Good things & bad things: competition and privatization

When I talk to students about anti-competitive behavior, I like to start with a stark illustration. There are lots of things firms might do in order to earn profit, and these things might be good or bad, broadly speaking. Profiting by producing a higher-quality product, or by producing at a lower cost than competitors: good things. Sending Fat Tony to threaten your competitors with violent death if they do not bow out of the industry: bad thing. The good things are profitable to firms because of the benefit to consumers that is generated, whereas the bad things benefit firms at the expense of everyone else. The purpose of competition policy is to preserve firms' incentives to do the good things and preclude them from doing the bad things. There are lots of complications, of course, making it difficult to sort out whether a particular strategy (e.g. a merger between two firms) is actually a good or a bad thing. But the basic idea is that when firms are doing their best to earn profit within the constraints of well-designed laws, their activities enhance consumer welfare.

The same question arises in the context of privatization. If some government-run entity, like a prison, is put into private hands, there is then someone who stands to profit if he does a good job of running the now-private entity. The hope is that a firm running a prison for profit will do good things for the sake of profits, like reducing costs, insofar as this can be done while still fulfilling the purpose of having a prison. I would guess that prisons are a target for privatization for two reasons: in addition to the general phenomenon of government agencies doing things less efficiently than private firms, incarcerating convicts is probably a relatively costly activity. Thus there would be a lot of benefit to be had by creating strong incentives for running prisons better.

Is everything debatable?

Near the beginning of this semester, in my macro principles class, we were talking about all the reasons why economists might disagree. Belief in different theories or methodologies, differing interpretations of evidence, and differences in values or priorities: these pretty much capture everything, I think, although you could elaborate on each of these and delineate subcategories. During this discussion, one of my students asked, "So, in economics, is everything debatable?"

Quantitative and qualitative economics

A post on the Scientific American blog asks, "Is Economics More Like History Than Physics?" I do not think that this is a useful question to ask, in that it implies that we must choose one approach or the other. A much better question is how we might use each kind of approach (historical and scientific), what insights there are to be gained from each, and what pitfalls each presents. This is really a two-sided argument (or perhaps a two-front war): there is nothing inherently wrong with the use of mathematical tools to analyze economic questions, and these methods have generated many valuable insights; but non-mathematical methods may also be useful. 

Do we really need to regulate that?

Why is it illegal to smoke on domestic flights in the U.S.? Whatever benefit there is of prohibiting smoking on a flight accrues to those who are actually on the plane. If this benefit is large enough, then it is in the interest of the airline itself to prohibit smoking, because the benefit to passengers translates directly into greater willingness to pay for airfare and greater profits for the airline. Is it somehow easier to enforce a smoking ban if the force of law is behind it? Did the government pass the law to insulate airlines from the ire of those passengers who would prefer to smoke in flight? Maybe, but I would also note that some airlines had their own smoking ban before the law took effect in 1998. Is the purpose of the law to level the playing field, because there is some negative consequence of allowing airlines to compete through their policies regarding smoking? Again, maybe. I wouldn't suggest that anyone should be able to smoke on airplanes, either as an economist or as an air traveler; but it is clearly incorrect to assume that the only way to achieve this outcome is by passing a law. This seems to be a fairly common belief: that if the government doesn't make something happen, it won't happen.

The liquidity's all right... isn't it?

In discussions of high-frequency trading (HFT), like this paper, liquidity always comes up as one of the benefits of HFT and thus a cost of restricting it. As far as I can tell, the benefit of additional liquidity is generally taken to be self-evident, and I don't understand why that is so. In this paper, I note the value of lots of liquidity in a financial market, but question the additional value of more liquidity:

The stock market is enormously beneficial insofar as it allows firms to raise capital easily; but the vast majority of stock trades involve previously existing shares and thus do not have a direct effect on the firm whose shares are being traded. There is of course some correspondence between a firm’s real economic activity and the trading of its shares; for example, the share price affects whether a management buyout or hostile takeover is attractive. However, this correspondence is not affected to any significant degree by HFT: HFT activity just changes the prices slightly more quickly.

Any statement about improvement in liquidity resulting from HFT typically is based on some measurement of liquidity in terms of assets or volume of trading, without any assessment of its actual benefit.

This new paper by Budish, Cramton, and Shim, which sparked this discussion at Marginal Revolution, proposes frequent batch auctions, i.e. trading intervals on the order of one second. One parameter in the paper is the cost of short delays in trading imposed by restricting HFT. The authors do not attempt to measure the actual cost, but they suggest that it is small. I don't see how this kind of cost is of any significance when the delay is on the order of a second. Does it capture the trader's impatience at having to wait to execute a trade? Lost interest while assets sit in limbo? Fear of missing some deadline? Even if the delay is minutes rather than seconds, what exactly is the problem? There could certainly be some problems if you have to wait a month, but once the market is thick enough that you can pretty much trade any time you want, what is the benefit of being able to trade at 12:00 instead of 12:01?

Budish et al point to the high costs of HFT infrastructure as well as greater stability in trading markets to justify the imposition of frequent batch auctions. I'm not convinced that there are any social benefits of HFT at all, especially in comparison to other forms of algorithmic trading (one of the points I made in my paper referenced above). If there are benefits, they are very small in comparison to the costs. I am no kind of finance guy, but am I missing something?

"Buy local": a slogan in search of a rationale

There may be a good reason to favor local firms, but movement supporters don't seem to know what it is.

Economists vs. everybody else: jobs and trade

What can and should be done to create and protect jobs? This is one of many questions for which economists and the general public do not see eye-to-eye. The public is often misinformed, but economists can be cavalier in their dismissal of the public's concerns and priorities.

Oh, fudge

I was recently vacationing with my family on Mackinac Island. It is a 3.8-square-mile island in Lake Huron, depicted in this map. Its attractions include the Grand Hotel, where much of the 1980 film Somewhere in Time was filmed; Fort Mackinac, which my son (below) particularly enjoyed; and an abundance of fudge. The map inset depicts a stretch of Main Street that is less than 1500 feet long and includes 10 fudge shops. There are 6 firms that own all of the shops on the island, and 3 of them had at least two outlets on Main Street. I did not sample extensively, but I had the impression that all the shops had similar selections of fudge, salt water taffy, and peanut brittle, as well as similar prices. There is a classic economic explanation for this kind of phenomenon: that, in some contexts, firms compete most effectively with each other by minimally differentiating themselves from other firms. Firms might differentiate by locating at a distance from other firms or by varying their products in any number of ways. This page illustrates the pressure for firms to locate close to their competitors, and this same reasoning applies metaphorically to product characteristics.  (There are lots of complications to this model, some of which result in greater degrees of differentiation.)

I think that one reason this effect is so strong in this case is that the market is relatively uninformed: most of the market is tourists, and most of them don't have good information about what they can buy on Main Street. Tourists do know that they will be able to buy fudge at lots of different locations; but this raises the question of how this came to be. Did all of these fudge sellers enter the market because of the enormous demand for fudge on Mackinac Island? Or perhaps it is a supply issue: a local abundance of materials or expertise necessary for fudge production. That fudge shops are common in many highly touristed areas favors the demand-side explanation. Maybe people associate fudge consumption with vacation, and maybe this is one means of restricting one's indulgence in certain items. I wonder how sensitive this situation is to its initial conditions, whatever they were: is the prevalence of fudge, peanut brittle, and salt water taffy in American resort towns a historical accident, or is there something about these products that inevitably leads to their provision in these markets? In either case, we live in an era in which consumers can expect a certain array of amenities at many vacation spots, and firms cater to these expectations. (I find it amusing that salt water taffy is popular at freshwater locales like Mackinac Island, although its production doesn't involve salt water per se.)

This minimal differentiation story applies in lots of other tourist-dominated markets. In Venice, for example, you can hardly walk a hundred feet without running into a gift shop selling cheap blown glass figurines and Mardi Gras masks.

Where'd that paper go?

Over a year ago, I wrote a paper called "Curbing the Dangers of High-Frequency Trading" and submitted it to the Economists' Voice.  The final acceptance came through in March of 2012.  The official link is here, and an ungated copy is here.  Here is the problem: I didn't know where to find the published version, or even  that it had been published, until this week.

Luck and taxes

Consider what makes a movie a blockbuster. Many factors contribute to a film's success: quality of the writing, acting, directing, marketing, etc., as well as the public's response to these inputs. Not all of these are within the control of any one person, including the film's producer. If a film is unusually successful, chances are that it is due to a combination of factors, including some that are not predictable or controllable. One way to see this is to note that sequels to very successful films are, on average, more successful than typical films but less successful than their predecessors, because it is generally impossible to replicate everything that made the original film successful. (It's also possible that a sequel is produced just to milk the success of the original, without any intent of comparable quality, or that a sequel happens to be better than the original; thus the qualification of "on average" above.) This is a well-known statistical phenomenon: regression to the mean. Observations at the extreme of a distribution tend to get there for lots of reasons, including some randomness. Successive observations tend to be closer to the mean of the distribution. For another example, the sons of extremely tall fathers tend to be taller than average but shorter than their fathers, whereas the sons of very short fathers tend to be shorter than average but taller than their fathers.

Now consider income distribution. Someone with a very high income probably got there for a number of reasons, not all of which were under the individual's control: i.e., such a person probably worked hard, made good choices, etc., but also got lucky in some respects. Similarly, someone in the very low end of the income distribution probably got there partly as a result of individual action (or inaction) but partly as a result of happenstance. It's also possible that one man becomes rich even though external factors are against him, and another man becomes poor despite having every advantage in life; but on average, those in the extremes of the income distribution are there because of a variety of factors pointing in the same direction. This to me is the most compelling justification for progressive income taxes. Life is not fair, and the tax system (as well as some of the ways in which the revenue is spent) mitigates the inequities. The justification is even stronger when we consider that some advantages or disadvantages are systematic but still outside an individual's control. Note also that the tax system is not coming anywhere close to equalizing incomes, because there are still plenty of factors contributing to income that would generally be regarded as fair and should not be discouraged.

Of course there are other rationales, including the idea that those who earn higher incomes are benefiting more from our whole economic infrastructure, and therefore should contribute more toward its maintenance; and this one from Mark Thoma.

(Another) criticism of the current state of the economics profession

From Nobel laureate Ronald Coase:

In the 20th century, economics consolidated as a profession; economists could afford to write exclusively for one another. At the same time, the field experienced a paradigm shift, gradually identifying itself as a theoretical approach of economization and giving up the real-world economy as its subject matter. Today, production is marginalized in economics, and the paradigmatic question is a rather static one of resource allocation. The tools used by economists to analyze business firms are too abstract and speculative to offer any guidance to entrepreneurs and managers in their constant struggle to bring novel products to consumers at low cost.

I think the last sentence is a bit of an overstatement--not any guidance? really?--but you could raise a similar concern for the applicability of some economics research to public policy.

What is the deal with “heterodox” economics?

Heterodox economics is anything outside the mainstream (which is sometimes pejoratively referred to as "orthodox" economics). It's difficult to be precise about what qualifies as heterodox, especially since the boundaries are changing over time. The term can be applied to a school of thought, a piece of research, a researcher, or a journal. It is my impression that the distinction is sharpest for journals: there doesn't seem to be any disagreement about which journals fall into which category (a list of heterodox journals is here). I don't know whether other fields have this kind of division. I've heard of, for example, a subset of political scientists who think that the work being done by some other subset of political scientists is worthless, but not of a majority against a minority.

Although I can’t come up with a non-tautological characterization of what distinguishes heterodox economics from the mainstream, it seems to be a question of what topics are of interest, what methodologies are most valid, or what political point of view is being promoted. Greater extremity in any sense tends to be less likely to be mainstream. Many of the areas of contention are macroeconomic. I'm interested in these debates, but as a microeconomist I’m only a spectator, and the finer points are often lost on me. There is also some disagreement about what defines a school of thought. For example, some Austrian economists categorically reject the use of mathematics to analyze social phenomena, and others say that this rejection is not in the true spirit of Austrian economics. There has been a lengthy debate on this question, for example here. Apart from the substantive issue—the role of mathematics in social research—I don’t find the debate over how different views should be labeled very interesting. The heterodox label itself is somewhat arbitrary and, in my opinion, not constructive. The important question to ask about any line of research is what insight it offers, and there is at best an imperfect correlation between this question and the categorization of research as either inside or outside the mainstream.

An economist might choose to pursue heterodox research for a number of reasons. There are those who seem to object to the mainstream in any sphere, or perhaps just enjoy being outsiders. Often it is simply a matter of the specific topics or methodologies of interest to the economist. Whether because of these areas of interest or for other reasons, heterodox economists commonly have not been successful in the mainstream. Here is where it gets tricky. If one lacks the ability or desire to go through the rigors of mainstream research, criticizing the mainstream becomes appealing. This fuels the mainstream's ability to dismiss heterodox research as amateurish (this post goes so far as to call the entire body of heterodox research "a joke"). At the same time, insiders always have incentive to keep outsiders out, for whatever reason, and economists understand this better than anyone. I have seen plenty of heterodox research that is of little or no value, whether because it is poorly executed, uninformed, or misguided. On the other hand, the same could be said for some mainstream research, and it does the profession no good to ignore research simply because it could be labeled as heterodox.

I don't think that mainstream economics is in danger of being overthrown, or that an overthrow is desirable; but I think that the profession would do well to be more open in terms of what questions are interesting, what methods are useful, and what we consider to be evidence. Personally, I think it's interesting to see how qualitative methods can contribute to economic understanding. At the same time, I support the mainstream view of the value of mathematical analysis (I think that quantitative and qualitative methods each have their own advantages and their own pitfalls, but that is the subject of another post). If I could do anything to change the relationship between mainstream and heterodox economics, it would be to blur the line between them. The profession does incorporate heterodox thinking over time, but I would say that this is happening too slowly. Giving some consideration to alternative points of view can never hurt, and disregarding these points of view can lead to some massive fails.

One of my students—intelligent, thoughtful, and responsible—came to my office during his final undergraduate semester, while he was taking a course in evolutionary economics. He had previously taken my classes in (mostly neoclassical) micro theory and industrial organization. He was having what I think is a common reaction from students when they are first exposed to heterodox thought: something like "Wait a minute!  Everything I've been learning is wrong!" I would never fan the flames of such a reaction—quite the opposite—but I think it is useful for undergraduate economics majors to have some acquaintance with ideas outside the mainstream. In any economics class, it is worth mentioning that controversies exist. A professor who, for example, teaches a single theory of economic fluctuations without even mentioning any alternatives is doing a disservice to students. And I would agree with others (sorry, can’t seem to find the references) who stress the importance of a course in the development of economic thought in any doctoral curriculum.