Credible Commitment Quotes VII

The argument of Klein and Leffler (1981) seems obvious once you know it. Haven’t we always known this? But that’s what makes it classic.

The paper opened up a world of means for securing commitment outside of third-party enforcement. My book relies on Klein and Leffler logic in chapter six as a means of augmenting the profit and loss system.

The abstract:

The conditions under which transactors can use the market (repeat-purchase) mechanism of contract enforcement are examined. Increased price is shown to be a means of assuring contractual performance. A necessary and sufficient condition for performance is the existence of price sufficiently above salvageable production costs so that the nonperforming firm loses a discounted stream of rents on future sales which is greater than the wealth increase from nonperformance. This will generally imply a market price greater than the perfectly competitive price and rationalize investments in firm-specific assets. Advertising investments thereby become a positive indicator of likely performance.

And from later in the paper, where they deal with the most common objection to the argument:

We obviously do not want to claim that consumers ‘know’ this theory in the sense that they can verbalize it but only that they behave in such a way as if they recognize the forces at work. They may, for example, know from past experience that when a particular type of investment is present such as advertising they are much less likely to be deceived. Therefore, survivorship of crude decision rules over time may produce consumer behavior very similar to what would be predicted by this model without the existence of explicit ‘knowledge’ of the forces we have examined.

Credible Commitment Quotes VI

“Economics is the study of mankind in the ordinary business of life,” says Alfred Marshall.

Mises puts it even better: “Economics deals with real man, weak and subject to error as he is, not with ideal beings, omniscient and perfect as only gods could be.” And later, also from Human Action: “Economics is not about goods and services; it is about human choice and action.”

As we like to say at CSOC, economics is about far more than “p’s and q’s.”

If that perspective is right, then classic art should be filled with economic themes, since economics is the stuff of life. See here, here, and here for a few examples.

Here’s the greatest credible commitment scene in literature:

First she said we were to keep clear of the Sirens, who sit and sing most beautifully in a field of flowers; but she said I might hear them myself so long as no one else did. Therefore, take me and bind me to the crosspiece half way up the mast; bind me as I stand upright, with a bond so fast that I cannot possibly break away, and lash the rope’s ends to the mast itself. If I beg and pray you to set me free, then bind me more tightly still.’

I had hardly finished telling everything to the men before we reached the island of the two Sirens, for the wind had been very favourable. Then all of a sudden it fell dead calm; there was not a breath of wind nor a ripple upon the water, so the men furled the sails and stowed them; then taking to their oars they whitened the water with the foam they raised in rowing. Meanwhile I look a large wheel of wax and cut it up small with my sword. Then I kneaded the wax in my strong hands till it became soft, which it soon did between the kneading and the rays of the sun-god son of Hyperion. Then I stopped the ears of all my men, and they bound me hands and feet to the mast as I stood upright on the crosspiece; but they went on rowing themselves. When we had got within earshot of the land, and the ship was going at a good rate, the Sirens saw that we were getting in shore and began with their singing.

‘Come here,’ they sang, ‘renowned Ulysses, honour to the Achaean name, and listen to our two voices. No one ever sailed past us without staying to hear the enchanting sweetness of our song-and he who listens will go on his way not only charmed, but wiser, for we know all the ills that the gods laid upon the Argives and Trojans before Troy, and can tell you everything that is going to happen over the whole world.’

They sang these words most musically, and as I longed to hear them further I made by frowning to my men that they should set me free; but they quickened their stroke, and Eurylochus and Perimedes bound me with still stronger bonds till we had got out of hearing of the Sirens’ voices. Then my men took the wax from their ears and unbound me.

Stakeholder Theory

At Mises.org, David Gordon appropriately takes a hatchet to defenses of so-called “stakeholder theory.”

He writes:

An obvious criticism of stakeholder theory is that the key notion of the theory is undefined. Who counts as a “stakeholder”? If the term means anyone whose activities are affected by the corporation, this includes a vast array of people. Competitors of the corporation will be adversely affected by its success; do they have a “stake” in preventing this? Are labor unions that sponsor crippling strikes against it also stakeholders? What about environmental activists who aim to put the company out of business?

For more on stakeholder theories, see this paper by Hansmaan and Kraakman.

As they put it:

Stakeholder models of the representative type, in turn, closely resemble yesterday’s labor-oriented model — though generalized to extend to other stakeholders as well — and are again subject to the same weaknesses. The mandatory inclusion of any set of stakeholder representatives on the board is likely to impair corporate decision-making processes with costly consequences that outweigh any gains to the groups that obtain representation.

Credible Commitment Quotes V

The “credible commitment quotes” series wouldn’t be complete without Oliver Williamson. His 1983 “Credible Commitments: Using Hostages to Support Exchange” has garnered over 3,500 citations as of my writing.

Here, though, I want to highlight a quote from a lesser-known paper (“only” ~830 citations!) Williamson was famous for his relentless attack on “squishy” concepts like “power” and “trust.” He thinks those words are non-explanations that stop the analysis short:

Taking the hazards of contracting as given, the message is this: do not allow user-friendly terms like promise and trust to mask the objective features of the deal. Identical contracting language and oral representations notwithstanding, if one contract objectively poses greater hazards than another, then the differential hazards should be reflected in the respective price of each deal-which could include a refusal to deal if the hazards are perceived to be prohibitive.

Hazards, however, need not be taken as given. Transactions that are subject to ex post opportunism will benefit if cost-effective safeguards can be devised ex ante. Rather than reply to opportunism in kind, the wise prince is one who seeks to both give and receive credible commitments. That is a much deeper and more important contractual response, but it requires that the hazards of opportunism be faced candidly rather than suppressed.

Williamson’s “wise prince” is an entrepreneur who secures the gains from trade by tying his hands.

No Free Lunch on Two Podcasts

Recently, I had the distinct pleasure of discussing my book, “No Free Lunch,” on two more podcasts.

Here’s my conversation with Lipton Matthews.

And here’s my discussion with Peter Boettke over at the Hayek Program podcast.

Addendum to the discussion with Boettke: Thank you to Brian Albrecht for informing me that Jason Furman took over Mankiw’s introductory economics class at Harvard. Raj Chetty’s course is (as I now understand it) an addition to the Harvard curriculum, not the replacement for Mankiw’s course.

Credible Commitment Quotes IV

Probably the most fun paper on credible commitments is Margaret Brinig’s 1990 “Rings and Promises.”

Brinig is a tremendous scholar of the family, and like the Becker quote I cited, her work on commitment comes in the context of the (pre) familial relationship. Read on, however, to see that Brinig is no Becker clone. She argues that the custom of giving engagement rings arose, in the United States, as a means of securing credible commitments after “breach of promise laws” were stricken from the books.

She writes:

The diamond ring rapidly changed from a relatively obscure token of affection to what amounted to an American tradition. It is customary to explain such a shift in demand in terms of an increase in income, a change in relative prices, or a change in tastes. This assumes a stable legal setting that contracts are enforceable. But if the enforceability of a contract is problematic, what formerly was a relatively costly (hence unused) form of private ordering may become more viable (Kronman: 5). This paper looks at the change in America’s demand for diamonds during the period 1930-1985, not as a Madison Avenue success story, but rather as a natural outgrowth of economic processes. The event beginning the movement toward diamond engagement rings was the abolition, with great fanfare, of a now relatively obscure cause of action called the “breach of promise to marry.”

Doug Allen’s laudatory paper discussing Brinig’s contributions is instructive. Notably, he contrasts Brinig’s approach to the family with Becker’s:

A simple reading of this passage implies that Peg Brinig recommends abandoning the most fundamental idea in economics (maximization). However, her real meaning is that the family can only be understood within the context of wealth broadly understood. Merely considering the dollar values, the
explicit market goods, or other financial benefits produced by a family is inappropriate and misleading.

The Becker model, like most competitive models, does well explaining quantities, production, and prices, but Peg Brinig has never been too interested in these questions. Her interests lie in how the quantities (the children, the division of labor, etc.) or the prices (the shares of parenting time and household goods) of the family are organized and put together, and how they can be put together in a way that makes family members happy. The neoclassical model of Becker turns out to be literally useless in explaining any element of the organization of the household; that is, it is useless in understanding the institutions of “marriage” or the “family.”

Our kind of scholar!

ASSC Papers

Grove City College recently hosted its annual Austrian Student Scholars Conference, where undergraduate students presented a number of excellent papers.

Here I want to highlight a few outstanding papers that fit the topics we explore at CSOC.

Sebastian Anastasi’s paper, cleverly titled “Organic Order,” explores credible commitments in the context of CSA arrangements. His abstract:

This paper develops a theory of how Community Supported Agriculture (CSA) arrangements ensure commitment on the part of farmers in the absence of explicit contracts or third-party certification. Due to the unique payment timeline of CSAs, where members pay for their produce before the growing season commences, and the lack of formal, legal protections it is possible for farmers to engage in opportunism. This opportunism could include shirking, employing objectionable growing practices, or decreasing the size of members’ weekly share of produce. I find that CSAs foster commitment by augmenting the power of the repeat purchase mechanism. Their community-building efforts create relational bonds and enable effective multilateral punishment. Additionally, farmers choose to grow crops with low monitoring costs. The CSA demonstrates how commitment can be ensured through private, informal mechanisms.

Kurtis Hingl offers a unique theory for the emergence of the first universities.

Why do universities offer room and board? Is the market not capable of providing food and housing, among other amenities, more efficiently than the university can? One logical answer can be found by viewing universities as clubs that govern information transactions. Because education is a subset of the market for information, it necessarily faces the problems of information asymmetry. These problems include hold-up, post-contractual opportunism, and free riding—any of which can lead to market breakdown. Information is a hot commodity, however, so entrepreneurs do find creative ways to govern the transactions and allow markets to clear. An illuminating case is provided by the evolutionary rise of integrated colleges in medieval Europe’s first non-integrated universities. These colleges were transaction-governing clubs using in-house amenities to help manage the club and distribute club goods while mitigating the problems of information asymmetry. This college-as-a-club theory can also be extended to today’s universities and explain variation in the array of in-house amenities.

Much has been written by economists on dowry payments and the bride price. Yet, the “dower” has been comparatively overlooked. Caleb VanGrouw explores the dower as a means of protecting women in societies where their property rights are lacking.

This paper develops an economic theory of the purpose of Islamic dower payments and the conditions necessary for their existence. Because women are susceptible to holdup, they demand contractual protection from abandonment and abuse in marriage. Successful marriage contracts must protect against opportunistic behavior within marriage, protect against undesired contract termination, and provide exit possibilities. In section one, I provide an overview of Islamic dower and distinguish it from other forms of marriage payments. In section two, I investigate the nature of marriage contracts and propose necessary societal conditions for dower payments to arise. In section three, I test my predictions by examining dower payments in 20th century Palestine. I demonstrate dower is a market solution to gender inequality in some of the
most oppressive societies in the world.

Lastly, Janna Lu applies Henry Hansmann’s underrated framework to explain the organization of “Fire Clubs” in colonial America.

In 1724, nineteen Bostonians founded a private fire company, the Fire Society, as a commercial entrepreneurial non-profit. Even though fire clubs were established in other cities within two decades, none adopted the same governance structure. Members of the Fire Society in Boston signed a constitution, met four times a year, and pledged to protect each other’s property in the event of a fire. After the Great Boston Fire of 1760, seven more fire companies emerged, with similar governance structures as the Fire Society. In this paper, I demonstrate how fire protection services emerging as a non-profit in Boston minimized the total costs of transactions, through a comparative analysis of the costs of market contracting and ownership. This paper adds an empirical example to Hansmann’s theoretical framework of the relative costs of ownership while illustrating how the private sector overcame collective decision-making costs and supplied goods with public attributes in the market.

Keep your eye out for these gifted young scholars!

Credible Commitment Quotes III

It’s harder for governments to offer credible commitments than it is for private parties. Nonetheless, a growing economy depends on it.

Here’s Alston, Eggertsson, and North, quoted in Higgs’ classic paper on the Great Depression.

They write:

“In an economy where entrepreneurship is decentralized, economic actors will hold back on long-term investments unless the state makes credible commitments to honor its contracts and respect individual ownership rights.”

How to effectively bind the state’s hands has proven a far more intractable problem.

Concentration and Antitrust

An intelligent, non-economist acquaintance sent me a question about whether increasing concentration ratios warrant heavy-handed antitrust actions. Because his question was general enough, I’ll only reproduce my response here.

Here’s what I wrote back.

Thanks for thinking of me. You’re far from alone in raising these important questions.

The first thing I’ll say is that defining the relevant market is an impossible task, and one that’s usually subject to political maneuvering in antitrust cases. The defense attorneys want to define the market with sufficient breadth, while the prosecution has every incentive to define it narrowly. Ultimately, this question is not answerable in an objective fashion by some third party. What matters is how consumers subjectively evaluate different goods. For instance, is Google truly a monopolist when when there are so many other ways to acquire information?

It’s also important to not equate “big” with “bad.” Many economists, for over a century, have argued that you can’t derive any immediate welfare implications from a firm’s size. Traditionally, economists have argued that we should distinguish between firms that have become large as a result of rent-seeking (that is, seeking special privileges from government) and those which have become dominant through superior satisfaction of consumer wants. Those that achieve success by way of the latter means make the world a wealthier place for everyone, even if one side effect is a high concentration ratio. Firms that “abuse” their newfound market niche by raising prices, restricting output, or cutting quality are inviting new entry, provided that government hasn’t erected artificial entry barriers. The threat of potential entry disciplines firms even when a market is comprised of only a handful of sellers.

This distinction between alternative means of achieving market dominance is why myself and many other economists are highly skeptical of policy aimed at curbing firm size. Antitrust skeptics see the market as a competitive, dynamic process that repeatedly selects for those firms that are best at satisfying consumer preference. I’d argue that highly dominant firms (dominant at what?), when they aren’t shielded by government-enacted entry barriers, tend to be fairly ephemeral.

The historical record seems to agree. All the classic examples—Standard Oil, A&P grocery stores, Alcoa, JC Penney, MySpace, etc… were all once considered unstoppable juggernauts, but had relatively limited heydays and were eventually outcompeted by superior rivals. This is true even for network industry firms like MySpace, where being a first-mover is of tremendous advantage. (See this infamous piece, humorous in retrospect.)

If my view of the market as a place of perpetual churn is correct, antitrust is analogous to a punishment for the winners—who have (temporarily) won precisely by making the world a wealthier place. On this view, antitrust is like setting up a system that assesses a fine on whoever wins the hundred-meter dash at the Olympics and then expecting this system to reveal who the world’s fastest man is. Suppose a cure for cancer is possible. The first firm to discover the cure would have a 100% market share and could be prosecuted under antitrust laws.

In other words, the existence of a particular distribution of incomes/profits/firm sizes/whatever, is not enough to infer any welfare implications by itself. What matters is the institutional environment within which these firms are seeking profits. In a context where private property rights are well-protected and where there’s little opportunity to seek privileges from government, the existence of large firms may simply reflect the fact that some sellers are better at satisfying consumer preferences than others. If we care about making the world a better place, this is something to celebrate. These firms are creating wealth, and much of that wealth goes to consumers. But to the extent that government is handing out lots of special privileges, then a high concentration ratio might simply reflect the fact that some firms are better at attaining crony, political favors. They are benefitting at the expense of their rivals and consumers; this is truly zero-sum, but market interaction is always positive sum.

An implication is that it’s always important to ask why concentration ratios have increased. There is significant debate on this topic, and there is much evidence suggesting that government-enacted entry barriers are a significant driver. I’ll offer just one example. Take the “Americans with Disabilities Act.” The ADA required that businesses incur a host of fixed costs to make their facilities handicap accessible. For enormous firms like Wal-Mart, a regulation like this amounts to pennies.

For mom-and-pop operations, having to double the size of their bathrooms to comply with the new regulations could represent a doubling of their costs. The result is that large firms are shielded from new entrants and this contributes to higher concentration ratios. This is not mere speculation; large firms sunk significant resources into lobbying for these regulations, which is puzzling when you consider their costs would increase as a result of the law being passed. It’s less puzzling when you realize that these regulations raise large firms’ rivals’ costs disproportionately to their own. To the extent that concentration ratios are increasing due to regulations like these (and there are tens of thousands like it), I’d agree that concentration is undesirable, but I’d argue the solution is repealing these indirect entry barriers.

It’s a naïve view of antitrust to assume that regulators are disinterested actors, seeking to promote consumer welfare. (In fact, some scholars are ready to jettison the historic consumer welfare standard altogether in service of other goals antitrust might achieve). What, then, does antitrust look like in the real world? The overwhelming majority of antitrust cases are not brought by consumers, but by firms that have been outcompeted by their rivals in the marketplace (for every 1 antitrust suit brought by a consumer, some 20 are filed by rival firms).

Another reason to be skeptical of antitrust is that it can harm consumers by, ironically, leading to higher prices. This can occur when (say) a merger which would have permitted economies of scale to be achieved is blocked. If technologies are changing such that ever-larger firm sizes are needed to access economies of scale, then mindlessly attacking concentration ratios can reduce consumer welfare. Firms fearing that they’ll charged with “predatory pricing” may also hesitate when cutting prices would have been their strategy otherwise.

There’s much more that could be said, especially as thinking in competition economics is changing rapidly (and not always for the better…) For more, check out Louis Rouanet’s review of Tomas Philippon’s The Great Reversal.