Posts Tagged Institutional Economics
Neoclassical (and Austrian) economics as a whole tend to emphasise market forces as the dominant determinant of employment, distribution and output in the economy. In the neoclassical theory of the firm, firms are something of a ‘black box,’ inside which uniform inputs are uniformly processed into uniform outputs. The firm can be thought of as an agent – or collection of agents – maximising some goal subject to resource constraints. The most commonly used version of this is the perfectly competitive firm, which treats prices as a given, has the single aim of maximising profits and makes ‘normal’ profits. However, even more elaborate theories of the firm – such as ones where managers have objectives that conflict with those of shareholders – retain the standard assumption that the exhibited behaviour of the firm can be deduced from the behaviour of optimising agents inside it. Firms are rarely assumed to have internal differences in production techniques. Instead, they simply serve as channels, coordinated by supply and demand, through which resources are allocated.
But there is good reason to believe producers, rather than the impartial ‘laws’ of demand and supply, are the dominant force in an economy. It is a stretch to suggest that products are merely the expression of consumer preferences; after all, consumers rarely have input directly into the production process. Products are created by a firm and the consumers role is passive in that they can only choose whether or not to reject it. There also exists a power asymmetry between producers and consumers (and workers): since producers are the ones who own the products, they can ‘hold out’ for longer than those without. A capitalist alone can subsist; one who is merely a worker and/or consumer relies on the capitalist(s) for employment, goods and services.
In neoclassical theory, any deviations from perfect competition, and even the mere existence of firms, is thought to be either a source of inefficiencies, a result of them, or both. Hence, an ‘ideal,’ Pareto Efficient economy is thought to be one of perfectly competitive, tiny firms, which have no individual impact on the market in which they are situated. Any questions asked about firms proceed from the premise of which ‘frictions’ we can blame for the observed real world deviation from this ideal.
Several questions about how firms work and their role in the economy are never asked in neoclassical economics. First, what really goes on inside the firm: how are organisation and management used to impact the ability of the firm to convert inputs into outputs? Second, what is the nature of ‘market power?’ Could it be that some industries are so characterised by ‘market power’ that it no longer makes sense to talk about ‘the market’ as a meaningful concept? Third, to what extend do ‘imperfections’ such as these – organisation, market power, scale – actually create beneficial effects that we would not observe in the world of perfect competition?
I believe that, under contemporary capitalism, firms have such an impact that it makes more sense to use ‘the firm’ as an epistemological starting point than ‘the market.’ I also believe that, at least from material point of view, large firms are probably a superior system to one resembling the perfectly competitive ’ideal.’
The competitive ideal seems illogical when applied to the real world. Market forces can be inherently uncertain and costly to adjust to. Any firm which is wholly subservient to market forces, and hence has no control over its future, is simply a terrible firm, and a poor prospect for any potential investor, shareholder or worker. Even consumers prefer an established brand they can trust, at least in the absence of regulation. Hence, no firm would go to an investor, shareholder or bank and say “I have a product, let’s see whether the market likes it or not;” what is expected is a clear strategy.
It would, of course, be wrong to suggest that firms are not under threat from the development on new technologies and from the demands of consumers. Even well established companies go bankrupt from time to time. Nevertheless, many firms persist for a long time, either because their position is that strong or because they insure themselves against market forces. Research and development can ensure a firm always has something new to offer and can adapt, should demand for a product fall or a new release flop. Horizontal integration - selling different products, perhaps in entirely different markets – can broaden a firm’s consumer base (Google’s massive diversification over the last decade is an example of this). Brand proliferation – the same firm creating multiple brands – can serve a similar purpose (think of the different cereals produced by Kellogg).
The challenge for a firm is to establish a degree of control over its respective market; the degree to which it manages this will be a determinant of its success; its ‘competitive advantage.’ Hence, many of a firm’s actions have the purpose of cementing that firm’s position in the marketplace, rather than simply responding passively to outside market forces. Numerous behaviours exhibited by firms support this idea:
- Some firms seek market share as opposed to profits: they want to make sure they have sufficient control over their industry.
- Prices don’t change constantly depending on the state of the economy; firms keep them the same for long periods of time to save money when performing calculations and to be able to produce projections.
- Branding, advertising, marketing and various offers are used to gain and retain customers so that the firm has at least a minimum flow of demand it can rely on. The mantra that it is far more costly to acquire new customers than retain old ones is well known; hence, firms try to make sure they are as unaffected by the whims of consumers as possible.
- Firms control supply through deals, perhaps exclusive, with suppliers; better yet, they can establish control of the supply chain themselves (vertical integration).
Firms also need to establish control over the labour market, as they often rely on the commitment of workers to a specific position in their organisation. The fact that knowledge and skills are often organisation-specific makes the cost of leaving – for both employer and employee – higher, and this effect becomes more amplified as one moves up the hierarchy of the organisation. The result is that the cost of even one worker leaving are often estimated to be well above their salary. It is no use starting a project if you know that, half way through, your manager – with his unique knowledge of what is going on – will just leave and work elsewhere. So firms retain workers with promises of career progression and rewards, as well as establishing a psychological commitment to their organisation. The most extreme example of this is the Japanese ‘employment for life‘ approach, which has proved to be remarkably competitive; moreso than many of its western counterparts.
The existence of long lived companies with significant influence over forces supposedly determined by ‘the market’ creates another problem for the state-market dichotomy. Many companies are economically bigger than countries or state and local governments, and hence their decisions have considerable political implications. A large company setting up shop in a small town, or even small country can significantly alter the landscape there.
Unfortunately, many supporter of “free markets” are driven to defending the actions of large, centralised entities as apolitical. This perspective is based on the false premise that they are simple conduits for scarcity and consumer preferences, rather than actively determining and influencing these things. It is clear this influence has largely driven us away from what economists typically mean when they speak of a ‘market.’ The implication is that, whatever you want to call the current system, it is vital that the entities which characterise it, with their significant impact on production, distribution and exchange, should be put into the political spotlight.
Recently, I’ve been reading a lot from the school of institutional economics. Consequently, I have noticed another problem with the way economists approach theory and evidence: the lack of institutional considerations. This can blind economists to the fact that they may be studying entirely different phenomenon due to differences between countries, periods of history, companies, genders, cultures and much more.
The standard procedure of economists is to derive a model rigorously, based on a set of assumptions or axioms. Economists, unlike physicists, cannot perform controlled experiments in order to verify these models. Instead, empirical corroboration entails the use of econometrics to verify predictions. Economists must rely on collections of data, sometimes from disparate sources, and try to ‘correct’ these collections of data for said disparities. Economists then perform regressions in an attempt to isolate the relationship between two variables, and cautiously interpret the results. As explained more fully in the paragraphs below, the problem with this approach is that institutional differences could mean that some of the data collections are simply irrelevant, whether or not they disagree with the predictions of the theory in question.
Problems with this Methodology
It appears that underlying this methodology used by economists to evaluate and analyze collections of data is a search for unifying principles that can be applied to all economies across space and time. The economic models of both neoclassical and heterodox schools reflect evidence a discipline aiming to isolate the true mechanics of the economy and build a model around it. The mentality often seems to be that, if only we could isolate the true mechanics of the economy, we’d be able to understand the economy and make informed policy decisions based on our ideal framework.
I expect many economists would probably agree that the institutional, legal, and cultural contexts are not the same for all economies. However, many economic models and the economist’s rhetoric reflect a discipline looking to uncover an equivalent of physical laws. Indeed, Larry Summers went so far as to claim that “the laws of economics are like the laws of engineering. One set of laws works everywhere.”
Even though most rational minds would disagree with Larry Summers, I find there is a tendency among economists to imagine that the institutional, legal, and cultural contexts are viewed as ‘constraints’ against which the ‘underlying mechanics’ of the economy are continually pushing. However, there is good reason to believe that the ‘real’ mechanics of the economy are determined by the context in which the economy operates, rather than said context merely influencing the economy exogenously. Here are some historic and contemporary examples to illustrate my point.
Industrialisation: the US versus England
English firms were fairly small during the industrial revolution. For reasons beyond the scope of this blog post, firms typically took it upon themselves to educate and train new employees on the job. Such a system diminishes the need for state education, at least from a labour market standpoint, and it wasn’t until the late 19th century that public education was finally established, by which time England was industrialised and the old system was becoming obsolete. In contrast, the USA followed a different path. During the growth period of the US, firms generally emphasised large production lines, and had a more ‘flexible’ approach to employment. Such an approach required that firms could rely on the competence of the average worker, and over the course of the US industrial revolution state education increased substantially, reaching something approximating a fully public system at around the same time as England, even though England was much later in its development phase. Both strategies successfully industrialised their countries; both presented different needs from a policy perspective. But using a single model to inform policy in these two countries would clearly be a mistake.
A similar contrast can be seen with Denmark and Japan. Historically, Japan has had a policy of lifelong employment, which means a majority of workers are, well, employed for life (the model may be waning due to the effects of the lost decade, but it was robust during Japan’s impressive industrialisation period). What would be the effect of restrictions on hiring and firing with such a model? It’s highly unlikely there would be much effect; in fact, the model itself is partly based on such regulations. But what if similar restrictions were applied to Denmark’s dynamic ‘flexicurity‘ model, in which hiring and firing is incredibly easy but there are strong social safety nets? I expect it would cause a lot of problems for employers and employees alike, as Danish firm’s strategies are built around being able to gain and shed workers quickly. On top of that, the safety net makes workers more willing to accept such treatment, as well as having obvious humanitarian attractions.
Again, though these two models are different – almost diametrically opposed, in fact – both have coped with recessions relatively well (in terms of unemployment). The countries simply have different institutions that operate under different mechanics, and no model could capture both (feel free to read that as a challenge). Despite this, Japan has recently enacted some ‘neoliberal’ reforms, perhaps based on the mistaken belief that they need to ‘free up’ the ‘underlying’ mechanics of the economy. Time will tell whether or not this was a smart move.
The Scandinavian Ideal
Apart from labour markets, there is another good example of interdependent institutions, laws and culture: the oft-cited Sweden. Both free marketeers and leftists like to hold Sweden up as an example of their ideas in action. “Look at the vast redistribution, unions and public goods!” Is the cry of the leftists. Meanwhile, the rightists will assert that beneath such institutions lies a relatively light touch, ‘neoliberal’ regulatory structure. In any many ways both are right; but in many more ways they are both wrong. Both approaches take the economy of Sweden and suggest that due to X, Y or Z policy, it is the way to go. But neither appreciate how the institutions identified by both fit together.
Sweden is historically a high-trust society and as such regulation is relatively simple. Even contract law is far less complex than that you will find in the UK or the States. Many businesses do something akin to ‘self regulation,’ reporting their own data to government agencies. Similarly, while it is questionable whether the generous welfare state is a cause of the trust, it is not unreasonable to suggest that the two are complementary. Furthermore, as in the case of Denmark, generous safety nets go well with light regulation in terms of dynamism. The approach has serious attractions, but only if the two institutions are combined: furthermore, it may well be the case that trust is a necessary condition for both of these institutions in the first place. Once more it is clear that certain historical circumstances have given rise to a specific set of ‘optimal’ policies that could not be applied elsewhere.
So if we take data points from between such disparate countries, is it really meaningful to try and ‘adjust’ them for this type of difference? What we are studying are economies with very different underlying mechanics. To aggregate over them and take the average result is to reduce the data to meaninglessness. What is needed is a historical, institutional perspective that understands how different aspects of the economy fit together, and how the economy fits into the background of politics, history, culture (not to mention to environment – for example, on an island country, even a corner shop can be a monopoly).
What is best for an economy will depend on initial conditions and current institutions. These institutions are not ‘artificial’ impositions on the underlying economy; they are inevitable political decisions which have been born out of specific historical context, and hopefully fit the culture of the nation in question. It would be at best costly and destructive, and at worst basically impossible, to uproot these institutions in search of some ideal. As such, any discussion of economic policy must proceed based on acknowledgment of the mechanics created by different institutions.
Much of what I’m saying isn’t new at all. In fairness, most empirical economic papers are careful about announcing they have found surefire causal links. And there might be new techniques in econometrics that attempt to deal with the problems in the methodology I outlined above. Furthermore, I am not suggesting economists are not at all concerned with institutions or history: development economists and Industrial Organisation economists speak of them frequently. Nevertheless, I believe the institutional considerations I described above create a clear methodological problem for large amount of economic theory, particularly macro.
This is because institutional considerations are a good reason that social scientists should be even more concerned about assumptions and real world mechanics than the physical sciences, and therefore that economists should be highly concerned with the historical, institutional and legal context of the economies they are studying. Such considerations are another nail in the coffin of Milton Friedman’s methodology, which posits that abstract models based on “unrealistic” assumptions are the appropriate approach to economic theory. Such an approach cannot even begin to comprehend institutional differences, and as such, applying any one theory – or group of theories – to every economy is bound to cause problems.
Is it really feasible that there can be a single theory of ‘the market’ that encapsulates everything from tomatoes to CEOs to houses? Engineers do not think they can apply the same theory to every fluid, and similarly, it is not unreasonable to suggest markets might function very differently depending on what is being bought and sold. In this post, I’ll set out a couple of alternative interpretations of supply and demand for different markets. I developed these alternative approaches based on some well known real world observations.
A few caveats:
(1) I am not interested in deriving these schedules ‘rigorously’ from arbitrary axioms about individual behaviour. Such an approach is unnecessary as phenomena may be emergent, and it always seems to run into problems.
(2) These models should really only be interpreted as working for individual markets on a small scale, as large scale feedback effects render this type of analysis irrelevant.
(3) I am aware that there is no such thing as a demand or supply ‘curve’ in reality. Perhaps the fact that I feel the need to reduce everything to intersecting lines is a testament to how much neoclassical economics has polluted my thought. I am undecided as to whether I regard the supply-demand framework as a useful tool that can be adapted in certain circumstances, or as something that needs to be done away with entirely. I’m sure heterodox readers can give me many reasons demand-supply as a concept is not worth keeping. In any case, I regard these examples as interesting, and at the very least they are a good way to take economists on on their own turf.
(4) Finally, I apologise for my drawings, which were constructed on MS Paint.
It is an observed reality that asset prices and demand are often positively related, since in many cases an asset is purchased for no other reason than selling it later on at a higher price. Price increases can act a signal for later price increases, and the opposite is also true. Hence, we will posit a positively sloped demand curve for this model. This relationship will also be exponential: at low prices, the effects will be relatively small ,but as prices spiral , the effect will get larger and larger. Since the supply of assets is relatively inelastic (in the case of land, perfectly inelastic), the supply curve will be a steep upward sloping line.
From the diagram constructed based on the observations above, we can deduce a few interesting mechanics. First, there large number of demand-supply combinations for which there is no equilibrium. If demand is to the left of the supply schedule, supply will always exceed demand and prices will fall to zero. The most likely cause of this is simply that a company or industry is not performing well, although tight monetary policy could also do it. If the demand curve is to the right of the supply schedule, demand will always exceed supply and price will spiral upward indefinitely. This could be due to excessive credit expansion or misplaced expectations.
However, between these two extremes there is a potential ‘golden zone’ for which equilibria exist. In this zone I have drawn two potential demand curves: D2, which just touches the supply curve, and hence has one potential equilibria; and D3, the likes of which would be more common and would have two equilibria. The two lower equilbria, e1 and e2, are not stable. Any drop in price will result in excess supply that will drive prices down the schedule. An upward increase in price from e1 or e2 will result in excess demand that will continue to increase price in a spiral. In the case of e2, it will propel the market up to the one stable equilibrium: e3. If the price increases, supply will exceed demand and it will quickly fall back to e3. If it decreases, demand will exceed supply, the price will rise and the market will again tend toward e3.
The volatile behaviour displayed by most outcomes in this model is in accordance with much real world experience in the stock market, from the downward spiral of Facebook to the internet stock bubble and other frequent historical experiences. But what about e3? Is it the case that certain firms or industries exhibit relatively high, consistent returns? In fact, relatively stable share prices do exist for some firms and industries: ones that are rarely hit by volatility. Insurance, transport and many consumption goods are all stable industries. Obviously this doesn’t protect them completely: firms, industries or the market as a whole may exhibit relative tranquility before something knocks them over the precipice.
We can draw a few policy conclusions from this framework. There is scope for a central bank to reduce or increase the liquidity of the system in order to try and knock the market into the ‘golden zone.’ The effects of an FTT are indeterminant, which is actually the only conclusion I can garner from the available evidence. However, the primary conclusion I would come to – which admittedly doesn’t flow completely from the model – is that due to the level of volatility, the trading day could be be extremely limited, or trade could be cut off if prices are rising or falling too fast. This way the price spirals can be curbed while the central bank adjust liquidity, and investors and funds adjust their positions, trying to shift the demand curve back into the golden zone (though I am willing to admit the last part verges on a spurious level of precision).
Another market that would be expected to diverge strongly from the ‘norm’ would be the labour market. Many aspects of labour make it different to other markets: it is required to subsist; it cannot be separated from a person; it is difficult to determine the productivity of potential applicants, or even present workers; time spent in work is related to leisure time. Below I’ll outline two alternative approaches (that are also somewhat compatible).
A more comprehensive approach to labour supply, which takes into account the need for subsistence, has been provided by Robert Prasch (whose book, which inspired this post, is recommended). His approach is illustrated in the diagram below:
This can be seen as an adaption of the typical ‘backward bending‘ labour supply curve found in economics textbooks. The subsistence frontier shows the total pay required to subsist at various wage levels, whether that is interpreted as literal subsistence or a conventional and socially acceptable level of income. Obviously, the higher the wage, the fewer hours required to work to reach subsistence.
Equilibrium C is unstable as either side of it creates a wage spiral toward the next equilibrium. If the wage decreases, the labour supply will be forthcoming as workers seek subsistence level pay. At Wu they hit the limit of how long they can work and give up, settling for a ‘poverty trap’ wage at D. If the wage increases above C, wages become less necessary for subsistence and workers will withdraw their labour while remaining on the subsistence frontier. Once the subsistence frontier becomes a distant memory and wages are high enough, workers will be willing to devote more time to work in order to purchase more goods and services.
The highest equilibrium, A, is also unstable. Should the wage deviate upward, there will be a resultant upward spiral as demand always exceeds supply. Should it be reduced or capped, the wages will settle down toward a lower level. This is consistent with the observed behaviour of CEO, footballer and celebrity pay in recent decades, which shot up when marginal tax rates were significantly reduced (and a direct cap on footballer’s wages was lifted).
Clearly, a couple of evil communist interventions can be proposed based on this framework. The first is a minimum wage at or above Wc to boost the market into the desirable area. The second is steeply progressive taxation above Wa to prevent pay from spiraling Such interventions would help to enhance labour market stability, equality and reduce poverty.
I have also constructed an alternative model of the labour market. My model is shown in the diagram below and illustrates what a labour curve might look if we included the assumption of the ‘conventional’ working day/week which characterises so many people’s lives. This may be enforced legally, by social norms, or by the power of capital of labour. Whatever the cause, it is an undeniable empirical reality.
This model of labour supply could perhaps be interpreted as an elaboration or magnification of the zone between Ws and Wh on the S-shaped labour supply diagram: that is, what happens once wages reach an acceptable level. In fact, I adapted the model from one found in Arthur Lewis’ 1972 paper (p. 10) on unlimited labour, which focuses on a wage given at a conventional level. This is compatible with the above diagram.
However, I don’t wish to stretch the comparisons, as this model can also be thought of in isolation. The point is that a worker will accept work at any ‘reasonable wage’ up to a certain amount of hours – I have suggested 40, which is the norm in most developed countries. After this point the time they have normalised as leisure time is far more valuable and they expect to be paid more at an increasing rate. Eventually, they reach the physical limit of work and the effective wage must be infinite to induce labour. There are multiple equilibria if the demand curve crosses the feasible wage zone, but only one if it moves beyond it.
There are a couple of conclusions we can draw from this model. The first is that a tax on labour will not alter the amount of labour supplied if the tax + the wage is within the ‘feasible wage zone.’ In fact, empirical evidence suggests the effect of income taxation on labour supply is negligible at most (though higher for women – perhaps this analysis only applies to primary earners). Second, an increase in demand need not increase wage inflation up to a certain point, provided there are labourers willing to work within a given wage range. Past this point, an increase in demand will cause a wage-price spiral. It’s harder to verify this point empirically, although it seems consistent with the frequently observed point that inflation isn’t a problem when unemployment is high (having said that, it’s by no means the only model that predicts this).
I think a pluralistic approach such as this would be interesting. It would not be wedded to any particular model, and the task of economists would be deciding which model to apply or devising alternative models to deal with a situation. In fairness, DSGE is characterised by this approach, so it would be unfair to suggest economists do not use it at all. Nevertheless, this calls into question the rigid supply-demand framework that pervades much policy discussion of price controls, taxation and various other ‘interventions,’ and the catch-all arguments made by some economists against them.