Friday, March 31, 2017

More Demsetz on Externalities

by Levi Russell

I recently ran across a lecture by Harold Demsetz presented at the Property and Environment Research Center in Montana back in 2011. Unfortunately, the video isn't online anymore, but I did find a written version. It's fairly short as lectures go, so I recommend you read it. If you don't have time to read 11 pages, check out the excerpts below.

Demsetz starts off by discussing the perfect competition model (which he calls the "perfect decentralization model"). This provides the backdrop for his discussion and critique of Pigou and Coase.
Consider Pigou’s method of argument first. He constructs examples of divergences between private and social cost. These examples differ circumstantially but in their nature s they are all the same. A favorite example involves the misallocation of traffic between two roads that connect the same terminal points. One road is subject to considerable congestion because it is narrow; the other road is wide and escapes much of this congestion but takes longer to transit because it lacks the directness of route of the narrow road. Pigou claims that the equilibrium number of autos using the narrow road will be inefficient. This is because drivers using this road do not take account of the costs of increased congestion they impose on others who use the road.  But what Pigou fails to do is show that the se example s are consistent with the presumptive conditions set down in the perfect decentralization model.  Frank H. Knight (1924), in a brilliant article on social cost, criticizes Pigou’s two -¬‐ road example. He notes that Pigou allow s free access to the two roads. Presumably, then, these roads are publicly provided and managed and, as such, cannot be a basis for criticism of private re source allocation. Knight argues that these roads, had they been private, would have been priced (in a competitive setting) so as to achieve an efficient allocation of traffic; price to use the narrow road would have been raised to levels higher than to use the broad road. Pigou’s examples do not uncover a logical flaw in the neoclassical model, since virtually all are based on an absence of private ownership. This is not to say that all resources in a real economy are privately owned but that Pigou’s work is properly interpreted in terms of the consequences of an absence of private ownership (or, more provocatively, as the presence of mismanaged public or collective ownership) than as inefficiency deduced within the context of the neoclassical model.
Coase noted a defect in Pigou’s argument that in its nature was much like that seen by Knight but which was not based on the absence of private ownership. Coase pointed to Pigou’s failure to recognize that the cost of using the price system disrupted the ability of a market-¬‐based price system to face users of resources with the full consequences of the uses they chose. Free use of the price system was implicitly assumed in the neoclassical model, since it treats prices as known to all who would use them. Coase’s complaint about neoclassical economics is empirical error, not logical error. The empirical error being that its model abstracts from an important aspect of the real world. As described above, Pigou gave no explanation for why a separation between private and social cost should exist in an economy that conforms to the conditions of perfect decentralization. Coase also offers no reason; instead, he openly modifies the perfect decentralization model to accommodate the fact that positive costs must be incurred to engage in exchange. The modified model allows him to rationalize the existence of a separation between private and social cost, or so he thinks. Just what this cost consists of remains somewhat vague, but I adopt Coase’s general notion.
Coase demonstrates the importance of transaction cost by way of two contrasting cases. The first shows that no difference between private and social cost can exist if the cost of transacting is zero, since, in this case, all who would bear costs from someone’s actions can bring these costs into that person’s calculations by making him or her offers to desist or modify the intended actions; similarly, this person can require revenues from those who would benefit from these actions. Nothing is left unaccounted for as long as legal rights of actions are in place. Coase’s argument is correct in this case. His presentation of the second case, involving positive transaction cost, claims that inefficiency may arise because some of the negotiations required to account for all costs and benefits cannot surmount the barrier put in place by transaction cost even if legal rights of action are in place. And here, Coase makes an error that still goes unappreciated by economists. 
Coase has treated the legal system and its courts as if they are parts of the economic system that was modeled by neoclassical economists, but, as already noted, their model assumes that all resources are privately owned and that ownership is fully respected; there is no place in it for the courtroom drama imagined by Coase. Moreover, real social systems in fact design courts so as to insulate them the influence of the marketplace. Offers and acceptances of payments to the court for desired decisions are illegal, and court survival is not made to depend on earned profit from decisions rendered. The neoclassical model of an economy and the conclusions drawn from it are confined to economic institutions, to firms, buyers, sellers and so on. The model draws no conclusions about resource allocation which results from actions taken by non-¬‐market institutions like courts and legislatures. In any case, Pigou did not base his examples of inefficiency on ownership ambiguity or court mistake.

While adopting the neoclassical perspective of market behavior, which sees ownership and markets as instruments by which resource values are maximized, Coase has relied on court decisions to assess the efficiency of the economic system. The implication he draws, that the economic system has made a mistake in allocating resources, is quite wrong. The court may have made its choice of owner for reasons different from maximization of market value or it simply may have made a mistake because it is not guided in its decisions by a market-¬‐based calculus. These reasons may seem good to some and bad to others, but they are irrelevant to the externality problem whose proper domicile is wholly within the economic system. Indeed, although there are good reasons for not creating a different legal system, if the court were to be transformed into a market institution and allowed to survive only by revenues secured from petitioners who buy its services and decisions, control of a resource would go to the person who can put it to its highest value use.

The economic system simply takes the court’s decision as an exogenously imposed constraint on its operations, much as it takes a decision by the State to tax or redistribute wealth. An efficient economic system is one that makes the most of scarce resources within the constraints handed down to it by courts and legislatures. Efficiency requires the market to block the transaction between the two claimants discussed above if the cost of their transacting exceeds the increase in value expected to be realized from a change in ownership of the resource.
There is no difference between transaction cost and other costs in this respect. The amount of soot from the production of steel may remain greater than is desired by the owner of a nearby laundry because the cost of transacting between laundry and mill owners is too great to make a transaction worth undertaking or because the launderer and steel mill owner believe that the cost of substituting hard coal for soft is greater than the cost borne by the launderer as a result of soot. In both cases, more soot descends on the laundry than if the cost of reducing soot were smaller. If we do not think resources are misallocated in the case in which hard coal is too costly to use, why should we think resources are misallocated in the case in which transaction cost is too costly to bear? Both situations are compatible with efficient resource allocation, and, after all, it is efficiency that is sought; neither negotiations nor hard coal are sought in and of themselves. Indeed, one can rewrite the neoclassical model with transaction cost included. This just shifts supply curves upward (or demand curves downward), but it carries no implications of inefficiency at equilibrium values of price and output.

I emphasize that none of what is written above denies the possibility of inefficiency in a competitive, private ownership economy. My message is that this possibility is not a result of positive transaction cost. Our reliance on a transaction cost rationale has caused us to exaggerate the scope of what externality problem might remain.

By now, the reader must suspect me of playing a word game. In part I am, but the game is not my doing. ‘Externality’ means nothing if it does not suggest something apart from a reckoning. Yet, a non-¬‐trivial component of what is written above makes a case that there is no ‘apartness’ from the market calculus. Something rationally not ‘worth’ taking into account is not equivalent to error or to inefficiency. That it is not taken into account is a reckoning if it follows from an anticipation that it is not worth taking into account. An explicit accounting for everything would be inefficient in a world in which knowledge is not free. 

Supply and demand as interpreted by the neoclassical model are expressions of true willingness to cooperate in a world that is highly dependent on specialization for its wealth. The neoclassical model faces buyers and sellers with given, non-­‐negotiable equilibrium market prices, determined on markets that cannot be influenced by individual bargaining. The model is not designed to treat strategic action, yet examples such as climate change and atmospheric quality represent problems that arise from the attempt to get others to settle for a smaller share of the surplus made available through cooperative behavior.

A close reading of Pigou and Coase does not reveal concern about strategic behavior. The distribution of traffic between Pigou’s two roads is inefficient because no price is charged for using them, not because drivers deceive each other. The failure to realize maximum value from available resources in Coase’s court room drama is a problem of legal error, not one of false testimony.

What advantage does the State bring to the resolution of strategic problems? It brings legitimate power to coerce; in these instances, the power to coerce people to pay for a public good. Just as we find that the State’s ability to coerce makes it a desirable agent in helping to maintain law and order, so we may find it a desirable agent in helping to finance production of goods and services that are important and are subject to serious strategic bargaining problems. It is possible in some instances to remedy the problem through a proper set of private rights –substitute a toll way for a free way. In other instances, the effective use of coercive power might require direct implementation by the State. People will value the alternatives of coercive State and voluntary-­‐dealings markets differently, depending on the confidence in which they hold the State and on the value they attach to personal freedom, but I see no reason to classify these important problems as externality-­‐caused inefficiencies. This now seems to me to be a classification without content.

Thursday, March 23, 2017

Should We Fear Tech-Driven Price Discrimination?

by Levi Russell

Writing at Bloomberg View, mathematician and author Cathy O'Neil walks through several ways in which new retail technology could enhance businesses' ability to engage in price discrimination. I recommend reading her piece, as it makes some good arguments in favor of being concerned. However, I think there are reasons to believe price discrimination either 1) is sometimes beneficial or 2) can be easily avoided.

What is price discrimination? It's the practice of charging people different prices for the same good based on their ability or desire to pay. O'Neil mentions that rules are in place that outlaw this practice, except in the cases of coupons, memberships, or bulk orders. But there are other cases. Senior citizen or military discounts are common. These discounts are based on the general idea that significant segments of these populations have relatively low incomes. Yes, there are well-paid soldiers and many, many people over 65 are quite wealthy, but these discounts apply to enlisted soldiers and elderly retirees on fixed incomes.

Coupons, membership deals, bulk discounts, and discounts for military and seniors are generally thought of in a positive light. People who have lower incomes but more time to cut out coupons will pay lower prices. Those willing to give shopping information to retailers get discounts. Some of us pay higher prices so that soldiers and seniors, who might have lower incomes, can still enjoy goods and services at prices they can afford.

Moving to online shopping, O'Neil explains how retailers collect data on their (potential) customers and are able to prey upon the desperate or cavalier by charging higher prices. Here are some examples with potential solutions in italics:

Retailers collect shopping and other data based on your IP address or browser "cookies."
Clear your browser's cache regularly.
Use the Tor browser, which makes it very, very difficult for you to be identified by websites

Retailers collect data based on user's individual profiles.
Many online retailers allow you to purchase without creating an account.

Personal assistants like Google Home or Alexa might pick up on behavioral cues that allow them to charge high prices.
 Just don't buy one. 

A common theme on this blog is that, as Harold Demsetz pointed out decades ago, comparing the real world with all its faults to a perfect ideal "alternative" isn't necessarily a good guide for policy. So, if advances in retail technology allow retailers to adjust prices based on income or stress or other factors, should something be done to slow these advances? Does it make sense to forego the benefits of improved technology to avoid these potential costs? I don't know the answer to that, but I'm interested in reading your thoughts.

Friday, March 17, 2017

A Lawyer and a Physicist Walk Into a Bar

by Levi Russell

A lawyer and a physicist walk into a bar... 

I don't have a good joke for that intro, but I do have a punchline: physicist Mark Buchanan's recent Bloomberg View column entitled "The Misunderstanding at the Core of Economics." What is this misunderstanding, you ask? Well, it's the (mistaken) belief that markets are perfect. This belief, Buchanan alleges, is widely held among professional economists. Buchanan argues that this widespread belief has had tragic consequences:
Economists routinely use the framework to form their views on everything from taxation to global trade -- portraying it as a value-free, scientific approach, when in fact it carries a hidden ideology that casts completely free markets as the ideal. Thus, when markets break down, the solution inevitably entails removing barriers to their proper functioning: privatize healthcare, education or social security, keep working to free up trade, or make labor markets more “flexible.”

Those prescriptions have all too often failed, as the 2008 financial crisis eloquently demonstrated. ...
The trouble with all of this is that none of it is true. If political party affiliation is any indication, the fact that academic economists are overwhelmingly Democrat indicates that pro-market utopianism isn't widespread. Another survey indicates that a mere 8% of academic economists can be considered supporters of free-market principles and only 3% are strong supporters. In terms of economists, Buchanan's only reference is to the late Kenneth Arrow. He provides no evidence that a massive swath of the profession are all free-market ideologues incapable of nuance. Buchanan cites one newly-popular economic commentator, an historian and lawyer, James Kwak. Kwak has been roundly criticized by economists for his simplistic analysis of economic phenomena many times, notably here, here, here, and here and many other times over the years.

So-called "free market" economists are far more nuanced in their views of market and government solutions to the problems in our imperfect world inhabited by imperfect human beings. A short but accurate summary would be something like: "In the real world, markets are, for the most part, better at dealing with externalities and other economic problems than actually-existing governments staffed by actually-existing politicians and bureaucrats." That is, no institutional arrangement is perfect, but the problems associated with voluntarily and spontaneously generated institutions are usually relatively minor when compared with those associated with institutions designed by a central authority. Examples of this nuanced position can be found in previous Farmer Hayek posts here, here, here, here, here, and here, as well as in the writings of Jim Buchanan, Gordon Tullock, Deirdre McCloskey, Pete Boettke, etc. A closer reading of these and other "free market" economists might change Buchanan's mind about the types and level of analysis that leads to "free market" conclusions.