Economics is applied morality

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

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

I couldn’t get the actual words morals and ethics into the new learning standard. But the result was very good I think, with the fifth learning standard being called Reflection, and containing the following. 

Bachelor graduates will be able to reflect on the:

• nature and implications of assumptions and value judgments in economic analysis and policy
• interactions between economic thinking and economic events, both historical and contemporary
• responsibilities of economists and their role in society.

You wouldn’t believe it, but one concern was that there may be insufficient expertise within the cohort of university professors to achieve this standard. So in the interests of raising awareness, I want to provide a very brief comment on the moral foundations of economics.

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

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

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

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

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

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

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

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

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

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

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

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

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

Organ markets and the problem of real options

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

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

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

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

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

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

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

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

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

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

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

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

Poverty is always a relative concept

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

Live and learn I guess.

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

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

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

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

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

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

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

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

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

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

The firm existence puzzle and how we solve it

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

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

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

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

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

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

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

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

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

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

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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. 

Moral Tribes: Emotion, Reason and the Gap Between Us and Them
Joshua Greene

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

Andro Linklater

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!

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. 

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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.

Please share this article. Tips, suggestions, comments and requests to rumplestatskin@gmail.com + follow me on Twitter @rumplestatskin

Behind neoclassicism's undiminished dominance

I am reading Yanis Varoufakis's excellent book, Economic Indeterminancy.

Today I want to share a section from that book, from which I borrowed the title of this post. It rather sadly describes the way I have observed the social aspect of theoretical (and the empirical work with close theoretical ties) economics research these days.

Neoclassicists are exceptionally open-minded people, willing to countenance any proposition, however farfetched, weird or even … leftwing. All they ask in return is that the said proposition is embedded within their three meta-axioms. This ‘openness’ is made all the more significant by the fact that, undoubtedly, any conceivable ‘story’ can be told by tinkering with neoclassicism’s first two meta-axioms (see Dasgupta, 2002). Lured by the prospect of unbounded theoretical possibility, the aspiring young economist delights in tinkering her way into the infinite vistas of potential neoclassical narratives; she even revels in sailing the oceans of indeterminacy stirred up by her tinkering. 

At some point, however, the fun must give way to publications, appointments and full induction into the profession. At that point, the lurking gatekeepers (supervisor, referees etc.) present her with a fresh condition: To be allowed into the priesthood, her models must have first achieved ‘closure’ (i.e. a restricted set of equilibria); she must, in effect, submit them to the merciless tightening of the third meta-axiom’s fist, thus tracing the r or b trajectories (see the previous section’s diagram) away from indeterminacy’s cul-de-sac. At that juncture, having already invested great energy and hope in her modelling, it takes a brave and tragic theorist to desist and call it quits. 

A tiny minority ‘close’ their models reluctantly, tucking critical comments away in their papers’ footnotes, biding their time and, once tenured, turn into resident critics. Some ‘close’ their models and steer clear of any controversy, but nonetheless manage to retain the memory of how determinacy’s imperatives whipped them back from a complex and rewarding inquiry to a paradigm devised for arid pure-exchange economies in which a sophisticated theory of agency, not to mention a left-of-centre political agenda, is as viable as a fire under a mighty waterfall (see Varoufakis, 2002, for the ‘postmodern’ aspect of this). Meanwhile, the vast majority not only leave no stone unturned to ‘close’ their models, often with moral enthusiasm, but also sweep under the emotional carpet any memory of how their models’ ‘closure’ was bought at the price of returning homo economicus to strict isolation from his brethren, of relinquishing meaningful social norms, and of losing social and historical contingency

The 'dance of the meta-axioms' is what separates economics from there social sciences.  In sociology, and particularly mathematical sociology, the problem of indeterminacy is widely accepted, and the approach to modelling social patterns of behaviour is far more diverse.

In a presentation of my signalling model (links to early presentation and pdf in this post) I was asked the question "In what way is this a model?" It seems that unless unique solutions are forthcoming, economists will back away from the 'wall of indeterminacy' to the happy place where all models have unique, of finite sets of, solutions. Never mind that, as Varoufakis explains, neoclassical models can be generated to support an 'infinite vista' of 'narratives'. That is, you can find any result you want within the meta-axioms if you are happy to tinker with assumptions, but you must follow the methodological conventions.

You can see this process play out across the discipline. I recently discussed how the 'Top young economists' are mostly playing at these games, getting sucked into the neoclassical vortex.

One can only hope that with the current period of naval taxing, and enough smart young economists entering the profession with much broader appreciations of the social phenomena economics attempts to explain, that the profession will gradually admit to these methodological limits and embrace alternatives.

Free entry assumption means zero prices

When learning about market models, perfect or otherwise, one critical assumption is that of free entry (and implied is free exit or free disposal) of new firms into a market. In fact, it is one assumption that drives the outcome of all the economic market models (including variations such as monopolistic competition), yet its exceptionally strong implications are usually glossed over.

So what does free entry really mean, and why does it matter?

The typical explanation of free entry is that in the situation where there exists a potential economic profit in a market, new firms can freely enter the market, increasing market output and reducing profits for existing firms back to zero. Any costs they incur in the process can be recovered perfectly if things go wrong. That means if a new firms buys a building or vehicle, employ some people and produce goods, but then find can’t make a profit, they can recover all their costs and try starting another business without losing a single dollar in the process.

That such as assumption obviously conflicts with behaviour in the real world is usually ignored with reference to Friedman’s ‘assumptions don’t matter’ quip. Even if, of course, the model still fails in any predictive capacity.

But taken to its logical conclusion, this simple assumption means that in any market economy with free entry all firms will be worth zero, since their profits are zero [1]. Moreover, if all markets have free entry, then all prices will be zero. 

The Twitter-verse didn’t quite understand what I meant when I said all prices will be zero, so I want to explain why this is the only logical conclusion in an economy where all markets have free entry.

First, we need to understand that the costs of production in any market for any firm are the prices set in an upstream market. That upstream market also has input costs set in an further upstream market and so on up the chain of production (and backwards through time). This is the essence of Saffra’s idea of the production of commodities by means of commodities.

The furthest upstream market is land - without a location to reside and the input of raw resources from land, no economic activity can take place. Here’s the crux of my argument. If the land market had free entry, any time the value of any piece of land became a positive non-zero amount an alternative new piece of land be instantly available to increase the stock of land and decrease all land prices back to zero [2]. 

The immediate downstream market, say for timber or some other naturally endowed product, would have a zero input cost for land and other resource inputs to growing their trees (rain, sunlight etc). The price of timber now reflects the cost of growing it, which is zero. The sawmill would have free land and free timber, and then cut free boards, and eventually the economy would produce free homes.

I’ve overlooked labour inputs, but in this free entry equilibrium all prices would be zero, which means even a zero labour wage rate would be infinitely valuable (you could buy every conceivable item with it).

Economic theory side-steps this issue by invoking a ‘normal’ rate of profit. Everyone goes and gets a normal rate, thanks very much. Any argument about the source of this magic normal rate is usually circular, and if price are zero it doesn’t matter what this rate is anyway!

As you might have noticed the world is finite, therefore not every market can be subject to free entry simultaneously, especially if they are already at the equilibrium point of using all the world’s resources!

The real world has no feature that correspond to the model. When we look at the short-list of conditions that invalidate free entry, we wonder where on Earth the whole idea came from in the first place. Even monopolistic competition invokes free entry in ‘the long run’ to push profits down to ‘normal’. 

Clearly this assumption can’t stand up and needs to be dropped if economic models of market are going to be of any use as representations of reality, and importantly, as tools to guide public policy.

One area of economics that addresses these points explicitly is real options theory. In this theory there is no free entry and exit - when a firm enters a market it can’t simply turn around and leave and recover all of its costs exactly. Moreover, firms may find it advantageous to delay entry into markets - something not possible in the orthodox models solved in a time singularity. 

fn [1]. Actually since there is another nasty assumption, that all costs embed a ‘normal’ rate of profit, a firm’s value will be proportional to its revenue. 

fn [2]. In reality of course, all land is a mini-monopoly on its location and this is an impossible scenario.

What equality-efficiency trade-off?

As my online debates with ‘well trained’ economists continue with full force I will again use this blog as an outlet to expand on arguments that can’t be made in 140 characters or less, or those that simply attract religiously-held views via comment pages.

On Facebook an otherwise innocuous comment, that it is “undeniable there is an equity-efficiency tradeoff,” really leapt off the screen at me. Why would a sophisticated economist make such a strong statement that has little to no empirical support. Could it be that this little book has had such an enduring impact on the discipline?

What is rarely taught, in the haste for economics departments across the Anglosphere to pump out energetic graduates, are the numerous built-in assumptions of the core models that lead to this apparent trade-off. Nor are alternative models presented that parcel together different, often more realistic, assumptions, and which arrive at far different conclusions.

To be more concrete, if there really is an equality-efficiency trade-off at a broad level, then there should be no single regulatory change that can increase both equality and efficiency, since if there exists such a reform, or set of reforms, it negates the entire aggregation to a macro level trade-off. Nor should you be able to simultaneous decrease efficiency and equality, as this leaves the door open for reversals of such policies.

My preferred alternative way to approach such problems is to consider the set of institutions that led to the current level of equality as a whole. Then evaluate the costs of these institutions against alternative institutions that result in more, or less, equality.

One might interject at this point to say that the shifting nature of equality is a product of technology change, education, or some other such thing. I’ll leave it to Matt Bruenig to address this point

When we talk about how economic changes, technological swings, and even education will affect the distribution of income in society, we always sort of assume away our government’s distributive policy as if it will or must remain static. But that’s not true at all. At any time we can change the huge set of policies that direct the distribution of income in society to something else. 

The last few decades of median income stagnation didn’t have to happen. Even if you say it was caused by international competition or technological change or whatever else, the point is that if we had put a different set of distributive institutions into place, we could have avoided the maldistribution of income that we have seen. It is not like the median incomes stagnated because the economy as a whole stagnated. Quite the contrary: the economy is much larger on a per capita basis now than it used to be. 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.

Let us now consider a couple of important cases in the set of reforms that, by most estimates, would increase both equality and efficiency.

First is shifting the tax base to land (and other resource monopolies). This is probably the simplest to  administer, and the one reform that would have the greatest efficiency boost and equality gains. Unfortunately it is also the one reform that, by virtue of its distributional impact, is the least palatable to the wealthy and therefore the least palatable politically.

The reason for the win-win nature of land taxes is that deadweight losses from taxation are reduced, increasing efficiency, while at the same time the tax will fall on those entities with the largest ownership claims to the natural wealth of a country, increasing economic quality.

The second case comprises any investment in public goods by government that would disproportionately benefit the poor due to their characteristics. I’m thinking here of, say investment in a fibre optic communications network to all homes, or investments in parks and community services in poorer neighbourhoods, or any number of things. These investments would then be provided free of charge or at token prices.

The policy space is vast, and economic thinking often limits it. Consider the case of gifts of land and accessible government-backed construction finance to households on low incomes. Such a scheme would provide the poorest in society an asset they can use to support themselves - to borrow against, to invest in, and use as a cushion in times of financial distress. We did it once before with the soldier resettlement programs, but for slightly different reasons.

In the case of Australia I might even suggest intervening in currency markets to keep the AUD low and foster local investment.

That’s a nice handful of policy ideas that appear to negate the apparent ubiquitous equality-efficiency trade-off. 

Why do these ideas still hold so much sway? Why do we teach that the usual case is for a trade-off, when it is equally valid to teach that the usual case that there is no trade-off? Why constrain the thinking of graduates in this way?

I can't provide a complete answer to these questions now. I can only do my part to expand the thinking of receptive readers of this blog. 

Please share this article. Tips, suggestions, comments and requests to rumplestatskin@gmail.com + follow me on Twitter @rumplestatskin