Friedrich Hayek and James Buchanan: Pattern Prediction and Scientism

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Alchian and Allen on the superfluousness of economic principles to civilisation

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Source: Alchian & Allen / UNIVERSAL ECONOMICS

The marvel of the market: the remarkable foresight of young adults in choosing what to study

Known but yet to be exploited opportunities for profit do not last long in competitive markets, including hitherto unnoticed opportunities for the greater utilisation and development of skills and experience (Hakes and Sauer 2006, 2007; Ryoo and Rosen 2004; and Kirzner 1992). Moneyball is the classic example of entrepreneurial alertness to hitherto unexploited job skills which were quickly adopted by competing firms (Hakes and Sauer 2006, 2007).

There is considerable evidence that the demand and supply of human capital responds to wage changes. For example, over- or under-supplied human capital moves either in or out in response to changes in wages until the returns from education and training even out with time (Ryoo and Rosen 2004; Arcidiacono, Hotz and Kang 2012; Ehrenberg 2004).

As evidence of this equalisation of returns on human capital investments across labour markets, the returns to post-school investments in human capital are similar – 9 to 10 percent – across alternative occupations, and in occupations requiring low and high levels of training, low and high aptitude and for workers with more and less education (Freeman and Hirsch 2001, 2008). There is evidence that workers with similar skills in similarly attractive jobs, occupation and locations earn similar pay (Hirsch 2008; Vermeulen and Ommeren 2009; Rupert and Wasmer 2012; Roback 1982, 1988).

Ryoo and Rosen (2004) found that the labour supply and university enrolment decisions of engineers is “remarkably sensitive” to career earnings prospects. Graduates are the main source of new engineers. Engineers who moved out into other occupations such as management did not often moved back to work again as professional engineers. Ryoo and Rosen (2004) observed when summarising their work that:

 Both the wage elasticity of demand for engineers and the elasticity of supply of engineering students to economic prospects are large. The concordance of entry into engineering schools with relative lifetime earnings in the profession is astonishing.

Ryoo and Rosen (2004) found several periods of surplus in the market for engineers. These periods of shortage or surplus corresponded to unexpected demand shocks in the market for engineers such as the end of the Cold War.

Figure 1: New entry flow of engineers: a, actual vs. imputed from changes in stock of engineers; b, time-varying coefficients.

Source: Ryoo and Rosen (2004)

Ryoo and Rosen (2004) noted that importance of permanent versus transitory changes in earnings. Transitory rises and falls in earnings prospects have much less influence on occupational choices and the educational investments of students.

In light of these findings that the supply of engineers rapidly adapted to changing market conditions, Ryoo and Rosen (2004) questioned whether public policy makers have better information on future labour market conditions than labour market participants do. When politicians get worked up about skill shortages, the markets for scientists and engineers often where they make extravagant claims about the ability of the market to adapt to changing conditions because of the long training pipeline involved in university study, including at the graduate level.

There can be unexpected shifts in the supply or demand for particular skills, training or qualifications. These imbalances even themselves out once people have time to learn, update their expectations and adapt to the new market conditions (Rosen 1992; Ryoo and Rosen 2004; Bettinger 2010; Zafar 2011; Arcidiacono, Hotz and Kang 2012; Webbink and Hartog 2004).

For example, Arcidiacono, Hotz and Kang (2012) found that both expected earnings and students’ abilities in the different majors are important determinants of student’s choice of a college major, and 7.5% of students would switch majors if they made no forecast errors.

The wage premium for a tertiary degree was low and stable in New Zealand in the 1990s (Hylsop and Maré 2009) and 2000s (OECD 2013). This stability in the returns to education suggests that supply has tended to kept up with the demand for skills at least over the longer term at the national level. There were no spikes and crafts that would be the evidence of a lack of foresight among teenagers in choosing what to study.

All in all, the remarkable sensitivity of engineers to a career earnings prospects, the frequent changes of college majors by university students in response to changing economic opportunities, and the stability of the returns on human capital over time suggest that the market for human capital is well functioning.

The argument that the market was not working well was assumed rather than proven. Likewise, the case for additional subsidies for science, technology, engineering and mathematics because of perceived skill shortages has not been made out. There is a large literature showing that the market for professional education works well.

The onus is on those who advocate intervention to come up with hard evidence, rather than innate pessimism about markets that are poorly understood because of a lack of attempts to understand it. Studies dating back to the 1950s by George Stigler and by Armen Alchian found that the market for scientists and engineers works well and the evidence of shortages were more presumed than real.

“Trapped” in Rental Contracts | Organizations and Markets

  • Mercedes and BMW drivers trapped in lease contracts, rather than buying their cars with cash or credit
  • Individuals trapped in wage and salary contracts, rather than raising the capital, arranging the inputs, and bearing the uncertainties to be sole proprietors
  • Companies trapped in outsourcing agreements, rather than owning all upstream and downstream production processes directly, as vertically integrated firms
  • Vacationers trapped in resort hotels, rather than owning their own vacation condos or timeshares
  • Readers trapped by downloading and reading books on their Kindles, essentially “renting” them from Amazon, rather than buying physical books
  • Movie fans trapped in DVD rental agreements with Netflix, rather than owning massive DVD libraries

via “Trapped” in Rental Contracts | Organizations and Markets.

George Stigler on do business owners maximise profits?

Entrepreneurs often do not know why they survived in competition. George Stigler in his autobiography told this wonderful story about how you could not get businessmen to admit in a survey that they maximise profits.

You go to their office and asked them: Do they maximise profits?

Their answer would be, of course, not. I am here to provide employment to my workers and put a small amount aside for the education of my children.

The surveyor would then ask them: if you do were to raise your prices, do you expect to increase your profits?

The businessman answers no.

The surveyor how would then ask them: if you were to cut your prices, do you expect to increase your profits?

The businessman answers no.

The survey would then ask: can you point to a time in the last 12-months where you substituted profit for some other objective?

At this point of time, you would be thrown out of their office as some sort of lunatic.

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The separation of ownership from control

Eugene Fama divides firms into two types:  the managerial firm,  and the entrepreneurial firm.

The owners of a managerial firm advance, withdraw, and redeploy capital, carry the residual investment risks of ownership and have the ultimate decision making rights over the fate of the firm (Klein 1999; Foss and Lien 2010; Fama 1980; Fama and Jensen 1983a, 1983b; Jensen and Meckling 1976).

Owners of a managerial firm, by definition, will delegate control to expert managerial employees appointed by boards of directors elected by the shareholders (Fama and Jensen 1983a, 1983b). The owners of a managerial firm will incur costs in observing with considerable imprecision the actual efforts, due diligence, true motives and entrepreneurial shrewdness of the managers and directors they hired (Jensen and Meckling 1976; Fama and Jensen 1983b).

Owners need to uncover whether a substandard performance is due to mismanagement, high costs, paying the employees too much or paying too little, excessive staff turnover, inferior products, or random factors beyond the control of their managers (Jensen and Meckling 1976; Fama and Jensen 1983b, 1985). Any paucity in knowledge slows the reactions of owners in correcting managerial errors including slip-ups in the recruitment and the retention of experienced older employees.

The entrepreneurial firms are owned and managed by the same people (Fama and Jensen 1983b). Mediocre personnel policies and sub-standard staff retention practices within entrepreneurial firms are disciplined by these errors in judgement by owner-managers feeding straight back into the returns on the capital that these owner-managers themselves invested. Owner-managers can learn quickly and can act faster in response the discovery of errors in judgement. The drawback of entrepreneurial firms is not every investor wants to be hands-on even if they had the skills and nor do they want to risk being undiversified.

Many of the shareholders in managerial firms have too small a stake to gain from monitoring managerial effort, employee performance, capital budgets, the control of costs and the stinginess or generosity of wage and employment policies (Manne 1965; Fama 1980; Fama and Jensen 1983a, 1983b; Williamson 1985; Jensen and Meckling 1976). This lack of interest by small and diversified investors does not undo the status of the firm as a competitive investment.

Large firms are run by managers hired by diversified owners because this outcome is the most profitable form of organisation to raise capital and then find the managerial talent to put this pool of capital to its most profitable uses (Fama and Jensen 1983a, 1983b, 1985; Demsetz and Lehn 1985; Alchian and Woodward 1987, 1988).

More active investors will hesitate to invest in large managerial firms whose governance structures tolerate excessive corporate waste and do not address managerial slack and error. Financial entrepreneurs will win risk-free profits from being alert and being first to buy or sell shares in the better or worse governed firms that come to their notice.

The risks to dividends and capital because of manifestations of corporate waste, reduced employee effort, and managerial slack and aggrandisement in large managerial firms are risks that are well known to investors (Jensen and Meckling 1976; Fama and Jenson 1983b). Corporate waste and managerial slack also increase the chances of a decline in sales and even business failure because of product market competition (Fama 1980; Fama and Jensen 1983b). Investors will expect an offsetting risk premium before they buy shares in more ill-governed managerial firms. This is because without this top-up on dividends, they can invest in plenty of other options that foretell a higher risk-adjusted rate of return.

The discovery of monitoring or incentive systems that induce managers to act in the best interest of shareholders are entrepreneurial opportunities for pure profit (Fama and Jensen 1983b, 1985; Alchian and Woodward 1987, 1988; Demsetz 1983, 1986; Demsetz and Lehn 1985; Demsetz and Villalonga 2001). Investors will not entrust their funds to who are virtual strangers unless they expect to profit from a specialisation and a division of labour between asset management and managerial talent and in capital supply and residual risk bearing (Fama 1980; Fama and Jensen 1983a, 1983b; Demsetz and Lehn 1985). There are other investment formats that offer more predictable, more certain rate of returns.

Competition from other firms will force the evolution of devices within the firms that survive for the efficient monitoring the performance of the entire team of employees and of individual members of those teams as well as managers (Fama 1980, Fama and Jensen 1983a, 1983b; Demsetz and Lehn 1985). These management controls must proxy as cost-effectively as they can having an owner-manager on the spot to balance the risks and rewards of innovating.

The reward for forming a well-disciplined managerial firm despite the drawbacks of diffuse ownership is the ability to raise large amounts in equity capital from investors seeking diversification and limited liability (Demsetz 1967; Jensen and Meckling 1976; Fama 1980; Fama and Jensen 1983b; Demsetz and Lehn 1985).Portfolio investors may know little about each other and only so much about the firm because diversification and limited liability makes this knowledge less important (Demsetz 1967; Jensen and Meckling 1976; Alchian and Woodward 1987, 1988).

It is still unwise to still suppose that portfolio investors will keep relinquishing control over part of their capital to virtual strangers who do not manage the resources entrusted to them in the best interests of the shareholders (Demsetz 1967; Williamson 1985; Fama 1980, 1983b; Alchian and Woodward 1987, 1988).

Managerial firms who are not alert enough to develop cost effective solutions to incentive conflicts and misalignments will not grow to displace rival forms of corporate organisation and methods of raising equity capital and loans, allocating legal liability, diversifying risk, organising production, replacing less able management teams, and monitoring and rewarding employees (Fama and Jensen 1983a, 1983b; Fama 1980; Alchian 1950).

Entrepreneurs win profits from creating corporate governance structures that can credibly assure current and future investors that their interests are protected and their shares are likely to prosper (Fama 1980; Fama and Jensen 1983a, 1983b, 1985; Demsetz 1986; Demsetz and Lehn 1985). Corporate governance is the set of control devices that are developed in response to conflicts of interest in a firm (Fama and Jensen 1983b).

Spans of control and the cost of entrepreneurial time

One constraint on the growth of any firm is entrepreneurs have a limited span of control (Coase 1937; Williamson 1967, Lucas 1978; Oi 1983a, 1983b). A span of control is the number of subordinates that an individual supervisor has to control and lead either directly or through a hierarchical managerial chain (Fox 2009).

There are only so many tasks that even the most able entrepreneurs can carry out in one day. Over-stretched spans of control motivate entrepreneurs to hire professional managers and delegate to them a wide range of decision-making rights over the firms they own (Williamson 1975; Foss, Foss and Klein 2008).

Entrepreneurs and the professional managers they hired to assist them must divide their respective time between monitoring employees, identifying new business opportunities, forecasting buyer demand and running the other aspects of their business (Lucas, 1978; Oi 1983, 1983b, 1988; Foss, Foss, and Klein 2008). The larger is the firm, the more employees there are for the entrepreneur to direct, monitor and reward. These costs of directing and monitoring employees will increase with the size of the firm and larger firms will encounter information problems not present in smaller firms (Alchian and Demsetz 1972; Stigler 1962).

The cost of entrepreneurial time spent monitoring employees will increase with the size of the firm (Lucas 1978; Oi 1983b). The time of the more talented entrepreneurs is more valuable because they had the superior managerial skills and entrepreneurial alertness to make their firms large in the first place and remain deft enough to survive in competition. Time spent on the supervision of employees is time that is spent away from other uses of the talents that got these more able entrepreneurs to the top and keeps them there (Williamson 1967; Lucas 1978; Oi 1983b, 1988, 1990; Idson and Oi 1999; Black et al 1999).

Firms in the same industry tend to exhibit systematic differences in their organization of production and the structure of their workforces because entrepreneurial ability is the specific and scarce production input that limits the size of a firm (Lucas, 1978; Oi 1983b). The less able entrepreneurs tend to run the smaller firms while the more able entrepreneurs tend to lead both the currently large firms and the smaller firms that are growing at the expense of market rivals (Lucas 1978, Oi 1983b; Stigler 1958; Alchian 1950).

Alchian and Allen’s list of economic fallacies

  • Price controls prevent higher costs to consumers;
  • reducing unemployment requires creating more jobs;
  • larger incomes for some people require  smaller incomes for others;
  • free, or low, tuition reduces costs to students;
  • unemployment is wasteful;
  • stockbrokers and investment advisors predict better than throwing a dart at a list of stocks;
  • international trade deficits are bad and surpluses are good;
  • inflation is caused by government deficits;
  • government budget deficits reduce saving and raise interest  rates;
  • new taxes are borne by the consumer of the taxed items;
  • employers pay for "employer provided" insurance;
  • tax-exempt bonds avoid taxes;
  • minimum wages help the unskilled and minorities;
  • housing developers drive up the price of land;
  • foreign imports reduce domestic jobs;
  • "equal pay for equal work" aids women, minorities and the young;
  • very low unemployment causes inflation; and
  • the Federal Reserve Board controls the rate of interest.

Source: Universal Economics

Armen Alchian would have been 100 today

From Alchian’s and William Allen’s 1968 “What Price Zero Tuition?“

Since the fiasco in the Garden of Eden, mankind has suffered from scarcity: there cannot be enough goods and services to satisfy completely all the wants of all the people all the time.

Consequently, man has had to learn the hard way that in order to obtain more of this good he must forego some of that: most goods carry a price, and obtaining them involves the bearing of a cost.

Poets assure us that the best things in life are free. If so, education is a second-best good, for it decidedly is not free. But if education is not free, if a price must be paid, who is to pay it?

By developed instinct, the economist initially presumes it to be appropriate that payment of the price should be made by those who receive the good.

"Those who get should pay" is a strong rule of thumb; the economist will deviate from it only for profoundly compelling reasons.

via Quotation of the Day…. Cafe Hayek

Alchian and Allen wrote the best economics textbook ever.

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Exchange and Production: Competition, Coordination and Control in 1977

Armen Alchian on property rights