The confused economic orthodoxy

Last year I presented the idea that perhaps a firm objective function of maximising their rate of return on all costs is more consistent with the stylised facts about firm cost curves.

I want to document here two things. First, the two mutually exclusive responses from editors and referees during the reviewing process, which to me reveals the general ignorance of what the core concepts in economics really are (opportunity cost anyone?).

Second I want to spend a moment showing the incoherent ways profit-maximising is used in economics, and reiterate Joan Robinson’s critique of profit-maximisation as it is still highly relevant.

Part 1: Challenging the scriptures
The basic idea of my alternative objective function is that maximising the absolute value of something is universally a stupid thing to do. We need a denominator in a world where what matters at an individual or firm level is relative performance.

I’ve had both the following responses. First is the more common response that the paper is wrong because it doesn’t look at profit maximising firms. Basically, this response involves re-explaining the standard result of profit-maximisation. To borrow Steve Keen’s favourite analogy, we are like Copernicus explaining what a model of the Earth revolving around the Sun predicts, and the response is to explain the predictions of the Ptolemaic orthodox model where the Sun revolves around the Earth. The comments on my first blog post about the paper were mostly along this line.

The second response from editors and reviewers is the opposite. We’ve also been told that return-seeking is natural and implied in the standard model of profit-maximisation.

Your paper argues that firms do not maximize instantaneous profit but instead choose to allocate resources in a way that maximizes return on investment. I don't think that this assumption would surprise or bother anybody.

Actually, yes, it surprises and bothers all your economics colleagues. Maybe you should sit down together and interrogate your own models with some objective clarity and see what they really say.

Even if you dismiss this bizarre series of responses as the outcome of time-poor editors looking for excuses to reject papers they don’t like the look of, you’ve just revealed an acceptance of the non-scientific nature of economics and the lack of openness to anything outside the accepted scriptures (and yes, this is a general social science problem).

Part 2: Sticking with inconsistent beliefs
This is my main problem with economics. Despite a long history of critiques of the core models from inside the discipline, including the impossibility of a representative agent (and it’s full information), the conflation of uncertainty with risk, the Walrasian auctioneer, the impossibility of aggregating capital quantities, and many others, somehow the core survives.

So let me add to this long history of critiques with another of my own.

Consider the short-run profit maximising model, where profits are revenues minus costs. By definition the short-run has a fixed factor of production, usually called capital, which can be any arbitrary set of inputs. What that implies is that the short run profit maximising output actually is more generally represented as

profit = (revenue - costs) / fixed capital amount

Magically we have an implied denominator, which we might consider sunk costs. But then we have another different set of costs in the numerator, the variable costs. Exactly how is this distinction between types of costs made in practice? More importantly, where do the funds come from to pay these variable costs?

Consider the standard short-run price-taking model in equilibrium. Demand then increases. Increasing output requires the imposition of greater costs for each additional unit (being on the upward-sloping part of the ATC), the firm must conjure these costs from somewhere. If they require a new investor (or the same investors to reinvest earnings), they are diluting the rate of return on all the other investors.

As I have explained before, no current investor would allow the rate of return on their share of the firm to be diminished by adding additional investors. Essentially the core short-run profit-maximising model is one of maximising profits per capital owner.

But then we have a long-run profit maximising model which typically looks like this

profit = quantity * price - (labour units * labour unit cost + capital units * capital unit cost)

The denominator has disappeared. All of a sudden firms don’t care how much it costs to make a profit. If there is a choice between spending $100 to make $40 profit, and spending $200 to make $41 profit, you choose the latter as a profit-maximiser.

But as a return-seeker you first take the $100 investment. You don’t ignore a 40% return because a 20.5% return is available elsewhere. Never.

There is much more to this story, particularly around the ability to leverage. But the biggest story is about how value is gained from high return investments. If I can get my 40% return on costs, I can later sell that firm based on the discounted value of net cash flows. If that discount rate is, say, 10%, then my $100 investment gains $27 in value immediately. I can then sell my firm for $127.

In any case, the point here is that profit-maximisation is, in the words of Joan Robinson, meta-physical doctrine. The empirical record is against it, yet it persists as a signal of membership to the economics tribe. And what is worse, it seems that very few economists at the top of the discipline are clear about the crucial and often hidden underlying assumptions of their models, and continue to teach a fairy-tale view of the core models.

ACE 2015: Day 1

This week I'm attending the Australian Conference of Economics.

The main event today was a debate on the topic that economics education needs saving. To me the debate revealed that the desire for change is widespread amongst the old and young alike within the discipline. What is not clear is agreement on an alternative - everyone wants to do 'something else', but agreeing on what that something else might be is a task never quite tackled systematically by potential reformers.

In my mind Rethinking Economics and Post-Crash have most clearly articulated an alternative pluralist, dare I say it, scientific, core. But few seasoned economists are willing to make such radical change. Opening the doors to cross-disciplinary research is scary. Alternative methods might just prove superior to the equilibrium representative agent models that dominate economics.

As a small example of just how hesitant even the relatively ope minds are in economics, when discussing that direct surveys of firm managers and anthropological-style observational studies of firms are a valid method in micro-economics (ala Alan Kirman) I was faced with the following response:

But how do we know that respondents would tell the truth? That's the power of models and various regression tools. We know the assumptions being made

But of course, most data that gets into these estimations is the result of a survey asking people to self-report their views, their income, their expenditure, and so forth. This response (from someone I respect white a great deal who is an excellent experimenter) simply reveals the narrowness of economics training.

To ram home the point, when Alan Blinder did actually send researchers to go and ask questions of firm managers and observe their decisions, his results, summarised in his fantastic book Asking About Prices, has had little relatively little impact on the profession. As Steven Keen writes in his review on Amazon

The chief author of this book is Alan Blinder, once a Vice-President of the American Economic Association, a Vice-Governor of the Federal Reserve, and currently President of the Eastern Economic Association. He is, in other words, no maverick, but firmly within the mainstream of economic thought. And yet the research he reports in this book challenges many of the accepted tenets of both micro and macro economics. 

The publication should therefore be taken seriously by the economics profession, and raked over carefully to find out whether what Blinder reveals is really the case, or simply a product of poor research. 

It speaks volumes for the way that economics handles contrary evidence to accepted beliefs that this has not happened. Blinder's book has instead simply been ignored. The book languishes around the 750,000 mark in Amazon's "best sellers" list, and this review will be the first ever given of it. Meanwhile Mas-Colell's Microeconomic Theory, published three years before Blinder's book, which states the accepted neoclassical microeconomic canon in excruciating mathematical detail, ranks in the mid 100,000s, and has over 80 reviews--most of them from economics PhD students and highly laudatory.

We'll see what Wendy Carlin, author of INET's CORE Economics project, has to say about it all on Friday.

Another productive chat was whether the core economics program could do away with supply and demand diagrams and market equilibrium altogether. Thinking this far outside the current norms are what is really required for change. So you know, two of us believed an economics course could be even more valuable the current standard courses by doing away with supply and demand as currently formulated altogether.

In another session on how to improve your academic writing some quality advice was offered

Focus on the problem of interest, not the method.

This resonated with me. I've long come to the realisation that economists have a small simple toolkit comprising equilibrium models of representative agents, who take that method to new problems, adopting the method across its infinite possible contortions to fit any problem - from reproductive choice, to education, and more. Even when vastly superior alternative are available. The simplicity itself, despite its irrelevance, seems to be quite attractive.

I had expected to be exposed more to new methods and new ideas but came away very much with the impression of the continued dominance of the core. One of the respected elders of the professions suggested we work together on a model of housing markets, but as soon as he talked about equilibrating forces of supply and demand I realised he hadn't actually thought about the housing market (crucially, the timing problems due to the real option nature of housing investment for landowners). Instead he was taking the method to a new area (for him at least).

More updates to come tomorrow.

Gay marriage: an institutional perspective

Since I last wrote about the issue I think we have all decided to just call it marriage now.

Four years ago I hadn’t put much thought into one of the big social questions of our time, so I wrote an intentionally controversial list of questions about the debate.

Since that time I’ve some effort into learning about the topic, and the topic of institutions in general. I’m not one to leave my questions unanswered or unexplored for long.

One big theme in my original questions about gay marriage was about how confusing it seems for modern gay couples to be attracted to what is basically a stifling old religious institution? Why do they even want to be in this club? Why not start a better ‘modern marriage’ club?

But I ignored the social and economic realities of institutions. Having now studied in quite some depth the formation and cooperative effects of in- and out-groups I must reconsider my views. Expanding the institution of marriage to allow for gay marriage, rather than superseding traditional marriage with some alternative ‘new marriage’ institution, is likely to result in a far more harmonious outcome.

Consider the diagram below showing on the left a society with two sub-groups; those who choose ‘old marriage’ for straight couples only, and those who choose ‘new marriage’ that allows for gay couples. Immediately we create a group division within a country or region. On the right is the alternative reinvention of a more inclusive institution of marriage. 

The importance of this divide becomes clear when we consider that group divisions lead to group loyalties in matters unrelated to the group itself. Such a divide will create competition between institutions of marriage that will see other social issues become divided along the new / old marriage lines.

To be clear, when people have little knowledge of an issue they default to a view that reflects that of their groups. Don’t know whether a free trade agreement is good policy? What does you political party say about it? Our groups and institutions allow us to put aside reason and default to the standard expected response without having to think every issue through.

If you don’t believe me, take a look at this vox.com post explaining recent research into how alignment of loyalty in politics has captured alignment of loyalties on race issues.

By introducing a new institution to compete with the old institution we are asking for continued disharmony and conflict as more social issues become divided on the lines of new and old marriage.

“I’m an ‘old marriage’ person, I couldn’t possibly believe that internet censorship is a bad thing”

By reinventing the same institution instead, we gather together with a little dose of self-delusion by rewriting history and creating marriage as a more inclusive institution. `Love is love’ we repeat to ourselves as we entrench the new normal into the collective consciousness.

The objective observer realises this is a big lie. Love is not love. Expanding marriage to include gay couples still excludes lots of love that we currently find socially unacceptable. We never thought that blacks could marry whites. Then we never thought gay couples could marry. Maybe one day the institution of marriage will allow of polygamy and sibling marriage (as it does in many places). It may sound ridiculous now, just as our modern views sounded ridiculous in the not-too-distant past. But the objective observer must see the institutional patterns this way, and for marriage it is one of expanding dominance across broader social spheres.

My big lesson from the past years of study is that in terms of internal harmony, reinventing our social institutions is often far better than introducing new institutions and the accompanying competition and conflict amongst them.

[Or maybe I am just defaulting to the view of my groups and have put aside reason]

Dodgy rezoning, a summary

If you click the news link above you will see that my research on land rezoning decisions and the relationship networks of land owners has had a fair bit of coverage.

One thing I have learnt is that this type of quite technical research requires some effort to translate into bite-sized pieces for the broad media-consuming audience.

This post will be a reference point for the media and interested people that summarises the key findings and provides a couple of simple graphs and visuals that are not specifically included in the original research paper, but that can communicate the basic findings well.

What I did

I took a sample of landowners inside and outside rezoned areas in 6 locations in Queensland, where the statuary body, the Urban Land Development Authority (ULDA), took planning controls away from councils with the intent of increasing density, land values, and the speed of housing development.

In the maps below the blue disks are the landowners in my sample inside the rezoned area (black outline), sized by their land area, while the red disks are outside landowners in my sample. 

The logic of doing this is that these outside landowners could have been rezoned had the boundary of the areas been decided differently. From interviews with former public officials, and many others involved with planning decisions, it came to my attention that there is quite a bit of discretion about boundary decisions in zoning and that well-connected landowners often use their political clout to make sure the boundaries encompass their properties. The odd shapes of these areas are quite suggestive of this type of favouritism, as they have no apparent economic justification.

The sample is filtered to ensure I capture only undeveloped parcels that are at least as large as the minimum size rezoned parcel. There are 1,137 landowners owning 1,192 parcels in the sample.

Land characteristics or owner characteristics?

To see whether the characteristics of landowners likely to reflect political influence were a key determinant of these boundary decisions I collected data from both inside and outside landowners on the following:

• Political donation activity 
• Professional lobbying activity 
• Membership of property industry lobby groups 
• Corporate relationships through cross-directorships and ownership 

I also created a network of relationships that included the landowners using lobbyist-to-client connections, industry group connections, corporate connections, and

• Connections from ULDA staff to their former employers 
• Connections to politicians from their former employers 

The network had 13,740 entities and 272,810 edges.

I then model the effect of these characteristic on rezoning success, finding that being connected in the network increased chances of rezoning by around 19%, and getting into the most favourable part of the network gained an additional 25% chances. Employing a lobbyist improves your chances 37%, even after controlling for all other factors. Political donations don’t show and significant prediction on land rezoning when controlling for these other factors.

Connected landowners owned 75% of the rezoned area, and only 12% of the land outside. 

In the graph above I have the proportion of connected and not-connected landowners that were rezoned, the proportion of landowners who don’t employ lobbyists rezoned versus the proportion of those who do, and the same with political donors. 

The size of rezoning value gains

Using 822 historical sales of development sites inside and outside the areas in the study I estimate the price deviation attributable to rezoning. Essentially the rezoning increase prices across all areas by 81% relative the the neighbouring sites outside the rezoned areas. The below graph shows the price deviation through time, and the big change that comes the year of rezoning.

In all the value to rezoned land owners was $710million, of which connected landowners gained $410million. In terms of the marginal gains to becoming connected in our sample, this was $190million. While on a per hectare basis the mean gains are just $56,000, which isn't much, the sheer scale of the the gains to a narrow group of people represent a problematic political transfer from the unconnected to the connected. It also suggests that many billions in value are regularly transferred to connected landowners through routine rezoning decisions.

What to do

There are two main ways to stop this political favouritism - disrupt the favour exchange, and remove the honeypot.

Disrupting the favour exchange means requiring cooling-off periods for former politicians and bureaucrats, but also a policy of electing independent people to boards and decision-making positions. Why does the ULDA need to have its board stacked with local developers? Why not have a planning expert from Europe? There is a myth that local expertise is somehow required in the regulatory positions, but most of the time you don't get expertise, just loyalty to mates.

Greater transparency from all our public registers would also go a long way. Why aren't land titles a freely available database? Why isn't ASIC register of companies available for free? Why can trusts conceal who owns what so easily?

In terms of removing the honeypot, or reducing the value of discretionary political decisions, the obvious point here is to enact a process of selling additional development rights rather than giving them to selected landowners for free. This requires a pretty radical change in the way planning is viewed, but it makes perfect sense. Planning rules, including zoning, are part of the definition of property rights. You wouldn't give away a land area for free, so why give away land right of a different kind for free?

Alternatives to selling development rights are betterment taxes, and land taxes, both of which are effective administrative alternatives.

We can also think outside the box and look at development timing fees. If the rezoning is intended to increase density and increase housing supply, why not provide incentives to build sooner rather than delay? A per-dwelling fee that increases every year in the rezoned area would encourage developers to bring forward construction and sales.

Lastly, we can have local referenda on town planning changes to allow for representation of the interests of the politically unconnected. 

Division of labour is the outcome, not cause

I’ve written twice now on the spurious ideas in the division of labour story as an underlying cause of productivity growth in economics.

First I questioned whether Adam Smith’s observation of a division of labour in 18th century pin factories made much sense, given that the 18 tasks required to make a pin were undertaken by 18 men in some factories, but only 10 men or fewer in others. Clearly even in this iconic case it was not the division of labour tasks into more specialist roles that was the cause of rapid productivity gains in pin factories.

Second, I made the comment that the division of labour story has become an endless repository of ad hoc explanations for productive gains. The story has even captured the imagination of archeologists and anthropologists who saw the invention of tool-making as “gearing up for a clearly defined division of labor.” Yet the simple logic of increasing the number of possible production tasks following the invention of certain tools would mean that each person could do more tasks rather than fewer, suggesting a rather strange interpretation of the division of labour. I also noted that the division of labour story rests on labelling conventions of roles in society rather than actual units of labour being devoted to fewer clearly defined tasks.

Here I want to be even more clear on this final point by presenting a minimal example of how confusion between our socially-labelled productive roles (i.e. butcher, baker etc.) and tasks (baking, mixing, filleting etc.) is partly to blame for this peculiar sate of play. I also emphasise that productivity is the result of doing more tasks with fewer people - the opposite of specialisation.

Inspired by the ancient tool-making tribes of Jordan referred to in my previous post, my example is a 6-person tribe that undertakes 6 defined tasks, of which the two named roles undertake 3 each. Thinking in terms of roles there are 3 hunters and 3 gatherers, yet each person undertakes just one task within those roles.

Task	Role	Person in role
Track	Hunter	1, 2, 3
Kill
Clean
Collect	Gatherer	5, 5, 6
Prepare
Cook

You might want to argue that the way I define tasks offers limitless ad hoc classification. Tracking an animal could be further divided into a team pursuit with specific sub-tasks for each member. Same with cleaning an animal. But this is kind of the point. Any defined task will be a bundle of sub-tasks. But in order to understand the division of labour we need to keep track of tasks at any one particular level of aggregation and not fall into the trap of calling something specialisation when it is just a different bundling of more tasks into one job.

One of the tribe members now invents the spear and woomera. Regular production of these tools requires 3 additional tasks to be undertaken by the new toolmaker role in the tribe.

Task	Role	Person in role
Track	Hunter	1, 2
Kill
Clean
Collect	Gatherer	3, 4
Prepare
Cook
Collect	Tool maker	5, 6
Carve
Assemble

Now we have more roles and fewer people in each of them! Exactly as predicted by the division of labour story.

But if we instead look at the tasks, we have more tasks per person. Each hunter, instead of being able to specialise in one task, like tracking, now must undertake more than one task on average as there are only two hunters available for three tasks. The same for our gatherers. What we see as specialisation in roles is the automatic result, not cause, of increasing productive capacities.

What has happened is that the invention of new production techniques has allowed more tasks to be undertaken by each person leading to fewer people in each role. It is not a case of dividing labour in a way so that each person completes fewer tasks, each requiring less training, in order to increase aggregate output, as is often argued. The most productive countries are not full of people doing repetitive narrowly defined non-skilled tasks, but highly educated people doing ‘specialist’ roles involving a hierarchy of complex and interrelated tasks that require years of training to master.

You might still be thinking that the joint production function from specialising on the task that each person has a relative advantage in rescues the division of labour story. Crusoe catches fish, Friday gathers coconuts, and their combined output can be greater than if they individually produced what they consumed. But the simplification in this story ignores the possibility that if Crusoe and Friday gather coconuts together, then fish together, that the complementarities in joint production for each task might increase their combined output by more than if they specialised and worked alone.

Maybe catching fish involves a number of distinct tasks that, when shared between them, would increase their their output beyond twice that of the most productive of the two men. Would that also count as division of labour? If so, then it appears that any joint production can be labelled as a division of labour without offering any insight as to why one division is better than another. What Crusoe and Friday actually need to grow their economy is to each achieve more tasks each in a given amount of time.

To cap off, for the division of labour story to me is just an observation about the human roles in large scale production. It is not a causal story for increasing productivity. Productivity requires that labour bundling, or given more tasks to each person, is the way to increase output.

Endless repositories of ad hoc explanations

Division of labour. It’s a thing. A big thing in economics.

But like many core economic concepts[1] it is mostly an endless repository of ad hoc explanations.

In my last post I showed how Adam Smith’s observations of production techniques in 19th century pin factories lead him to make many contradictory remarks about the division of labour. Yet the implicit argument of a single causal mechanism leading from more division labour to greater productivity has become gospel, filling pages of economics texts for a century.

Let’s take a recent example to show exactly why the division of labour is such a slippery concept.

@AlanHonick Interesting, but surely division of labour predates humans and is common to most species.

— Cameron Murray (@Rumplestatskin) June 13, 2015

The title, and indeed much of the text reporting the discovery of new stone tools from Jordan, implies that these tools are somehow evidence of the dawn of the division of labour.

These toolmakers appear to have achieved a division of labor that may have been part of an emerging pattern of more organized social structures
…
They were gearing up for a clearly defined division of labor, including firewood gathering, plant gathering, hunting and food foraging.

But the invention of these tools probably led to less division of labour rather than more!

Let me digress for a moment. To be clear about a division of labor story requires being clear about the counterfactual world of undivided labour. It should not involve counting up the labelled roles within organisations, as larger organisations will have more uniquely named roles for their employees purely due to size.

To really narrow down we need to think in terms of tasks, not labelled roles given to different people. And then think about all the tasks that need doing for basic production of life’s necessities, then make everyone do all necessary those tasks AT THE SAME TIME IN THE SAME ORDER.

That’s right. That is the counterfactual of undivided labour. A tribe of people who all wake up at the same time, collect berries from the same location at the same time, start a fire at the same time, hunt alone the same animal at the same time, cook the animal at the same time, build a hut at the same time. Also procreate at the same time.

The reason all of this has to occur at the same time is because if it doesn’t then we have naturally a division of labour already. I hunt animals while you collect fruit. Though tomorrow you may hunt and I may collect berries. Turn-taking is quite clearly not the fundamental idea behind the division of labour, yet I often get the feeling the fancy terminology is used to capture this childish idea.

More important is the question of complementarities in joint production, like hunting in groups. I track, you kill. Division of labour.

But if we invent the spear I am able to more effectively hunt AND kill myself than in a team of specialists. Two tasks by one person becomes more efficient. The hunter becomes an anti-specialist, accomplishing more tasks than before.

Even in the iconic pin factory, the story of specialisation can be seen in reverse. Modern pin factories require very few people to do all the 18 tasks required in Smith’s time and in far greater quantities. The specialist maker of a single pin production stage has been replaced by a generalist who controls the whole process, including, no doubt, more advanced packaging.

The division of labour story about productivity is mostly a story about naming conventions for roles in society rather than the tasks achieved in those roles. I am an engineer, you are an account. Mostly though we both use spreadsheets to add numbers, make phone calls, type sentences, maybe drive a car. In fact from a task perspective rather than a role-in-group perspective, there is almost no specialisation. The majority of tasks are the same. But with more people we define each other’s roles more precisely. The ‘division of labour’ story unravels into a ‘large groups can accommodate more named roles’ story.

In modern lives as a whole there are far more tasks we each undertake. Rather than each doing fewer tasks better, we are all doing more than ever thanks to technologically superior capital. The diversity of our own life experience is far higher than ever. More so, those countries with more diversity, rather than specialty, are routinely the most economically advanced.

Returning to the ancient stone tools of Jordan, the invention of those tools would allow the tribe as a whole, and each member within it, to achieve a greater variety of tasks than ever and expand their production possibilities. But if the number of tribe members was the same, no additional specialisation of tasks could take place. Each unit of labour would accomplish a more diverse variety of tasks than ever, which is what expands the production frontier.

To really make the point, imagine a tribe of 50 people can undertake 100 productive tasks. Then with the invention of new tools, the number of possible tasks the tribe can undertake expands to 125. Clearly, the means the average tribe member is doing 2.5 instead of 2 tasks each - the opposite of what you'd expect from a division of labour story.

So what exactly is this phenomena of divided labour about anyway? To me it is mostly a sign of our level of ignorance about human coordination in groups. When looking to why one company, one country, or one historical period was different from the others, the idea of a division of labour is a catch all term that means ‘something to do with cooperation in groups’, and without further refinement, is an endless repository of ad hoc explanations.

fn[1]. I’m thinking here of concepts like capital (including human), technology, utility/preferences. The phrase 'endless repository of ad hoc explanations' comes from this paper.

The inferiority of renting

Debates about housing affordability in Australia are clouded by the belief that renting is an inferior substitute to home ownership. Renters are all just home owners who haven’t made it yet.

Sadly, this leads to the debate ignoring the very real and beneficial option of improving tenant’s rights in order to improving affordability for renting households as well.

Our collective ignorance leads to loud calls to cut stamp duties, the government fee on property transfers, because they are economically inefficient. They make it costly for homeowners to relocate via selling and buying in a new location.

But stamp duties are only inefficient in a world of homeownership, and even then there are alternatives.

1. Don’t sell your home, rent it out. Then rent a home in a new location. 
2. Just rent in any location if you have a highly mobile career.

For some reason these perfectly legitimate alternatives are considered inferior. Who would someone rent if they could buy? And shouldn’t we make it easier for homeowners to buy and sell as they please?

What we then ignore is that prices are being set not by the homeowner market, but by investors who time their purchase and sale decisions in order to capitalise on the land value cycle. Cut stamp duties, and we are also giving this group a free lunch, even though they are the ultimate beneficiaries of high prices, while future homeowners bear the costs.

But what if renting wasn’t inferior? What if tenants had greater rights and obligations? Maybe in a ‘renter society’ like Germany and Switzerland, where the majority of households rent, the debate about housing affordability and stamp duty would be very different.

Maybe the policy options would look at lot more like what we see in Germany - greater rights for tenants including limits on rental increases and higher capital gains taxes. Removing stamp duty in order to improve household mobility is a second best alternative to better tenant rights.

Adam Smith’s Pin Factory: Capital vs division of labour

Like many well-trained economists, I took Adam Smith’s argument about the productivity gains from the division of labour at face value. It wasn’t until I read Joan Robinson dismiss the argument in her 1973 textbook An Introduction to Modern Economics that I began to really put the effort into understanding the division of labour. I finally realised its incoherence as an explanation for productivity gains, but also that the pin factory story could provide valuable lessons about economics nonetheless.

Robinson dismisses Smith by suggesting that people can equally divide their own labour across different tasks through time. The 18 distinct operations Smith recounts could just as easily be conducted by the same labourer on 18 different days to generate the same output per person over an 18 day period as in the case where labour is divided between workers.

Further, the fact that relatively unskilled labour could perform any of these tasks adds to the case that it is not the division of labour at play in generating productivity gains. One-way causality from the division of labour to productivity gains is a highly problematic story.

But that leaves open the question about the actual mechanism that provided the enormous productivity gains in the pin factories of the mid-1700s.

Instead of Smith’s division of labour hypothesis, let me propose a capital investment hypothesis to explain the productivity of his pin factory. This hypothesis suggests that it is the technical nature of capital that determines the way labour will be divided across tasks to maximise output and that the division of labour responds to capital investment. The causality goes from capital investment to labour division.

To guide my inquiry I use the structured approach I have advocated for in the past, confronting economic issues by first asking questions about aggregation. For example, why are there 18 tasks to make a pin? Why are 18 workers in one pin factory and not 9 in one factory and 9 in another owned by a different entity? 

The answer to these questions is capital. The image above (source) shows the tools and equipment used in the pin factories described by Smith. Notice that the tools and machines in the picture have been designed to more efficiently perform distinct parts of the pin-making process. It is the way the tools have been designed to efficiently break down the task of making pins that leads to the labour division to ‘man the tools’.

Smith came close to instead presenting the capital investment hypothesis. He says

…a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. [my emphasis]

He suggests that it is the division of labour that has probably given rise to the machines, rather than the machines themselves giving rise to the division of labour. But this logic comes undone later in the paragraph, even though he ignores the inconsistency in his argument.

…the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. [my emphasis]

Even based on Smith’s own observations it is the tools and machines that generate the 18 tasks since people can perform more than one of them. So how exactly how did the division of labour give rise to the invention of the necessary machines that generate 18 tasks with only ten men?

If it was the division of labour that led to increased productivity, labour could just as easily be divided between firms. The fact that pin factories, even with only ten men, still performed all 18 tasks, instead of specialising in just 10 tasks, is clear evidence that there is something special and coordinated about the tasks themselves that arise from the particular capital investments. The tools and machines are designed to be compatible with each other, and if part of the process is done outside the firm, each of the two firms would inevitably be tied to the same compatible capital equipment, and would therefore find gains by merging into a single firm.

When we ask questions about the timing of investment in machines we can more sharply distinguish between the division of labour and capital hypotheses. If it was only after the machines were introduced that labour was divided in a particular way, then that is evidence for the capital hypothesis. If labour was divided into 18 tasks prior to the investment in machines, achieving the same tasks in the absence of tools, then the division of labour hypothesis holds.

Indeed, the prediction of the capital investment hypothesis is that labour task specialisation responds to capital investments in either direction - either with the division of labour, or consolidation of tasks by a single labourer.

A modern test of these predictions could be garbage collection. With rear-loading trucks, labour is divided between driving the truck and loading the bins. But with more advanced side-loading trucks with robotic arms, the labour is once again undivided between driving the truck and collecting the bins. The progression of capital technology determines the division of tasks.

Like many stories in economics, the division of labour as a productivity-enhancer has been approached far too narrowly. There are many economic lessons in the story of the pin factory, and if we probed deeper we could understand more about what considerations determine the boundaries of firms, and why firms are internally not-structured around market principles. But a structured approach to economic inquiry is required to turn Smith’s pin factory into a useful learning tool. The same applies to other stories, like economists favourite Robinson Crusoe story about specialisation and equilibrium. But that will have to wait for another time.

Will higher standards make apartment residents worse off?

No. 

Despite the fact that the principle lesson of economics is that there is no free lunch, for apartment residents this is a free lunch. To be more accurate, it is the landowners who are paying; they will now get less for their land because of the higher cost of converting it to apartments at the new higher minimum standard.

The usual arguments against such regulations are:

• Costs will be passed on to apartment prices and rents 
• Pro-choice, freedom and all that
• Regulations often do more harm than good 

All of these arguments are on display in an overly elaborate and ill-informed way in this piece by the usually sophisticated Alan Davies who argues that higher design standard for apartments will make residents worse off. My beef is with first of them.

This 'cost passed on' argument arises in the economics of housing all too often, particularly in regard to rental regulations. I expect the econ-blogosphere to be bubbling with such 'cost passed on' arguments forthwith after Berlin introduced maximum rental increase regulations. I have briefly had my say about this in the past, as has Matt Bruenig who makes the point that property ownership rights themselves are a form of rent control for property owners. If you believe that rent control is inefficient for standard economic reasons, you open yourself up to the problem that freehold title to property - apparently the building blocks of capitalism - are just as inefficient. 

For the pro-choice people, I’m happy for you to take your chances with a heart surgeon who hasn’t been screened through minimum standards regulation, or buy a house that doesn’t meet minimum building standards. Good luck [1].

But back to minimum design standards for apartments [2].

In standard economic analysis, the incidence of the cost of a tax or regulation does not always fall on the person who is obliged to pay it. What Davies argues is that the incidence of the additional regulatory cost falls predominantly on apartment buyers even though developers and builders pay such costs directly when constructing better buildings. In his view it is

Landowner	⇒	Developer	⇒	Apartment buyer
(no economic effect)		(pays the cost)		(economic incidence)

Why does Davies, and for that matter the much of the economics profession, believe this to be the case? Take the simplest of case of stamp duties on property sales. The economic incidence can clearly be shown to fall completely on the seller rather than the buyer, even though the buyer actually pays the cost. To be clear, if the stamp duty cost of purchasing a home is $5,000, buyers will factor that in and pay the seller $5,000 less for their house. Hence the incidence is on the seller who is $5,000 worse off, not the buyer. Economists routinely get this wrong.

In reality what happens in the case of apartment design standards is that the landowner bears the cost. In the short run that will also include developers who own land.

Landowner	⇒	Developer	⇒	Apartment buyer
(economic incidence)		(pays the cost)		(no economic effect)

Why can I be so confident that this the case and the economic incidence is not shared?

Land is a special case in terms of economic incidence because there is no substitute market for a plot of land. All buyers of any particular vacant plot are price-taking in their developed housing output, but price setting monopsony buyers of their land inputs. Although a development site can be sold in a market with many buyers competing on price, all those buyers will be working backwards from the highest and best use of the land, subtracting costs, and working out how much the site is worth. Add more costs into the development equation and each potential buyer will put these cost in their feasibility spreadsheet and reduce their bid for the land by the same amount. In terms of market power the situation is identical to having a single buyer (alternatively, think of the highest bidder the single buyer).

But how do we know developers can’t pass on costs to buyers through higher prices. Mainly because if they could sell at higher prices they would do so WITHOUT incurring any costs.

As a rule, you can tell where the economic incidence of a regulation is by the groups that oppose it, particularly if their logic makes no sense. The Property Council of Australia opposes stamp duties by arguing that they add to prices. But if developers can simply pass on these costs to the price of housing a) why do they oppose it, since they've admitted it costs them nothing, and b) why aren't they already charging higher prices? The Pharmacy Guild is another great example of lobby groups that proclaim that the economic incidence on regulation will be buyers rather than those who hold monopoly pharmacy licences. 

In sum, there is no free lunch by setting minimum apartment standards. But for residents, the lunch is being shouted by landowners and developers so it will make them better off.

fn.[1] The image above is from a recent fire in Melbourne that spread 15 storeys up the building in minutes due to the use of cladding that did not meet minimum fire standards.

fn.[2] Note that I am ignoring the macroeconomic cost in terms of resources potentially diverted from other uses in the construction sector from building these higher standard buildings. And why not. It’s not like Australia, nor most of the world right now is anywhere near full-employment growth rates. There is slack everywhere you look. Higher standards could even be stimulatory in this environment.

Renegade Economists interview on dodgy rezoning

I was interviewed recently about my research on political favouritism in land rezoning by Karl Fitzgerald from Prosper Australia, the country's leading land tax advocacy group. You can subscribe to Karl's podcast, the Renegade Economists, in iTunes.

Enjoy.

Clean Money, Dirty System by Renegadeeconomists on Mixcloud