Sunday, October 23, 2016

Monopoly Concerns with Baysanto

by Levi Russell

The recent merger of DuPont/Pioneer with Dow and the acquisition of Monsanto by Bayer have sparked a lot of discussion of market concentration, monopoly, and prices. A recent working paper published by the Agriculture and Food Policy Center (AFPC) at Texas A&M University written by Henry Bryant, Aleksandre Maisashvili, Joe Outlaw, and James Richardson estimates that, due to the merger, corn, soybean, and cotton seed prices will rise by 2.3%, 1.9%, and 18.2%, respectively. They also find that "changes in market concentration that would result from the proposed mergers meet criteria such that the Department of Justice and Federal Trade Commission would consider them “likely to enhance market power” in the seed markets for corn and cotton." (pg 1) The paper is certainly an interesting read and I have no quibble the analysis as written. However, some might draw conclusions from the analysis that, in light of other important work in industrial organization, are not well-founded.

The first thing I want to point out is that mergers an acquisitions can, at least potentially, result in innovations that would justify increases in the prices of the merged firm's products. To the extent that VRIO analysis is descriptive of firm's behavior with respect to innovation, we would expect that better entrepreneurs would be able to price above marginal cost. Harold Demsetz made this point in his 1973 paper Industry Structure, Market Rivalry and Public Policy. The authors of the AFPC study point this out as well, but the problem is that, even though we have estimates of potential price increases due to the mergers, it is very difficult to determine whether any change in price in the future is actually attributable to market power or simply due to innovation in the seed technology.

Secondly, the standard models of monopoly assert that pricing above marginal cost is at least potentially a sign of a firm exercising market power. Here, articles by Ronald Coase and Armen Alchian are relevant. I provided a discussion of the relevant portions in a previous post so I'll just briefly summarize here: pricing above marginal cost is an important signal that the current market demand is potentially not being met by the firms in the industry. It's a signal to other potential investors that entering the industry might be worth it. Further, there is an issue of measurement. Outside observers may calculate fixed cost, variable cost, and price and determine that a firm is pricing above marginal cost. However, there may be costs of which said observers are unaware. For example, there may be significant uncertainty (which is not the same as risk) about the future prospects of the industry. This is certainly possible in the biotechnology industry since the government heavily regulates firms in this sector. This is not to say that such regulation is bad or should be removed, simply that it presents costs that are difficult for outsiders to calculate.

Finally, I want to examine one part of the analysis in the AFPC paper. On pages 10 and 11, the authors write (citations deleted):
A market is contestable if there is freedom of entry and exit into the market, and there are little to no sunk costs. Because of the threat of new entrants, existing companies in a contestable market must behave in a reasonably competitive manner, even if they are few in number.
Concentrated markets do not necessarily imply the presence of market power. Key requirements for market contestability are: (a) Potential entrants must not be at a cost disadvantage to existing firms, and (b) entry and exit must be costless. For entry and exit to be costless or near costless, there must be no sunk costs. If there were low sunk costs, then new firms would use a hit and run strategy. In other words, they would enter industry [sic], undercut the price and exit before the existing firms have time to retaliate. However, if there are  high sunk costs, firms would not be able to exit without losing significant [sic] portion of their investment. Therefore, if there are high sunk costs, hit-and-run strategies are less profitable, firms keep prices above average costs, and markets are not contestable. 
I submit that under this definition, scarcely any industry on the planet is contestable, yet we see prices fall in many industries over time, even in those we would expect to have significant sunk costs and in which we would expect incumbents to have significant cost advantages over new entrants.

It's true that we sometimes must make simplifying assumptions that are at odds with reality to forecast future market conditions. However, some might infer from the AFPC paper (though I stress that the authors do not) that something must be done by anti-trust authorities to unwind the mergers and acquisitions under discussion. To infer this would be to commit the Nirvana Fallacy. To expect anything in the real world (whether in markets or in the policymaking arena) to be "costless" is an impossible standard.

It will be interesting to see what becomes of these mergers and whether seed prices move sharply upward in coming years. What is certain is that there is tremendous causal density in any complex system, such as the market for bio-engineered seed. Thus, policymakers should be humble and cautious about applying the results of theoretical and statistical analysis in their attempts to better our world.

Thursday, October 20, 2016

Klingian Philosophy of Economic Science

by Levi Russell

One of my favorite things to do in this blog is to talk about unconventional perspectives on economic theory. A great source for such unconventional views is Arnold Kling's blog. The recent Nobel Prize awarded to Oliver Hart and Bengt Holmstrom prompted Kling to write a series of posts detailing his views on economic theory, specifically about the epistemology of economics. Kling's own brand of unconventionality is especially interesting given that he received his PhD from MIT. Below I reproduce a post from last week:

A commenter writes,
So in your opinion intuition is sufficient. As long as we can tell an intuitive story about something, that is as good as proving it?
I think that “proof” is too high a standard to use in economics. If our knowledge is limited to what we can prove, then we do not know anything. I think that we have frameworks of interpretation which give us insights. This is knowledge, even if it is not as definitive or reliable as knowledge in physics or chemistry.

As an example, take factor-price equalization. The insight is that the easier it is to trade across countries, the more that factor prices will tend to converge. I think that this is an important insight. It is one of what I call the Four Forces driving social and economic trends in recent decades. (The other three are assortative mating, the shift away from manufacturing toward health care and education, and the Internet.)

Paul Samuelson proved a “factor-price equalization theorem” for a special case of two factors, two goods and two countries. However, it is very difficult, if not impossible, to extend that theorem to make it realistic, including the fact that not all industries are subject to diminishing returns. In my view, Samuelson’s theorem per se offers no insight, because it is so narrow in scope. The unprovable broader insight is what is useful.

Incidentally, I also think that factor-price equalization is hard to prove statistically. Too many other things are happening at once to be able to say definitively that factor-price equalization is having an effect, say, on unskilled workers’ wages in the U.S. and China. I believe that it is having an effect, and there are studies that support my view, but it is not provable.

In order to prove something mathematically, you have to make narrow assumptions. In physics or engineering, this often works out well. When you roll a ball down an inclined plane, ignoring friction causes only a small error in the calculation.

In economics, the factors that you leave out in order to build a mathematical model tend to be more important. As a result, the requirement to express ideas in the form of mathematical models is harmful in two ways. We waste time proving false theorems and we miss out on useful insights.
The narrow assumptions lead you to prove something which is false in the real world.. For example, the central insight of the “market for lemons” proof is that a used car market cannot work. However, once we expand the assumptions to allow for warranties, dealer reputations, mechanics’ inspections, and so on, the original theorem does not hold.

Meanwhile, there are insights that are missed because they cannot be represented in an elegant mathematical way. A lot of the insights that I offer in Specialization and Trade fall in that category.
Our goal should be to acquire knowledge. The demand for proof hurts rather than helps with that process.
Bonus: I really enjoyed this piece from the Sloan Management Review published back in 2011.

Teaser: I'll be giving my thoughts on the Baysanto merger later this week or weekend.

Thursday, October 13, 2016

Some Alternative Views on the Recent Nobel

by Levi Russell

I enjoy talking about and linking to alternative, minority points of view in economics on this blog. Sometimes the views I talk about are genuinely only held by a minority, others are held by many but are under-emphasized or, in my mind slightly misunderstood.

In this case, I just want to link to some short (and one very long) posts I read about Hart and Holmstrom's Nobel. Certainly I'm happy to see the prize go to work on theory of the firm and contracts and I believe they are deserving of it. That said, here are some alternative perspectives you might not read in other outlets.

Pete Boettke has a rather long, but certainly interesting, post here.

Arnold Kling gives his thoughts in two posts here and here.

Finally, here's Peter Klein on the prize.

Friday, October 7, 2016

Farmers as Environmentalists

by Levi Russell

This morning in my daily ag reading I came across an article entitled "Greens Make Green." The author lays out the case for the farmer-as-environmentalist better than I've ever seen, so I thought I'd share it here. The underlying economic argument here is that there is great incentive compatibility between farmers (who are interested in long-term profits) and environmental sustainability. Do you find it compelling? Let me know in the comments.

In truth, farmers and environmentalists should be allies. The environmental and agricultural communities have more in common than conventional wisdom might suggest. Both desire to preserve our planet and its resources for future generations. I am not shy about saying farmers are the original environmentalists.

To a person, every farmer I have ever met is driven by an ethical obligation to protect the environment. They view themselves as stewards of the land. And for good reason: Nearly all want their children and grandchildren to carry on the tradition. Cousins Scott and Tom Deardorff II reflect the common theme of sustainability that connects the past to the present and future. Founded in 1937 by patriarch and great-grandfather W. H. Deardorff, Southern California-based Deardorff Family Farms has dedicated four generations to refining its environmental craft. For nearly eight decades, the Deardorff family has been driven by the relentless pursuit of improvement, pioneering many farming practices aimed at increasing productivity while reducing their reliance on natural resources.

Today, Scott and Tom have not only embraced but expanded the family legacy of stewardship. For example, they have invested heavily in the latest water-saving technologies, including drip irrigation and state-of-the-art weather stations and soil moisture monitors. The cousins have also curtailed the use of fertilizer and pesticides on their organic vegetable farms through innovative soil fertility programs and integrated pest management systems. And they recently completed construction on a cooling and packing facility that meets the highest green building standards in the country.

Multigenerational farms like theirs are the heart and soul of agriculture in the West and across the country. They are the very embodiment of sustainability. We should be so lucky as to entrust all our natural resources to the collective care of such thoughtful stewards.

If you can't bring yourself to buy the moral argument, at least consider renting the financial one. Farmers are business owners. They are motivated by sustainable profit. Their businesses are dependent on healthy soil and clean water, both of which lead to stronger yields and higher quality products. The math is quite simple: An environmentally healthy farm can deliver sustainable profits, while land that has been abused will one day cease to produce anything. Furthermore, inputs like fertilizer and pesticides are expensive; a business that doesn't minimize operating costs won't stay in business very long. Clean air, soil, and water are all outcomes supported by environmentalists. So why do so many continue to paint farmers as the enemy?

In his farewell address, President Eisenhower famously warned the nation against "unwarranted influence .  .  . by the military-industrial complex." Today we see the maturation of an environmental-industrial complex, defined by multimillion-dollar global enterprises closely integrated with academia and government regulators implementing environmental programs.

Like a storyline out of Mad Men, environmental activists have channeled their inner Don Drapers, fomenting fear of business and industry, and of human activity generally, in order to build a database of committed donors. It is an ingenious business model, used by corporate America since the early 1920s, when Gerard Lambert stigmatized halitosis to sell Listerine. Marketers have long understood that fear is a powerful motivating tool.

Every cause needs a bad guy, a threat that must be put down. For Listerine, it was bad breath. For too many environmental organizations, farmers—cast as the pillagers of Mother Earth—have served as compelling bogeymen (typically referred to as "corporate agriculture," "industrial agriculture," or the like) to alarm the 98 percent of Americans who aren't farmers.

We are all motivated to some degree by self-interest. Farmers are motivated by the love of farming and social good that comes from providing healthy food, and they are also motivated by the desire to succeed financially. Environmental activists working in big organizations aren't all that different. There is no doubt that most choose a career based on a commitment to environmental values and a desire to do good. And there is also no doubt that another motivation, and one that is entirely defensible, is the financial reward and career security that these organizations can provide.

Unfortunately, in the public debate, it is perfectly acceptable to point to farmers' financial motivations and equally unacceptable to acknowledge the financial motivations of environmental advocates. Those in private enterprise who are targeted by the policy and political initiatives of the environmental lobby ought to be more vocal about that.

If one can acknowledge the reality that the environmental lobby is motivated not only by the values of environmentalism, but also by the financial rewards of growing a motivated donor base, one might ask whether it would benefit these organizations to ever declare a problem solved. After all, while committed donors might feel good upon hearing such an announcement, they would also have one less reason to contribute.

Nowhere was this more in evidence than during the opposition waged against Senator Dianne Feinstein's compromise California drought legislation in 2014, which culminated in a joint-letter from multiple organizations slamming her bill.

Not one to seek the ire of environmentalists, the senator candidly responded—as quoted in the San Francisco Chronicle—that they "have never been helpful to me in producing good water policy." She went on to lament, "I have not had a single constructive view from environmentalists of how to provide water when there is no snowpack."

The practice of environmental protection and the business of environmentalism are two sides of a scale. Our nation's natural resources have benefited from much that has come from the former, but today the scale is weighted too much to the latter. It is the business side of environmentalism that produces the political targeting of agriculture.

It should stop. We share a common aim: to safeguard the planet for its people, animals, and plants. Imagine how much good could be accomplished if all farmers, regardless of size, whether conventional or organic, were accepted and embraced as partners for environmental protection. Now that is a narrative I know Don Draper could sell.

Tom Nassif is president and CEO of the Western Growers Association.

Monday, October 3, 2016

A Simple Observation

by Levi Russell

I don't claim to be the first to make this observation and it might very well be something that is discussed often in undergrad micro (though I can't find it mentioned in the 20 or so lecture notes I found online on the subject. Nevertheless, I thought I'd discuss the following briefly:
From the perspective of the consumer, price discrimination and cross subsidization are the same thing.
Here are the simple definitions Google gives when you search "price discrimination" and "cross subsidization"
price dis·crim·i·na·tion
the action of selling the same product at different prices to different buyers, in order to maximize sales and profits
Cross subsidization is the practice of charging higher prices to one group of consumers to subsidize lower prices for another group.
In cases like afternoon matinees at a movie theater or senior citizen discounts at the grocery store, we can certainly see the positive side of firms charging different prices for different people. While it's true that this increases producer surplus, presumably, some of the people who receive the good at the lower price wouldn't be able to get it if the other group weren't paying a higher price.

The problem is that we use two terms to describe the same concept. The first one has a clearly negative connotation (discrimination) but the second sounds more sterile and scientific. There are certainly cases in which we might view price discrimination/cross subsidization as a bad thing. For instance, when an online retailer charges a higher price for someone who shops online a lot. Still, I can't help but think "cross subsidization" is a better term for the phenomenon since it isn't loaded with a negative connotation that might diminish students' focus on its effects, both positive and negative.

Thursday, September 22, 2016

Political Economy of Crop Insurance

by Levi Russell

Last week my (co-authored) article on the political economy of crop insurance in the next farm bill (coauthored with Art Barnaby of Kansas State University) was published in Choices Magazine. I thought I'd reproduce the theme overview here and link to all 4 articles for those who are interested.

The Farm Bill, passed every four or five years, is a large piece of legislation which includes agricultural, food, conservation, and rural development programs. The most recent bill, passed in 2014, made significant cuts to commodity programs and increased budgeted spending on crop insurance. This change shifts the focus of farm risk management toward crop insurance, making it an even more important part of a producer’s toolkit. Looking ahead to the next farm bill in 2018/2019, this focus on crop insurance will likely continue.

The articles in this issue anticipate three discussions surrounding crop insurance’s role in the next farm bill: the political economy of crop insurance by Barnaby and Russell, economic evaluation of crop insurance’s role in the safety net by Zacharias and Paggi, and crop insurance’s role in specialty crop agriculture by Paggi.

Barnaby and Russell examine three crop insurance alternatives which are likely to be proposed in the debate over the next farm bill:

 1. Replacing crop insurance with a free, area-based disaster program,
 2. Making modifications to existing policy which would significantly reduce support to  farmers and jeopardize the private delivery system, and
 3. Complete elimination of the safety net.

The article summarizes the political factors and their interaction with the economic effects of these proposals.

Zacharias and Paggi identify the key considerations for improving crop insurance’s role in the farm safety net. Among these are regional and commodity-specific considerations, government budget constraints, and interactions between crop insurance and other titles in the farm bill. They emphasize the importance of developing appropriate metrics for evaluating the simultaneous performance of crop insurance and commodity programs and conclude with a research agenda for examining these issues.

Paggi discusses the broader role of crop insurance as a risk management tool for specialty crop producers. Specialty crops are of interest due to the increase in specialty crops’ share of the total crop insurance liability over the last 15 years. Paggi details the connection between crop insurance and specialty crops and provides a discussion of factors affecting the future of this connection.

Finally, Woodard addresses the elasticity of demand for crop insurance issues.  This key value will determine the maximum achievable size of any cuts in USDA’s share of the crop insurance premium and still maintain a politically acceptable level of farmer participation in crop insurance needed to prevent any future ad hoc disaster program.  It is critical for policy makers to understand the impact of elasticity of demand to prevent unintended consequences by making Federal budget cuts to crop insurance.  All budget cuts are not equal so how those cuts, if any, are made is extremely important.

Given the important role of crop insurance in the future of the farm safety net, political and economic factors affecting policy decisions are particularly of interest. This issue provides a first look at the conversations policy makers, industry representatives, and academic economists will have leading up to the next farm bill.

Monday, September 19, 2016

Anti-Trust vs Regulation: The Case of Baysanto

by Levi Russell

Bayer's impending purchase of Monsanto is all over the news lately. As is typical in these situations, the conversation centers around concerns of increasing market power and monopoly profits. Regular readers might expect me to focus on the notion that industry concentration doesn't necessarily imply welfare losses, but I'm not.

It seems to me that the relationship between anti-trust legislation and regulation is an under-discussed issue in these cases. Agribusiness firms are heavily regulated by three of the most powerful regulators in the US: the FDA, the USDA, and the EPA. Many regulations function as fixed costs, implying that there are economies of scale in regulatory compliance. Thus, the greater the regulatory burden placed on firms in an industry, the greater the inducement to merge.

These regulatory economies of scale militate directly against the goals of anti-trust policy. The latter, perhaps as an unintended consequence, gives us fewer and larger firms while the latter attempts to reign in these cost-saving mergers in the name of competition. If we're going to seriously discuss regulation and anti-trust, we need to be cognizant of the interplay between them.

Of course, there are plenty of problems with the regulatory revolving door and other public choice issues to deal with as well. On this front, it seems fairly obvious that the incentive to rent-seek is positively correlated with the prize being offered. Perhaps this is an argument for less power vested in the administrative state and more power returned to the courts.