in reconciling static equilibrium and evolution [...]. Second, thanks to the representative firm, an industry supply price can be downward-sloping but compatible with equilibrium, as the supply curve is not expressing the marginal costs of production for various firms in the industry, but 'the prices at which particular quantities demanded will be supplied in equilibrium' [...]. In other words, 'marginal' cost in Marshall's wording is something to be applied to aggregate values; that is, to the shape of the supply curve for the whole industry. It is a means of expressing the fact that cost lies on the marginal short-period cost curve but is conditional to any movement along the long period unit cost curve. As pointed out by Frisch [...], Marshall focused his attention much more on the nature of marginal production than on that of marginal cost. Therefore, a marginal cost curve for the individual firm is not meaningful. With the representative firm theory, Marshall was providing the best approximation he could find to solve the difficulty of making long run evolution compatible with equilibrium analysis.

Third, beyond the issue of costs, the representative firm theory also expresses the need to deal with the structure of industries. This is where I think Marshall's economics is still very relevant. With respect to this, it is especially essential to highlight two central issues: one is the heterogeneity in the organization of industries, the other is the importance of market imperfections with regard to the dynamics of industries.

The representative firm theory legitimates the importance of the concept of industry, which can he defined as a set of producers, a group of various firms significantly affected by any decision of one of them [...]. Wolfe insists on the usefulness of that Marshallian definition, which frames 'a theory [of the structure of industries] much more complete than any competitor' [...]. Moreover, the representative firm theory is a means of reflecting about the variety of firms' behaviour and performance (weak, average, strong) within an industry. Due to internal economics, firms in the same industry do not command the same technological and organizational resources. The representative firm theory is therefore an attempt to take into better account not only the structural variety among producers hut also their various reactions to changes and shocks in their environment. Both differ substantially from industry to industry: the representative firm theory is a means of expressing how industrial contexts are differently organized, sensitive, and reactive to shocks. By doing so. Marshall provides the best possible way of applying his constructive work philosophy lo the problem of the organizational diversity of industries.

The second issue is the importance to be given to 'market imperfections', to use the modern phrase. Free competition requires that internal economics do not lead to a permanent monopoly. This is only possible because of the twofold importance of innovation and market imperfections. Innovation brings about the weakening of temporary monopolies, but this point is not really considered in Marshall's analysis, which is mainly concerned with 'limited dynamic change' [...]. But a free competitive context also requires the existence of market imperfections; that is, of all kinds of frictions in the working of markets. Without the latter, an individual firm experiencing increasing returns would come to monopolize the whole market and increasing returns would then be incompatible with competitive equilibrium. Connections between producers (taking care of a whole 'supply chain oligopoly') are very influential in determining the price that will prevail at equilibrium. Now, if market imperfections are essential for understanding Marshall's dynamics, their critical importance cannot be really acknowledged within the frame of the Principles, at least with regard to the representative firm theory. Finally, despite the richness of the latter, one has to remember the prominence of Marshall's machinations at Cambridge to establish economics as a profession, and the role played by the Principles in establishing marginalism as the dominant paradigm.
While there was this renewal of interest in the representative firm it largely came to nothing. The mainstream theory of the firm remained the equilibrium firm up until the 1970s (and in textbooks even to today) when the Coaseian approach to the firm began to be developed by people like Oliver Williamson.

So what is the representative firm? Damned if I know. But even if I did I'm not sure it would matter for understanding the modern theory of the firm.

  • Quere, Michel (2006). 'The representative firm'. In Tiziano Raffaelli, Giacomo Becattini and Marco Dardi (eds.), The Elgar Companion to Alfred Marshall (pp. 412-7), Cheltenham, U.K.: Edward Elgar.