Are Australian universities just not good enough?

The reserved and mild-mannered American Canadian law Professor James Allan, who works at an under-performing Australian university, has recently written a long tirade against the bureaucratisation of higher education in Australia.

While it contains a few home truths which need public acknowledgement - like the centralisation of decision-making and the power of university executives to make inappropriate rules, and also set their own pay - it also misses important context, and offers personal biases and anecdotes instead evidence and constructive suggestions for improvements.

I want to respond here to that article. First let me attempt to summarise Allan’s points about what is wrong with Australian universities.

• University administrators seem to value research grants as outputs rather than inputs
• Bureaucratic decisions at universities are quite centralised
• Students work and study, meaning they want lectures recorded and don’t want to do extra reading
• Students don’t travel to other cities to study
• University ranking tables are a sham, and Australian universities are not performing as well as these tables make out

However Allan doesn’t actually explain what a suitable output performance measure should be for a university. The most we get is this

In Canadian law schools (and US ones, and UK ones) you are expected to be working on your degree full-time. You are expected to do lots of reading. You are expected to think. You are expected to pursue things on your own. You are not expected to schedule classes all on two days of the week so you can work the other three. Or tell your professor that you can’t do something because it conflicts with work. Or be so tired that you do as little reading as you can get away with. 

Yet that is now standard practice in Australia. I can still, just, get away with refusing to record any of my lectures and so insist that students come (or not, since as adults it is up to them, but if not they are on their own). But the university administration detests that position and is making it harder and harder to take. As I came to Australia already with a chair I can ignore the students who get infuriated about this practice of mine in their course evaluations. But no junior academic wanting to be promoted can do so. It is no exaggeration to say that the incentives are slanted heavily in favour of caving in, of spoon-feeding students, of recording all lectures for viewing from home (with much reduced class attendance as a result)—anything to facilitate the job commitment of the supposedly full-time undergraduate. 

The flip-side of this situation is that the demands on students (even at our Group of Eight universities) are noticeably below what they are in good Canadian and UK and US universities. As for a serious Ivy League or Oxbridge undergraduate education, well, we are not in the same league as those institutions because we demand so little of our students.

Australian universities are not good enough, apparently, because students need to read more, and think, and pursue things on their own. 

He also makes a personal judgement that what you learn at university must be superior to the skills you learn at work, or that working and earning a living is not ‘pursuing things on your own’. That doesn’t really sound like a typical Australian attitude to me. My personal experience in economics is that a degree gets you in the door, then it is all down to experience. Working while studying, especially in your chosen field, is quite advantageous.

But he really doesn’t elaborate any further. Is university performance measured by research output? Is it measured by revenue? If so, he doesn’t have much of a case against the administrative bias towards academics who generate research grants.

Or is it the number of peer reviewed journal articles? If so, is it quantity or quality? Who will judge quality? Is it student numbers per academic? Or is it student quality? Who will assess that? Or do we judge performance on the gut feel of visiting academics with their own personal biases?

I don’t want to sound harsh, but for a senior academic writing about the underperformance of Australian universities, a little note about what underperformance really means, framed within the role of universities within society, would be nice. He signals that it should be research output, noting that people

…could see the difference between judging people based on what they wrote and produced versus one that judged them based largely on winning as many grants as possible.

but fails to return to how this measure fits into his picture of a competitive university system.

Whinging about the rules doesn’t really help. It is like an Apple employee coming into the company and saying they have a lot of centralised decision-making and that engineers were slugged with bureaucratic tasks, such as getting central approvals to spend money on new equipment. Whereas at their last job they could do as they please.

Sure, from the employee perspective this seems like a horrible system to work in. But any outsider assessing the performance of the company as a whole would feel it is worth it. That’s because we have an agreed measure of what company performance is. For universities we don’t, and that is usually the recipe for a growing bureaucracy.

Allan lays some of the blame at a lack of competition, perhaps due to some cultural norm of families not sending their sons and daughters interstate to the ‘best’ university in their field. Apparently this lack of competition means that universities can slack off and amuse themselves with ever more burdensome central rule-making and ever-greater executive pay.

Allan writes

In this sense, Australia and its universities are at a disadvantage. Imagine what would happen if parents were as likely to send their kids to Melbourne University as to Sydney University or the University of Queensland or Australian National University, and the deciding factors came down to what the universities had to offer, say in terms of class sizes or contact with professors or the “undergraduate experience”.

There are two problems with this point. First, is that the universities are full of international students. Outside of law especially. Surely these students are discerning about their university choice and hence provide a great deal of competitive pressure. According to the ABS 22% of students at university in Australia are international students, while at some universities that figure is over 40%. Monash and Melbourne universities seem to be competing quite fiercely, with Melbourne experimenting with student offerings at great risk.

Second, the central rules that Allan hates so much are just as much the result of competitive forces, than on the lack of such forces; of trying to attract students by ensuring the get the easiest path through their study. We’ve seen the gimmicks about giving new student iPads. Allan mentions the imposition of consistent marking systems, PhD criteria for lecturing positions, timing of student evaluations; all of these are about managing university-wide quality in order to assure new students of what they will be getting. Haven’t you seen advertisements?

This is what happens with competition for students (customers), and students mean revenue. If you want universities run competitively like private businesses, you must expect that they will measure their success in similar ways.

So where does research output fit into his competitive picture? It certainly doesn't raise revenues, and most undergraduates, the customers of universities, wouldn’t have a clue about their school’s research anyway.

Regarding the lack of travel to university, if I can sum up the Australian view very roughly, it is that university is more like advanced vocational training. Degrees that used to be provided by technical colleges are now integrated into universities. Students don’t travel because their local university usually maintains standards high enough to get them into their chosen field. Why travel if you can be assured of equally good local training? After all, once you are in the door, your experience counts much more than your degree in most fields.

He writes

When I try to point out the advantages of sending one’s kids away to university here in Australia I am generally met with blank stares of incredulity.

But of course, he didn’t mention any of those advantages in his article. Could it be that there really aren’t many? Or is he saying that Australians are just too stupid to see them?

Which leads to the more entrenched problem. The competition that drives student selection and travel for study in the US and the UK is the result of monopoly power of universities so that students must compete rather than universities. And this competition between students is also driven from a higher level. Reputation and insider connections within top universities to political and corporate elites means the payoff to getting into those universities is much higher. A degree at Princeton or Harvard is a meal ticket with a value far higher than cost of tuition itself. This not only means that students want to travel to get in to these universities, but that they (and their parents) are willing to pay through the nose for it as well. Here’s just one example of the political connections a degree at Oxford brings.

In Australia we don’t have that ‘boys club’ mentality to such an extent, especially not in most degrees. Having a teaching degree from QUT doesn’t open doors at Goldman Sachs, unlike a finance degree from MIT.

While I am sure Allan feels much better getting this all off his chest, I can’t help but think he has missed the important points to focus on his personal gripes. He overlooks exactly why Australian universities aren’t good enough, and then appeals to competition as some magical remedy to all organisational problems like some evangelical Chicago economist. Lastly, his suggestions for improving the situations include a bunch of central administrative tools!

One of his suggestions, the publication of remuneration of the highest paid employees, is generally already complied with in the annual financial accounts, where executive pay is itemised (here’s UQ, here’s QUT). But of course, executive pay exploding is not limited to universities. It is a general problem of power that competition alone does not solve.

Another suggestion is to publish the ratio of academic to non-academic staff, which is essentially a meaningless ratio because it absolutely depends on the tasks each staff is responsible for. If administrative staff are freeing up time for academics, then that is a good thing. I could imagine these suggestions being implemented and a future version of Professor Allan writing another article deriding them!

He suggests scrapping the ARC grant system, but makes no suggestion of alternative funding allocation mechanisms, as if by magic money will find worthy researchers. I agree the system is poor, but we need to be discussing better alternatives. Why didn’t Allan tell us a bit about the funding systems in those hot-shot universities he so reveres?

When push comes to shove Allan goes for the practical over the ideological, which is a good thing. But it leaves you wondering what the point of all those words really were. Will they merely be interpreted as at the ravings of a sheltered and entitled academic? We have quite enough of that already.

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Wages share and investment

Kieran Latty produced this chart on wages share and investment share in OECD countries. If we take this at face value it implies the existence of a wage share that maximises investment - which in the long run is what makes us wealthier. 

To me this seemed a little too neat. Economists love the inverted U-shape relationship, or concave relationships in general, because it implies the existence of some kind of equilibrium - just set labour share correctly and you will maximise investment. Or something like that.

It turns out to produce the ‘inverted U-shape’ curve Latty used a time fixed effect and a non-linear estimator on data from AMECO. While this may be somewhat normal in the literature on this topic - for such reasons as removing the effects of international business cycles and to control for any secular trend in international growth rates - ultimately these model choices fundamentally determine the results. Like most observational data from complex systems, we are applying models as mere plausible stories, with no objective criteria for assessing their validity.

Often the details (including the outliers) in these types of international comparisons reveal much more of the story than the general trends. To satisfy my curiosity I constructed a similar chart from OECD and World Bank data.

Below is the scatterplot of my sample (you will notice the chart is animated to show country data connected through time) . Eyeballing the data there seems to be no general time-independent inverted U-shape. This is confirmed by regressions on the sample without controls, and indeed, with a quadratic specification we find a positive coefficient on the squared term.

 

Notice that each country seems to occupy a distinct section of the chart. Such divergence between countries should be of great interest to macroeconomists. In my smaller sample below Japan has consistently high labour share and investment share, while New Zealand is consistently low on both measures. Then we have the US and UK with consistently low investment accompanying a rather high labour share. 

My expectation is that a high labour share of income would result in greater investment share, if only because owners of capital would have greater incentives to invest and innovate in order to gain a return, rather than simply hold existing assets. Who knows whether this is the case at all. But it’s my current speculation.

What is, for me, more fascinating in this data is the trend over time. We know that the labour share of national income has been falling in most countries since the 1970s. We can see that trend, along with short-term cycles, in the animated chart below that tracks my six country sample since 1970. 

In broad terms the maturing nature of these economies may mean that such a downward trend in labour share is naturally expected. Or it could be that policy choices for the past four decades have directed national income towards owners of capital, which resulted in lower investment in some cases but not others. The answer still seems completely unclear. If you want more analysis, you can read the Productivity Commissions recent work on the topic. 

Like many macroeconomic curiosities, the relationship between wage share and investment is a puzzle unlikely to find a satisfactory conclusion any time soon. 

What does affordable housing mean?

In my submission to the Senate Inquiry on Housing Affordability I wrote the following

Home ownership and reducing housing costs are not necessarily related policy goals. Housing can be cheap with extremely low rates of home ownership, and expensive with high rates of ownership. Clarity about what housing affordability means as a social policy goal is necessary.

There is usually an implicit stance in the housing affordability debate in Australia that a high rate of home ownership is a desirable policy goal. For some reason, a renting society is frowned upon. I put this down to tradition.

In Switzerland and Germany for example, around 60% of households rent. In Denmark and Austria it is around 50%. In Australia 30% of households rent.

We must remember that affordability of buying homes is not the same as making housing cheaper. Making housing cheaper means focussing on rental prices and their share of household income. If rents fell by 25% but prices didn’t, surely we would say housing has become more affordable. And vice-versa, if home prices increase 25% but rents were flat, we should say that housing has become less affordable.

A home is a financial asset that produces a place to live. Why do we care about owning the financial asset that produces our housing, but we don’t care about owning the assets used to produce our food, clothing and other goods? No one ever talks about a BHP share affordability problem!

The exact meaning of affordable housing is a crucial question to consider before any constructive housing policy can be developed.

Some may argue home ownership is about security. Home owners can put down roots because they know they won’t be evicted by a greedy landlord. But security of tenure can equally apply to rental housing, as it does in many countries. We just choose not enact the regulation to enable this to happen. Maybe readers have other reasons that home ownership is socially desirable.

For my part, I believe it is actually counterproductive to tackle housing affordability by encouraging greater home ownership.

Here’s why.

High home-ownership rates imply that most of the electorate has a financial interest in keeping prices high. This implies an interest in keeping rents high in order to maintain those prices. Thus, the interests of the home owner and the investor are aligned against the interests of the renter. 

When the bargaining power of renters is curtailed it merely enables investors to extract the full share of rents - that is, they are able to charge the maximum that renters are willing to pay. Any reduction in rents is merely a transfer of wealth from investors and home owners to renters.

With a higher proportion of rental households governments would be forced to improve conditions for tenants, and by doing so, increase their bargaining power.

Buying a home in Australia currently costs between 1.5 and 2 times more than renting, meaning that few rental households have an outside option of buying. They rent because they have to.

We can improve the bargaining power of renters either though changes to rental regulations, or through improving the home-buying outside option. This means that the very act of reducing prices, via LVR restrictions, removing the FHOG, and limiting CGT discounts and negative gearing, means that home buying will reduce in cost compared to renting, allowing buying to be a financially viable alternative to more currently renting households.

For more discussion on the issue I recommend this paper, which contains a wealth of data on rental housing in the OECD, and reasonable discussion about these important issues, including rent controls and the need to shift bargaining power towards tenants to reduce housing costs.

Once we focus on the rental price of housing, and not the price of the financial asset of residential property, we get a very different picture of the housing affordability debate. In fact, we get a picture where housing affordability has remained relatively stable in Australia over the past 20 years. And one where home ownership may even be a policy goal at odds with the goal of affordable rental housing.

But that doesn’t mean we can’t change the situation if we wanted to. We just have to accept that doing so involves a massive transfer of wealth.

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Inequality is a capital vs labour story

I was in a seminar recently where the presenter explored some trends in income inequality in Australia, Canada and the US over the past century. While there was much to like about economists trying to unravel this issue, including the repeated reminders that representative agent models cannot deal with this problem, I had some niggling doubts that the whole story was being considered. I thought this presenter was sticking to only the issues deemed acceptable to discuss in the economics community, while ignoring the more important political issues.

First the good parts. Education is not a solution to income inequality. Canada and the US in particular are very highly educated countries, whose average educational attainments have soared for the past 30 years - the exact period that also saw huge growth in inequality. 

It was acknowledged that the greater the degree of inequality, the easier it is to buy favours within political processes, further entrenching the income divide. It was nice to see economists raise these political points, but equally it highlighted how much of a disgrace it is that economists (and economic theory) play such a key role in capturing political processes for the 1%. 

Now to the issue I believe is the crux of the income equality debate.

I was informed in the presentation that the inequality story of the past 20 years is not about the division of income between capital and labour. Labour incomes in the top 1% are increasing very rapidly too. Sure. But we know that CEO and executive pay is more closely linked to capital returns than ever before, following the wide acceptance of the principle of incentive pay and aligning executive pay to share market performance. 

When I look at the data from the Henry tax review, I find that in fact that the distribution of income from capital is far more distorted towards the upper end than income alone. 

I’ve borrowed the chart below from the Henry Review website. What we see is that the top 5% of income earners in Australia get half of total national income from owning capital assets. While they only get 15% of the wages. 

We can even see that the bottom 20% are making capital losses (capital gains and dividends), highlighting the process by which the poor are becoming more dependent on labour income. 

Many researchers do in fact note that decreasing labour share, and therefore increasing capital share, of national income has been a global trend since the 1970s. What few say however is that this is trend is a result of policy choices informed by neoliberal ideology. We certainly could have avoided this trend if we desired. It was simply a matter of different policy choices. And to reverse the trend is also very simple, should be desire to do so. 

There is no 'natural' outcome when it comes to inequality.

In a mere technical sense, reversing the trend couldn’t be easier. Off hand I can think of dozens of policies; from inheritance taxes, greater public transparency of personal income data (including trusts), land taxes, improving the power of shareholders in the determination of executive pay, grants of land or capital for public service, and more. The options are limitless. 

The barrier to change is modern realpolitik. Those at the top have captured the political process, partly by capturing the media. Any change will entail a massive redistribution of wealth from those who bankroll the political parties, to those with the least resources, the least education and the least interest. 

This is the heart of the matter, and one we repeatedly avoid discussing.

Pretending to care about housing affordability

Australia is embarking on another Inquiry into housing affordability. In the past decade almost every government body, at every level of government, that has any function related to any aspect of housing policy, has conducted similar inquiries. With zero results.

Is it time we stopped pretending to care?

I made a submission (pdf here) to the inquiry, not because I think things will change, but to highlight the 'big picture' considerations in any housing policy. You know, the ones we don't talk about because the Overton window has been slammed shut by decades of well-funded propaganda by wealthy interest groups. Just look at the content of other submissions to see how they miss the big picture, either simply promoting their own financial interests or preserving their reputation by reiterating arguments deemed acceptable in polite company.

My main point is this - any policy that successfully reduces housing rents, and subsequently home prices, entails a massive redistribution of wealth from the richest to the poorest. I wrote the following in my submission.

At current prices Australia’s total housing stock is valued at around $5 trillion. If a policy successfully reduced rents and prices by 20% it would wipe $1 trillion of value from this market. Purchasing power of around $40 billion per year would be redistributed from the almost 6 million current home owning households and 1.8 million residential property investors, to the 2.8 million renters, along with future home buyers and owners of other non-residential domestic assets. 

There is no win-win scenario. Housing affordability is almost completely a question about the distribution of wealth in society. 

To understand the magnitude of potential redistribution from successful policy to improve housing affordability, a reduction in housing rents by even as little as 10%, would lead to possibly the largest redistribution of wealth from the richest to the poorest in Australia's recent history.

Politically it makes sense to pander to the majority. And while the majority of households still own their own home, absolutely nothing will be done to reduce rents and home prices. Even the ridiculous fig leaf of the First Home Owners Grant is actually a subsidy to existing home owners. It's the most fantastical piece of doublespeak to not call it what it really is - the Current Home Owners Grant.

This is the elephant in the room on housing policy. Here. Right here. I'm pointing at it.

Watch me be ignored.

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The 140 year cycle in macroeconomic thought

I am reading Progress and Poverty: An Inquiry into the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth: The Remedy by Henry George (free ebook available here).

I’ve been fascinated so far that the economic debates that occurred during the long recession of the 1870s are almost identical to those still occurring during the great recession. I would have expected more progress in macroeconomic thought in 140 years.

Here’s George describing the utter disarray of the economic elite of that time in explaining how the depression had arisen, and where to look for a remedy.

This is shown by the widely-varying attempts to account for the prevailing depression. They exhibit not merely a divergence between vulgar notions and scientific theories, but also show that the concurrence which should exist between those who avow the same general theories breaks up upon practical questions into an anarchy of opinion.

Upon high economic authority we have been told that the prevailing depression is due to over-consumption; upon equally high authority that it is due to over-production; while the wastes of war, the extension of railroads, the attempts of workmen to keep up wages, the demonetisation of silver, the issues of paper money, the increase of labour-saving machinery, the opening of shorter avenues to trade, etc., etc., are separately pointed out as the cause by writers of reputation.

The modern equivalents are

1870s excuses		2000s excuses
over-consumption	→	excess household debt
over-production	→	excess housing construction
wastes of war	→	government waste or regulation
high wages	→	high wages
currency debasement	→	currency debasement
labour-saving machinery	→	robots

I found even more interesting the debates about the nature of capital and wealth that occurred at the time. George criticised the writers of common textbooks for not being specific in their definitions which caused much confusion when applying economic reasoning to the problems of the day. It seems an awful lot like the Cambridge Capital debates of the 1970s and reminded me of debates (or indeed lack of debate) around foreign investment that appear to have subsided in the past few decades. 

Here’s a snippet, which shows George would firmly be on the side of Cambridge, England, in the capital debates, and would be firmly of the position that foreign investment is merely a transfer and is not wealth-creating. 

As commonly used, the word " wealth " is applied to anything having an exchange value. But when used as a term of political economy it must be limited to a much more definite meaning, because many things are commonly spoken of as wealth which in taking account of collective or general wealth cannot be considered as wealth at all.
...
Increase in the amount of bonds, mortgages, notes, or bank bills cannot increase the wealth of the community, that includes as well those who promise to pay as those who are entitled to receive.

The enslavement of a part of their number could not increase the wealth of a people, for what the enslavers gained the enslaved would lose. Increase in land values does not represent increase in the common wealth, for what land owners gain by higher prices, the tenants or purchasers, who must pay them, will lose. 

And all this relative wealth, which, in common thought and speech, in legislation and law, is undistinguished from actual wealth, could, without the destruction or consumption of anything more than a few drops of ink and a piece of paper, be utterly annihilated. 

By enactment of the sovereign political power debts might be cancelled, slaves emancipated, and land resumed as the common property of the whole people, without the aggregate wealth being diminished by the value of a pinch of snuff, for what some would lose others would gain. 

There would be no more destruction of wealth than there was creation of wealth when Elizabeth Tudor enriched her favourite courtiers by the grant of monopolies, or when Boris Godoonof made Russian peasants merchantable property. 

All things which have an exchange value are, therefore, not wealth in the only sense in which the term can be used in political economy. 

Only such things can be wealth the production of which increases and the destruction of which decreases the aggregate of wealth. If we consider what these things are, and what their nature is, we shall have no difficulty in defining wealth.

What amused me is that George looked for answers in political economy

It must be within the province of political economy to give such an answer. For political economy is not a set of dogmas. It is the explanation of a certain set of facts. It is the science which, in the sequence of certain phenomena, seeks to trace mutual relations and to identify cause and effect, just as the physical sciences seek to do in other sets of phenomena.Maybe it’s time to follow his lead, again, and look outside of sterile economic theory to resolve problems of macroeconomic instability.

Open borders: A morality play by the 1%

Alex Tabarrok, who I rarely agree with, has recently argued his moral position on open borders here. There is no doubt that most moral frameworks also support his position. As do I in the mere theoretical sense. As Tabarrok argues

How can it be moral that through the mere accident of birth some people are imprisoned in countries where their political or geographic institutions prevent them from making a living?

I have argued before that redistribution of wealth from the world’s richest to the world’s poorest should be at the top of the policy agenda for any economist who believes in the utilitarian foundations of their discipline. Open borders is an indirect method for pursuing similar goals of increasing wellbeing for the poorest, and usually promoted by those who fall on Mankiw’s side of the political spectrum; by those who typically argue that the rich ‘deserve’ their wealth (counterargument here).

Open borders is merely the logical outcome of any type of ‘natural rights’ approach to moral reasoning. People should have the opportunity to flourish irrespective of the patch of Earth they were born. Yet the idea boils down to being the policy you support when you want to help the world’s poor but don’t support actually giving them money. Tabarrok’s argument equally applies within borders between the rich and poor, and I paraphrase his comment to make this point. 

“How can it be moral that through the mere accident of birth some people are imprisoned in towns and suburbs where their financial and geographic constraints prevent them from making a living?”.

That open borders within countries does not automatically eliminate poverty reminds us be skeptical of claims that opening borders between them will reduce poverty automatically.

It helps to identify the potential winners and losers from opening borders in order to better understand the motivations of its proponents. If open borders works, and large scale migration occurs, the net effect is that the poorest in the world’s richest countries would have their wages reduced due to competition for unskilled jobs. By contrast, the richest individuals in rich countries, whose incomes are derived mostly from owning capital, would increase due to the greater demand for their domestic assets (such as land) following high levels of immigration. 

Even the wildest proponents of open borders agree that

…open borders could not on its own eliminate poverty and that international migration could only help the relatively better off among the global poor

The rich get richer; that we know with some degree of confidence. The poor get, well, we don’t know. Probably poorer in relative terms, maybe richer in absolute terms. We just don’t know. But we can be fairly certain that the poorest in the world are unlikely to walk away from their homes and straight into the most exclusive enclaves of New York and London. Indeed, one suspects that the most highly educated from the poorest countries will be the first to leave (as they often are now).

Open borders in a global sense is therefore likely to be a game that benefits the richest from the poorest countries and still leaves the poorest with few options to improve their economic fortunes.

Putting this raw economic analysis to one side for a moment, one question seems completely overlooked by proponents of open borders. Why do borders exist in the first place? If we can’t satisfactorily answer that question we won’t get far understanding the many important social issues that would accompany open borders.

A very brief and abstract story of borders is as follows. National borders typically exist as a result of previous wars, or the negotiations that took place between competing interests under the threat of war. These borders now serve as moral boundaries, whereby we see those within our border as part of our tribe. Tribes reinforce their internal cohesion through social signals, customs and rituals which foster stability. This process, however, can distance them from other tribes (countries).

It is these tribal and moral values of borders that make integrating tribes quite difficult. Immigration is always contentious not because of the existence of a line on a map, but because of these deeper social customs, norms and rituals are often in conflict. It takes a mighty will for immigrants to adapt to their new countries, and for citizens of destination countries to patiently accept new people with often conflicting customs and beliefs in their towns and suburbs. I generalise here probably a little too much, but the point I hope to make is that social integration is not automatic and is an extremely complex issue that needs to be properly considered in arguments for open borders.

While I don’t have a disagreement with open borders on moral principles, I disagree on practical grounds that they should be promoted as a first-best way to improve the lives of the world’s poorest. Any economic success from such a fantastical global open borders policy would come at cost of social challenges arising from what I’ve described as ‘tribal integration’. The greater the economic benefits to the, the higher the social costs at both source and destination countries. 

In many ways open borders is the type of policy you support to display street cred in the company of the economically rational, particularly when discussions turn to inequality and, god forbid, redistribution. Making the poor richer is as simple as giving them money and therefore access to resources, whether they are fellow citizens of your country, or your planet.

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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.

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