Monday, May 25, 2015

Paul Krugman is Confused About the Theory of the Firm

Krugman's Memorial Day blog post shows his unfortunate misunderstanding of the difference between government bureaucracies and the managerial structures of private businesses. He goes as far to state that those who work for large private firms work under "command-and-control" regimes.

At one level, this is all just semantics. Certainly one can define the managerial structures of private businesses as bureaucracies or define "command-and-control" broadly enough that it encompasses private firms. However, defining these terms so broadly is not helpful because there is an important distinction between the ways in which a government bureaucracy and a (truly) private firm operate.

It's true that both private entrepreneurs and bureaucrats have to direct resources within the firm or bureaucracy without the benefit of market prices. According to famous economist Ronald Coase, firms exist because of a need to reduce transactions costs that exist in markets. The managers of a firm may prefer to manage employees (with contracts of indefinite length) rather than continuously go to the market and bid for contractors to do their work. In this sense, the managerial structure of a firm is a "bureaucracy."

The important distinction is that government bureaucracies lack the feedback of profit and loss. Private firms have the advantage of input and output prices that reflect, to an imperfect degree, the preferences of firms and individuals regarding those inputs and outputs and their respective scarcities. These prices provide profit and loss signals that guide firm behavior. Good managers continue to operate while poor managers are weeded out. Government bureaucracies are shielded from the profit and loss mechanism since tax money can always be funneled to the pet projects of politicians. The prices of the inputs required for any bureaucracy can also be manipulated by rent seeking behavior of "private" firms and individuals.

Thus, while there is a kernel of truth in Krugman's article, it is misleading if taken out of the narrow context of the theory of the firm. Given the political tenor of Krugman's column, I seriously doubt he is focusing on the theory of the firm here.

Krugman goes futher, stating that "... in many areas bureaucracy works better than laissez-faire." This is probably a better reflection of Krugman's politics than of sound economic analysis. I've covered the arguments against bureaucratic direction of resources and in favor of markets in a couple of recent posts, so I'll leave it to Krugman to muster some kind of argument in favor of his position.

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