Credible Commitment Quotes XIV

The “fundamental problem of exchange” arises from the propensity of exchange partners to act opportunistically. The fact that most exchanges are contractual, and therefore involve the passage of time, only exacerbates this fundamental problem.

As Greif puts it in a classic paper:

A fundamental issue in economics is the allocation of scarce resources, products, and services. A basic economic premise is that this allocation is best made through voluntary exchange. Yet we know very little about the institutional foundations of markets in past and present societies.

For individuals to enter into mutually beneficial exchange relationships they have to recognise them as such and they have to be able to commit to fulfil their contractual obligations. A lender will not lend without being assured that the borrower will not invest the money in a hopeless venture or take the money and run; an investor will not invest unless assured that the government will not ex-post expropriate his assets. In a modern economy a host of inter-related institutional features mitigate “this fundamental problem of exchange (FPOE),” thereby enabling exchange to take place. Institutions structure our relationships in a manner that enables us to, benefit from transacting.

That’s a wrap on this series for now. On to the project itself…

Credible Commitment Quotes XIII

Milgrom, North, and Weingast explore Greif’sfundamental problem of exchange” in their classic 1990 paper, “The Role of Institutions in the Revival of Trade: The Law Merchant, Private Judges, and the Champagne Fairs.”

The opening paragraph identifies this fundamental problem:

“How can people promote the trust necessary for efficient exchange when individuals have short run temptations to cheat? The same question arises whether the traders are legislators swapping votes, medieval merchants exchanging goods, or modern businesspeople trading promises about future deliveries. In each of these situations, one of the important ways in which individuals ensure one another’s honest behavior is by establishing a continuing relationship. In the language of economics, if the relationship itself is a valuable asset that a party could lose by dishonest behavior, then the relationship serves as a bond: a trader would be unwilling to surrender this bond unless the gain from dishonest behavior was large.”

As they show, organizations arise as a way of mitigating the transaction costs that purely isolated traders would face.

Credible Commitment Quotes XII

Chris Coyne and Pete Boettke highlight the intertemporal nature of commitment problems, as well as their broad applicability. The (broadly) Neoclassical framework abstracts from many of the real-world features that characterize economic life. These include problems of imperfect enforcement and the passage of time. In fact, it’s profitable to interpret the New Institutional Economics as a means of explaining institutions by appealing to these critically important, yet often ignored, aspects of economic life. Austrian economics, following in the footsteps of Menger and the “exchange paradigm,” is likewise an example of pursuing economics without abstracting from these aspects of social interaction.

Coyne and Boettke:

Commitment problems are present in all areas of life. Most economic, political, and social interactions are characterized by some temporal dimension. Individuals involved in these interactions must be confident that agreements made in the present will be binding in future periods. To understand this, consider a basic exchange involving credit. The creditor delivers a good or service in the present with payment to be made by the creditee in a future period. The issue is that when the future date arrives, it may not be in the creditee’s interest to make the previously agreed upon payment. If this is indeed the case, payment fails to be made and the agreement breaks down. If the creditor realizes this possibility at the time of the initial agreement, he may refuse to enter into the exchange. Similar logic can be extended to a wide array of interactions (e.g., political, social, and so on) beyond basic economic transactions. In many cases, solutions (e.g., enforceable contracts, repeated interactions, third-party agencies, and so on) to the problem of credibility have emerged which provide incentives for parties to deliver on their agreements and promises.

See pages 18-20 for a discussion of the solutions to commitment problems in the context of the state.

Credible Commitment Quotes XI

Thomas Schelling explores commitment–tying one’s hands–at the individual level.

Schelling explains his motivation in the introduction:

My usual interest is in how people actually exercise strategy and tactics, successfully or unsuccessfully, in constraining their own future behavior. Often the ways people try to constrain their own future behavior are like the ways they would try to constrain someone else’s behavior; they appear to be treating their “future self” as if it were another individual.

His first example is of someone trying to kick a smoking habit:

A man gave up smoking three months ago. For the first six or eight weeks he was regularly tormented by a desire to smoke, but the last three or four weeks have been less uncomfortable and he is becoming optimistic that he has left cigarettes behind for good. One afternoon a friend drops in for a business chat. The business done, our reformed smoker sees his friend to the door; returning to the living room he finds, on the coffee table, an opened pack of cigarettes. He snatches up the pack and hurries to the door, only to see his friend’s car disappear around the corner. As he will see his friend in the morning and can return the cigarettes, he puts the pack in his jacket pocket and hangs the jacket in the closet. He settles in front of the television with a before-dinner drink to watch network news. Twenty minutes into the news he walks to the closet where his jacket hangs and takes the cigarettes out of the pocket, studies the pack for a minute, and walks into the bathroom, where he empties the cigarettes into the toilet and flushes it. He returns to his drink and his news.

What have we witnessed? I think we can confidently guess that our subject came to anticipate that in the presence of the cigarettes something might occur that he did not want to happen; by disposing of the cigarettes he has made it not happen. Wasting a dollar’s worth of his friend’s cigarettes was an inexpensive safeguard. He has coped rationally with the risk that he would do something he did not-at the moment of flushing the cigarettes – want himself later to do.

Numerous other examples follow this one in one of the most entertaining papers you’ll ever read.

Credible Commitment Quotes X

It’s not just ancient literature that grapples with the commitment problem.

And it’s not just books for grown-ups either.

Consider this classic scene from Frog and Toad Together:

Frog and Toad ate many cookies, one after another. “You know, Toad,” said Frog, with his mouth full, “I think we should stop eating. We will soon be sick.”

“You are right,” said Toad. “Let us eat one last cookie, and then we will stop.” Frog and Toad ate one last cookie. There were many cookies left in the bowl.

Frog,” said Toad, “let us eat one very last cookie, and then we will stop.” Frog and Toad ate one very last cookie. “We must stop eating!” cried Toad as he ate another.

“Yes,” said Frog, reaching for a cookie, “we need willpower.”

“What is willpower?” asked Toad.

“Willpower is trying hard not to do something you really want to do,” said Frog.

“You mean like trying hard not to eat all these cookies?” asked Toad.

“Right,” said Frog.

Frog put the cookies in a box. “There,” he said. “Now we will not eat any more cookies.”

“But we can open the box,” said Toad.

“That is true,” said Frog.

Frog tied some string around the box. “There,” he said. “Now we will not eat any more cookies.”

“But we can cut the string and open the box.” said Toad.

“That is true,” said Frog.

Frog got a ladder. He put the box up on a high shelf. “There,” said Frog. “Now we will not eat any more cookies.”

“But we can climb the ladder and take the box down from the shelf and cut the string and open the box,” said Toad.

That is true,” said Frog.

Frog climbed the ladder and took the box down from the shelf. He cut the string and opened the box.

Frog took the box outside. He shouted in a loud voice.

“Hey, birds, here are cookies!” Birds came from everywhere. They picked up all the cookies in their beaks and flew away.

“Now we have no more cookies to eat,” said Toad sadly.

“Not even one.”

“Yes,” said Frog, “but we have lots and lots of willpower.”

Political economy in a nutshell.

The Return of Rent Control

Price controls are making a comeback.

Here are my minimalist slides from my presentation on rent control at this year’s annual Institute for Faith and Freedom conference.

As always, I attempted to go beyond p’s and q’s to examine other margins of adjustment.

At first I thought the low-hanging fruit of rent control had been beaten to death, but with publications like Business Insider and prominent politicians proving me wrong, I decided to go for it.

Contracting Creativity

I have a new working paper up at SocArXiv. It’s the latest entry in my series on the economics of Renaissance art markets (see, for instance, this draft and this JCE paper ). I’m pasting the abstract below:

For centuries, the production and exchange of Renaissance paintings took place under a commission system. Disagreements arose between patrons and artists over what the finished product should look like. In such circumstances, the patron may try to impose restrictions on the artist’s creative freedom. We study contractual solutions to creative disagreements in Renaissance art markets using a sample of 90 commission documents (1285-1530). We investigate the determinants of creative freedom by comparing the length of the description of the final painting with a number of variables capturing painter-, patron-, and commission-specific characteristics. Our results suggest that corporate patrons are positively associated with creative freedom as compared to individual patrons. We also find evidence that the reputation of the painter (at commission) and larger compensations are negatively associated with creative freedom.

The paper is co-authored with my wife, the great Clara E. Piano.

Credible Commitment Quotes IX

One of the most important papers on commitment is undoubtedly Williamson’s 1983 “Credible Commitments: Using Hostages to Support Exchange,” the text of which also appears in his classic “The Economic Institutions of Capitalism.”

Credible commitments and credible threats share the following common attribute: both appear mainly in conjunction with irreversible, specialized investments. But whereas credible commitments are undertaken in support of alliances and to promote exchange, credible threats appear in the context of conflict and rivalry. The former involve reciprocal acts designed to safeguard a relationship, while the latter are unilateral efforts to preempt an advantage. Efforts to support exchange generally operate in the service of efficiency; preemptive investments, by contrast, are commonly antisocial. Both are plainly important to politics and economics, but the study of credible commitments is arguably the more fundamental of the the two.

In other words, commitment is important and, arguably, understudied relative to its importance.

While Williamson is not always the easiest to read, this paper contains some of the most colorful language in the commitment literature. Here he is describing his “ugly princess principle”:

Specifically, a king who is known to cherish two daughters equally and is asked, for screening purposes, to post a hostage is better advised to offer the ugly one.

Of particular interest is the contrast that Williamson draws between his and the Klein/Leffler perspective on commitment.

Credible Commitment Quotes VIII

North’s 1993 paper, appropriately titled “Institutions and Credible Commitment,” identifies commitment (or lack thereof) as a key determinant of the evolution of economies through time. The concern with commitment is multi-faceted. On the one hand, growth depends on sufficient commitment from the state to refrain from predation. On the other hand, the “institutional environment” must also be capable of facilitating commitment on the part of private parties.

His abstract says:

This essay describes the changes made in institutional theory in the 10 years since the first conference on institutional analysis, and then explores the problem of creating institutions that can credibly commit the players to solve problems of exchange. The issues are explored in terms of the historical evolution of economies.

Most interesting, for my purposes, is the distinction North draws on page 13:

In an excellent essay Shepsle [1991] stresses that a commitment is credible in either of two senses, the motivational or the imperative. A commitment is motivationally credible if the players continue to want to honor the commitment at the time of performance. In this case it is incentive compatible and hence self-enforcing. It is credible in the imperative sense if the player cannot act otherwise because performance is coerced or discretion is dissabled (as illustrated in the case of Ulysses and the Sirens).

The Economic Way of Thinking

Economics is more than puzzle-solving. Without economics, we don’t have a systematic way of grappling with the big questions like growth or business cycles.

Nonetheless, a healthy dose of puzzle-solving is an important ingredient in acquiring the mental framework for thinking like an economist. Indeed, while the “economic way of thinking” is central to being a good economist, it’s seemingly taught less frequently to young economists in contemporary Ph.D. programs. As a way of pushing back on this sorry state of affairs, my annual Intermediate Micro class features a handful of “economic way of thinking” questions each period. We discuss them as a class.

Most questions are no more than a sentence. Some are open-ended, but most have a definitively correct answer, discernible only to those wearing their economic eyeglasses.

All but a few of these questions are unoriginal to me. They come from Walter Williams, who adopted many of them from Armen Alchian, Steven Landsburg, Yoram Barzel, Deirdre McCloskey, Gary Becker, and others I wish I could more easily recall.

Because I’ve received so many requests for a “list” of these questions over the last few semesters, I decided to include my students’ favorites here. Always open to more suggestions-send more questions my way!

Why have shopping carts gotten bigger over time?

Why do people with more desirable marriage characteristics often marry later?

Are arbitrary attributes (i.e. race, sex, etc…) more likely to be used as a selection criteria for lower-level jobs (i.e. custodian) or higher-level jobs?

Why is obesity more prevalent in 2022 than in 1922?

Why do we tip our waiter, but not our brain surgeon? My favorite question and the one most applicable to topics we love on CSOC.

Why does purchased blood have a higher incidence of hepatitis contamination relative to donated blood?

Why do more attractive teachers get better teaching evaluations on average?

Is smoking bad for your health?

Do taxicab medallions confer profits in perpetuity on taxicab drivers?

The physical productivity of barbers has remained constant over the last century, yet their real wages have risen dramatically. Why? A question that famously stumped a majority of Ph.D. students in economics during the 1990’s. Presumably, the situation is worse now.

Why do governments build infrastructure that lasts so long? Armen Alchian said he didn’t know the answer.

Why do utilities companies, granted a regional monopoly, expend resources on advertising?

What would happen if blackmail were legalized?

How did the 9/11 terrorists continue to kill American citizens after 9/11 (and don’t make reference to war in your answer)?

How might an FCC penalty for profanity in TV shows alter the proportion of alternative swear words written into shows?

Doctors often charge higher prices to wealthy patients than to poorer patients. Why?

A tourist to Paris may notice that many lunch menus list higher prices on the English menu than the French menu, even for the same dishes. Why?

Why do women’s hair products, razors, and the like sell for higher prices than men’s?

Why will you typically pay more when you book a flight the night before, as opposed to a month before?

When tomatoes are sold separately, their per unit (i.e. per tomato) prices is higher than when they are packaged together. Why?

Why does popcorn cost so much at the movies?

Do companies suppress innovation (do they engage in “planned obsolescence”)?

Do farmers benefit from bountiful harvests?

Do producers who rent machines possess a cost advantage over those who buy?

Why does school “pay”?