Monthly Archives: June 2015

Greg Mankiw on Ex-Im

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He writes,

One of the other speakers–this one a politician rather than a nerdy academic like me–spoke about the need to reauthorize the Export-Import Bank. (I won’t mention the person’s name, since the event is off the record.) What struck me is how weak the arguments were.

He goes on to list and to refute those arguments. This reminded me of a couple of things I recently wrote about.

1. The WaPo frames the story of the Ex-Im bank as a struggle between right-wing Tea Party crazies and sober centrists.

2. I still would think a lot more highly of left-leaning economists if they, too, would speak out against the Ex-Im bank.

Non-marketable Outputs and Executive Compensation

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I have suggested that one can think of firms as taking marketable inputs and producing non-marketable outputs. These non-marketable outputs ultimately contribute to marketable outputs. It is the non-marketable outputs that bind the firm together. If instead all outputs were marketable, then you could unbundle the firm and arrive at marketable output using market transactions among many firms.

I have also suggested that non-marketable outputs have an indeterminate value. This in turn makes the compensation paid to workers indeterminate.

Apply this to CEOs or other top executives. A CEO produces non-marketable output. The CEO’s “output” consists of key decisions with regard to strategy and personnel. It also includes intangible effects on employees, customers, and other firms.

Non-marketable output is, by definition, mostly valuable within the firm. The value of firm X’s CEO to firm X is likely to be quite a bit higher than the value of firm X’s CEO to firm Y. Thus, the CEO’s opportunity cost easily could be low relative to the value that the CEO provides. Whereas for low-level positions, it is plausible that competition serves to narrow the range of potential compensation, the same is not true at the level of CEO. It would seem that the range of indeterminacy in CEO pay ought to be especially high.

Observers on the left have argued that the rise in CEO pay in recent decades reflects changes in social norms rather than an increase in CEO productivity. Although there may be other explanations, I would think that the range of indeterminacy is sufficiently high that one should not dismiss the social-norms story out of hand.

Non-marketable Outputs

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A non-marketable output is something that has relatively little value outside of one firm. One company’s tax return won’t help any other firm file its return. A half-finished Chevy is not of much use to Toyota.

1. I claim that a typical firm buys marketable outputs, produces non-marketable outputs, and turns at least some of these non-marketable outputs into marketable outputs.

2. I can imagine a firm that produces only non-marketable outputs because it works only for a single buyer. However, there is a sense in which the firm and its buyer can be treated as a single entity.

3. Non-marketable outputs are what determine the configuration of firms. Suppose that there are ten stages of production. If at each stage the output is marketable, then there might exist firms at each stage of production. On the other hand, if only the final stage is marketable, then there will be just one firm.

4. The value of a non-marketable output is indeterminate. It has to be worth at least as much as the cost of the inputs required to produce it, and it cannot be worth more than the entire marketable output of the firm. But that leaves a wide range. Consequently, workers engaged in the production of non-marketable output do not have a well-defined marginal revenue product.

5. I conjecture that the larger the firm, the higher the proportion of non-marketable output relative to total output. If all you are doing is buying marketable outputs and selling marketable outputs, then you can be a tiny firm, like somebody who sells on e-Bay. On the other hand, if you manufacture airplanes, then most of your effort goes into producing unfinished airplanes, so you need a large firm.

Compare the old-fashioned general store to Wal-Mart. Wal-Mart has important non-marketable output in its supply chain, consisting of logistical systems and contracts with sellers. That supply chain might be worth something to an old-fashioned general store, and you can imagine a different Wal-Mart acting solely as a wholesaler/distributor. However, the supply chain is worth even more when it is integrated with large, strategically-located retail outlets, namely Wal-Mart stores.

6. I conjecture that non-marketable output tends to become increasingly important as the economy becomes more complex. That in turn would suggest that the trend would be for firms to get larger.

7. Some important creative destruction takes place in the arena of non-marketable outputs. Uber and taxi companies both offer on-demand rides. But Uber replaces the taxi company’s non-marketable output, its dispatching system, with something different. Amazon and traditional sellers both offer books. But Amazon replaces the non-marketable outputs of the traditional sellers (inventory management, product display, and customer fulfillment) with something else.

Note that Amazon found that a lot of its infrastructure proved to be marketable. Other companies rent server space from Amazon or sell products using Amazon.

The WaPo Frames a Story

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Robert McCartney writes,

Gov. Larry Hogan’s imminent choice about the Purple Line will play a large role in defining whether his first year in office steers his Maryland Republican Party toward the middle or gives Democrats a cudgel to beat him as an anti-spending ideologue.

…Hogan’s continuing doubts about the project’s cost and benefits show he still shares some anti-transit views that he and his conservative supporters have long championed.

So, if you are not on board with the view that the benefits of this project exceed the costs, then you are “anti-transit” and an “ideologue.”

In general, I find the WaPo’s front page to be more loaded with left-wing rhetorical framing than is its editorial page. And I find that its Metro section is more loaded with left-wing rhetorical framing than its front page.

One of my pet peeves is the metro section’s constant reference to the “excellent reputation” of Montgomery County schools. What the schools have is a reputation for having an excellent reputation, but (and I have pointed this out in emails to Wapo reporters) the test scores for Montgomery County schools are close to the median for all counties in the state, even though Montgomery County spends way more than the median on a per-student basis.

In fact, if you plot the percent of students that perform well on tests against percent of students not on free and reduced meals, Montgomery County schools fall right in line. Statewide, the percentage of non-FARMs students is what drives school outcomes, and spending per student makes no difference. The null hypothesis wins again.

Capital Indivisibility as a Theory of the Firm

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Cameron Murray writes,

If it was the division of labour that leads to increased productivity, labour could just as easily be divided between firms. The fact that pin factories, even with only ten men, still performed all 18 tasks, instead of specialising in just 10 tasks, is clear evidence that there is something special and coordinated about the tasks themselves that arise from the particular capital investments. The tools and machines are designed to be compatible with each other, and if part of the process is done outside the firm, each of the two firms would inevitably be tied to the same compatible capital equipment, and would therefore find gains by merging into a single firm.

Pointer from Mark Thoma.

According to Alchian and Demsetz, Murray’s first sentence is false. If the value of labor is in their combined product, rather than in each individual task, someone must manage the production process and allocate payments to individual workers. Remember, in an Alchian-Demsetz firm, marginal product is not defined.

I agree with Murray that if two firms have complementary capital then there is an incentive to merge, at least if one or both firms does not have a lot of other choices for partners in production. But what Murray sees as the gains from merging firms that use compatible capital equipment also would arise from merging firms whose workers who undertake complementary tasks in a production process.

Rent Control, House Prices, and Incomes

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A commenter on my earlier post writes,

In San Francisco, over 70% of rental units are rent-controlled. This allows a lot of low-income people to live there, pushing down the median income. Meanwhile, there are no price controls for home sales, and these are pushed up by the shortage of market-rate units.

If you excluded everyone in a rent-controlled unit, I think the price-income ratio would look more reasonable.

Arithmetically, this explanation works. The median income would be artificially low relative to the median house price. But what about the economics?

I expect rent control, along with building restrictions, to lower the quality and quantity of housing services supplied. It also creates a big incentive for owners to convert rental properties into homes for sale. Over a long enough run, these supply effects tend to push up rents. I am a bit reluctant to believe that rent control achieves an equilibrium in which housing is affordable for renters and not for buyers. I am more inclined to side with the view that rent control backfires in the long run, leading to high rents.

Of course, one can argue that there will still be a gap between prices and rents, particularly if conversion of rental units is impeded by regulation. In that case, the only option available to property owners would be to limit maintenance. If the quality of rental units has tended to deteriorate, then that would support the commenter’s explanation.

Incidentally, another commenter suggested that the ratio of wealth to income might be high in cities with a high ratio of house prices to income. This would be very plausible if we were talking about average ratios. It is somewhat less plausible for median ratios, because median wealth tends to be pretty low.

The Computer as Economic Metaphor

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Cesar Hidalgo says,

So countries with a lot of trust and good institutions can create very complex computers that are able to process large volumes of information and create complex products that are rare and have a big premium on the market. So by thinking of economies in terms of information and computation, you can also connect institutions with the mix of products that countries make and with wealth. A social network is nothing other than a distributed computer.

Pointer from Mark Thoma. Read the whole interview. Perhaps he is one of those fellows who sounds deep and profound but is not really saying anything.

But I think that there is some significance in the availability of the computer and the Internet as a metaphor. In 1960, machines were the most salient sources of metaphors, and so economists thought in mechanistic terms. As we start to expand our use of computers and networks as metaphors, I think this affects how we view the economy. In some sense, the emphasis on institutions and other components of what Nick Schulz and I call the “software” of the economy are insights that are more likely to occur to economists living in the computer age.

House Prices and Incomes

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The data in this story suggest that they are most out of line in San Francisco and Los Angeles. That is, the ratio of the median home price to the median income is highest in those two cities, and it is dramatically higher than in the other cities listed (where it also is high).

The price to income ratio exceed 8 in both cities. A normal ratio of price to rent is about 12. A normal ratio of rent to income is about 25 percent. So a normal ratio of price to income would be 3. To get to 8, you need, say, a ratio of rent to income of 40 percent and a ratio of price to rent of 20.

Some possibilities:

1. This is a sign that some time in the next few years home prices will fall in those two cities.

2. It is the rest of the country that is under-priced. People in other cities should be bidding up house prices where they live.

3. Perhaps there is some statistical fluke. Perhaps the discrepancies across cities go away if you break things down to individual neighborhoods. Note however, that the ratio of two medians is a harder statistic to skew than, say, the mean of income. So I doubt that this is the explanation.

4. Foreign ownership plays a larger role in those two cities than elsewhere, so that the inadequacy of median income is not a factor.

5. Supply is more constrained in California than elsewhere. Note, however, that I have a hard time specifying the demand curve that creates such a dramatic ratio of house prices to incomes.

I think that supply constraints are more likely to lead to volatility in house prices than to house prices that are permanently super-high relative to incomes. And in fact LA and SF have a history of high volatility.

More Essential Hayek

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Again, the book will be released next week.

Another point Boudreaux makes is that in a specialized economy, our production activities are much narrower than our consumption activities. This makes rent-seeking more prevalent on the production side.

This point is easily missed. For example, Stephen G. Cecchetti and Kermit L. Schoenholtz write about the mortgage interest deduction as if its political strength comes entirely from home owners. (Pointer from Mark Thoma.) In fact, I would argue that it is the NAR, NAHB, and the MBA that make it inviolable.

We know that food stamps are popular with the farm lobby. And perhaps Medicaid does not benefit recipients as much as it does providers of medical services.

When Marginal Product is Undefined

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In an Alchian-Demsetz firm, marginal product is not defined.

Think of a business that has exactly one full-time tax accountant (TA). In a sense, the marginal product of the TA is zero, since the TA contributes zero output. On the other hand, the tasks performed by the TA have tremendous value, allowing the firm to remain in business and keeping the owner out of prison.

What determines the compensation paid to the TA? It cannot be less than the TA’s best alternative, or opportunity cost. It cannot be more than the firm’s best alternative, which could be to hire a different TA, outsource to an accounting firm, or try to automate the process using software. If there is lots of competition on both sides of the market, then compensation will be driven to some unique level. Otherwise, there may be a range of plausible outcomes.

Remember that most of us are Garett Jones workers. We do not produce output. We produce organizational capital. So most of us have undefined marginal product.