Friedrich von Hayek and Armen Alchian Part I

Armen Alchian’s Contributions to Law and Economics  

Source: Armen Alchian’s Contributions to Law and Economics – Coordination Problem

Rejoinder to @geoffsimmonz and Jess Berentson-Shaw on are we all sexists – Part 1

Morgan Foundation researchers Jess Berentson-Shaw and Geoff Simmons were good enough to write a long reply to my recent post on the role of unconscious bias in the gender wage gap. My post was in reply to a Friday whiteboard session by Geoff Simmons.

I thought the best way to start is to summarise their reply in terms of how my rejoinder will be structured:

  1. There is a persistent, known but unexploited entrepreneurial opportunity for pure profit arising from employers not hiring women on merit because of an unconscious bias against them. This unconscious bias among employers against women explains 20-30% of the gender wage gap. Most of the rest of that gap is due to factors such as differences in occupation and education.
  2. The gender wage gap is smaller at the bottom of the labour market because of the minimum wage.
  3. The gender wage is smaller in the middle than at the top of the labour because of “far more standard contracts in the middle”. I take this to mean recruiting firms set a hiring standard and make a wage offer. This does not mean they have a free hand in their wage posting. A higher wage offer attracts better qualified applicants. Posting a low wage attracts fewer candidates that meet their hiring standard from other jobs and from the ranks of the unemployed. The available evidence suggests that one-third of job matches are based on wage bargaining and two-thirds through wage posting. Wage posting is more common in larger firms, the public sector and where there is collective bargaining. Wage bargaining is more profitable for occupations and jobs with a high dispersion in workers’ skills and productivity and in tighter labour markets.
  4. The gender pay gap is largest for the top 10% of female wage earners because “…  what scientific evidence supports the argument that better paid women have the ability to negotiate pay & conditions better? The very fact that there is a consistent and large gap between highly paid men and women suggests that where MORE negotiation, discretion, more complex selection processes are involved the more women are discriminated against”. The available evidence is wage posting is less common the more skilled is the worker. It pays to invest more in scrutinising recruits against hiring standards and to consider offer matching when the wage is higher for applicants and for employees threatening to quit. The payoff from a longer job search is greater the higher is the wage. There is a greater chance of higher skilled jobseeker of finding a better paid match between their more idiosyncratic skills and backgrounds in vacancies elsewhere or which might appear later. Low skilled jobseekers invest less in job search because one vacancy is frequently as good as another in their occupational and industry labour markets. The higher skilled are also more geographically mobile than the low skilled and more likely to live in cities and earn the urban wage premium.
  5. “Better paid professional women may have more options than lower paid women but they still have fewer than their male equivalents.” I take this to mean the greater the ability of workers to move from employer to employer, the better are they paid. Women have a weaker average attachment to the labour market. The human capital interpretation of this is woman and mothers in particular have lower productivity because they have spent less time accumulating on-the-job human capital. In the search and matching interpretation, women have less search capital. Workers start out as job shoppers: the longer a worker shops around, the more likely after a succession of job matches that they chance upon better paying job and occupational matches. Women through career interruptions for motherhood spend less time in the labour market, accumulate less search capital and are therefore are paid less. Women find it harder to work their way into the better-paying job matches.
  6. “Removing unconscious bias requires cultural change and will take time to resolve but it is possible to do with concerted effort.” This as example of what Adam Smith called the overweening conceit of youth.

My reply to the original Friday whiteboard session by Geoff Simmons relied on invisible hand explanations. Nozick argued that invisible hand explanations of social phenomena must have a filter and an equilibrating mechanism.

Geoff Simmons’ hypothesis about the gender wage gap is an invisible hand explanation: 20-30% of the gender wage gap is driven by unconscious bias. There could be no greater an invisible hand than an unconscious one.

There must be a mechanism in Geoff Simmons’ hypothesis that guides market participants to not hire and not promote women on merit. Not hiring on merit forfeits profit. There must be a filter that penalise hiring on merit.

The market has a filter and an equilibrating mechanism that constitute its invisible hand. The equilibrating mechanism – the mechanism that prompts people to hire on merit – is price signals. Prices are a signal wrapped in an incentive. If prices go up, buy less and look for other options, if they go down, buying more is profitable. The filter, which is more of an invisible punch than an invisible hand, is profits and losses. Higher costs, lower profits, loss of market share, insolvency and bankruptcy drive out the entrepreneurs who fail to hire on merit.

Entrepreneurs that hire on merit are more likely to survive in market competition than those that do not. Entrepreneurs must adapt or die.

There is no similar institutional filter in Geoff Simmons hypothesis to ensure that not hiring on merit is the unintended outcome from the decentralised behaviour of countless employers and job seekers trying to improve their own circumstances. Self-interested employers are not prompted by price signals to not hire on merit. More importantly, their chances are surviving in market competition are increased rather than are reduced if employers resist the temptations arising from their unconscious biases against women.

This institutional context is the reverse of what should be for unconscious bias against women to survive in market competition as suggested by Geoff Simmons. Firms that hire on merit should have a lower probability of survival, not a higher chance of staying in business if the unconscious bias hypothesis is to prevail in the face of market competition.

Geoff Simmons and Jess Berentson-Shaw is they didn’t address my extensive comments about the market as an evolutionary process. They did not explain how market competition would not penalise employers who fail to hire on merit for any reason including unconscious bias. That is the fundamental flaw, a fatal flaw in their reply to my comment on their Friday whiteboard session.

Most of all, Geoff Simmons and Jess Berentson-Shaw succumb to what Robert Nozick christened normative sociology. This is the study of what the causes of social problems ought to be.

For Geoff Simmons and Jess Berentson-Shaw, the gender wage gap ought not be the result of the conscious choices of women making the best they can do what they have. The gender wage gap must be the result of the bad motivations of employers and other external forces. The bad motivations must be unconscious because conscious prejudice is rare these days.

The unconscious bias hypothesis suffers from the same floors as the occupational crowding and occupational segregation hypotheses. Neither the unintentional bias hypothesis nor the occupational crowding and segregation hypotheses have a filter and an equilibrating mechanism that guides employers into make unprofitable choices about hiring. These hypotheses must explain how unconsciously biased employers survive in competition with less unconsciously biased employers.

Central to Gary Becker’s theory of prejudice based discrimination is competition in the market will slowly wear down prejudice-based discrimination in the same way that it drives out any other practices inconsistent with profit maximisation and cost minimisation. Profit maximisation gets no respect in the theory of unconscious bias and the gender wage gap put forward by Geoff Simmons and Jess Berentson-Shaw.

If there are sufficient number of less unconsciously biased employers, there will be segregation. Some employers will hire a large number of women because they have the pick of the crop and will be more profitable to boot at least in the short run.

The more unconsciously biased employers will have a large number of men working for them and will be less profitable and more likely to fail. At worst, men and women will be paid to same but most women will work for these less unconsciously biased employers. The possibility of labour market segregation rather than gender wage gap was not considered in the unconscious bias hypothesis.

Unconscious bias is a preference-based explanation of the gender wage gap. The young are the last to notice the rapid social change that came before them. Cultural and preference based explanations underrate the rapid social change in the 20th century. As Gary Becker explains:

… major economic and technological changes frequently trump culture in the sense that they induce enormous changes not only in behaviour but also in beliefs. A clear illustration of this is the huge effects of technological change and economic development on behaviour and beliefs regarding many aspects of the family.

Attitudes and behaviour regarding family size, marriage and divorce, care of elderly parents, premarital sex, men and women living together and having children without being married, and gays and lesbians have all undergone profound changes during the past 50 years. Invariably, when countries with very different cultures experienced significant economic growth, women’s education increased greatly, and the number of children in a typical family plummeted from three or more to often much less than two.

Goldin (2006) showed that women adapted rapidly over the 20th century to changing returns to working and education as compared to options outside the market. Their labour force participation and occupational choices changed rapidly into long duration professional educations and more specialised training in the 1960s and 1970s as many more women worked and pursued careers. The large increase in tertiary education by New Zealand after 1990 and their move into many traditionally male occupations is another example.

The main drivers of the gender wage gap are unknown to recruiting employers such as whether a would-be recruit is married, how many children they have, whether their partner is present to share childcare, how many of children are under 12, and how many years between the births of children. Spacing out the births is a major driver of the gender pay gap but this information is unknown to employers when hiring. As Polachek explains:

The gender wage gap for never marrieds is a mere 2.8%, compared with over 20% for marrieds. The gender wage gap for young workers is less than 5%, but about 25% for 55–64-year-old men and women. If gender discrimination were the issue, one would need to explain why businesses pay single men and single women comparable salaries. The same applies to young men and young women.

One would need to explain why businesses discriminate against older women, but not against younger women. If corporations discriminate by gender, why are these employers paying any groups of men and women roughly equal pay? Why is there no discrimination against young single women, but large amounts of discrimination against older married women?

… Each type of possible discrimination is inconsistent with negligible wage differences among single and younger employees compared with the large gap among married men and women (especially those with children, and even more so for those who space children widely apart).

The main drivers of the gender wage gap are of no relevance to entrepreneurs making a profit. These findings are devastating to the notion that there is some sort of discrimination against women on the demand side of the labour market.

Employers lack the necessary information to implement any unconscious bias they might have against women in fact is mainly a bias against older women and mothers and mothers in particular the space out the births of their children. The emergence of the gender wage gap is through the supply-side choices of women because employers lack the necessary information to drive the emergence of a gender pay gap.

The career cost of a family is central to the emergence and size of the gender pay gap because it leads to self-selection on the supply-side in terms of human capital to mitigate the cost of careers breaks.

The gender gap is fairly minor before the age of 30. The female full-time employment rate drops by 10 percentage points after women enter their 30s before recovering by the time women reach the age of 50 (Johnston 2005). The gender wage gap also widens between the ages 35 to 64 when women are raising children; the biggest gap is for the ages of 44 to 44; a wage gap of 22 per cent (MWA 2010). The first child is estimated to reduce New Zealand female earnings by 7 per cent and second child reduces earnings by 10 per cent (Dixon 2000, 2001).

This self-selection of females into occupations with more durable human capital, and into more general educations and more mobile training that allows women to change jobs more often and move in and out of the workforce at less cost to earning power and skills sets. Chiswick (2006) and Becker (1985, 1993) then suggest that these supply side choices about education and careers are made against a background of a gendered division of labour and effort in the home, and in particular, in housework and the raising of children. These choices in turn reflect how individual preferences and social roles are formed and evolve in society.

Source: On Equal Pay Day, key facts about the gender pay gap | Pew Research Center.

Tiny differences in comparative advantage such as in child rearing immediately after birth can lead to large differences in specialisation in the market work and in market-related human capital and home production related work and household human capital (Becker 1985, 1993). These specialisations are reinforced by learning by doing where large differences in market and household human capital emerge despite tiny differences at the outset (Becker 1985, 1993).

Many women choose educational and occupational paths that give them more control over their hours worked, and lowers the cost of time spent on maternity leave and the associated depreciation of skills during career breaks and reduced hours (Polachek 1978, 1981; Bertrand, Goldin and Katz 2010; Katz 2006; Sasser 2005). Women over the entire run of the 20th century often end up in jobs that reduced the career cost of a family and rapidly changed their plans when new opportunities emerge (Katz 2006).

The prospect of children drives the early choices of women on education and occupations. Careers requiring continuous commitment, long hours and great sacrifices do not attract and retain as many women (Bertrand, Goldin and Katz 2010; Goldin 2006). Goldin and Katz (2011) found that differences in the reductions on the cost of career breaks was a major driver in the influx of women into previously male dominated occupations.

The key is what drives the rapid changes in the labour force participation and occupational choices of women. Some of the factors are global technology trends such rising wages and the emergence of household technologies and safe contraception and antidiscrimination laws. All of these increased the returns to working and investing in specialised education and training.

Up until the mid-20th century, women invested in becoming a teacher, nurse, librarian or secretary because these skills were general and did not deprecate as much during breaks. When expectations among women of still working at the age of 35 doubled, there were massive increases in female labour force participation and female investments in higher education and specialised skills (Goldin and Katz 2006).

In summary, Geoff Simmons and Jess Berentson-Shaw put forward an invisible hand explanation of the residual in the gender wage gap that lacks that all-important invisible punch. There is no market mechanism which penalises employers who rise above their unconscious bias against women to hire on merit. The invisible hand rewards employers that hire on merit with higher profits and penalises those that indulge a bias of whatever origin. The invisible hand consists of an invisible finger and an invisible punch. The invisible finger points the way forward through price signals; the invisible punch slaps down those entrepreneurs whose attentions wander from their bottom line when deciding who to hire and promote.

Part two of this reply will address the particulars of the reply of Geoff Simmons and Jess Berentson-Shaw. In particular, the search and matching aspects of their explanation and whether we are all sexists.

France, here the New Zealand labour market comes – part 2! How the Employment Court is re-regulating

As discussed yesterday, if the Employment Court had its way, New Zealand case law under the Employment Relations Act regarding redundancies and layoffs would be as job destroying as those in France.

The Employment Court’s war against jobs goes back more than 20 years. To 1991 and G N Hale & Son Ltd v Wellington etc Caretakers etc IUW where the Court held that a redundancy to be justifiable under law it must be ‘unavoidable’, as in redundancies could only arise where the employer’s capacity for business survival was threatened.

The Court of Appeal slapped that down and affirm the right of the employer to manage his business in no uncertain terms:

…this Court must now make it clear that an employer is entitled to make his business more efficient, as for example by automation, abandonment of unprofitable activities, re-organisation or other cost-saving steps, no matter whether or not the business would otherwise go to the wall…

The personal grievance provisions … should not be treated as derogating from the rights of employers to make management decisions genuinely on such grounds. Nor could it be right for the Labour Court to substitute its own opinion as to the wisdom or the expediency of the employer’s decision.

When a dismissal is based on redundancy, it is the good faith of that basis and the fairness of the procedure followed that may fall to be examined on a complaint of unjustifiable dismissal

… the Court and the grievance committees cannot properly be concerned with an examination of the employer’s accounts except in so far as it bears on the true reason for dismissal.

The Employment Court could only inquire as to the genuineness of the employer’s decision and the procedures adopted. The Court could not substitute their views on management decisions. No second-guessing.

In Brake v Grace Team Accounting Ltd, the Employment Court found its way back into second-guessing employer’s decisions about how to manage their business. The figures used by the employer to decide that a redundancy was required were in error. The employer miscalculated.

The Employment Court had previously held in Rittson-Thomas T/A Totara Hills Farm v Hamish Davidson that the statutory test of what a fair and reasonable employer could have done in all the circumstances applies to the substantive reasoning for redundancies. Some enquiry into the employer’s substantive decision is required to establish that a hypothetical fair and reasonable employer could also make the same decision in all of the circumstances.

Subsequently in Brake v Grace Team Accounting Ltd, the Employment Court found that the actions by the employer were “not what a fair and reasonable employer would have done in all the circumstances” and “failed to discharge the burden of showing that the plaintiff’s dismissal for redundancy was justified”.

The Court found that the redundancy was “a genuine, but mistaken, dismissal”, but it still found that the dismissal was substantively unjustified. That is a major new development. Mistaken dismissals that are genuine are unlawful and grounds for compensation under the employment law.

The case was appealed where the issues were whether the correct test had been applied. The Court of Appeal, in a sad day for employers, job creation and the unemployed, found that the Employment Court was within its rights to do what it did and applied the statutory tests correctly:

 GTA acted precipitously and did not exercise proper care in its evaluation of its business situation and it made its decision about Ms Brake’s redundancy on a false premise.

So it never turned its mind to what its proper business needs were but rather proceeded to evaluate its options based on incorrect information. We can see no error in the finding by the Employment Court that a fair and reasonable employer would not do this.

The test is now that fair and reasonable employers in New Zealand do not make mistakes. A much greater burden is now laid upon employers to show that not only that redundancies are justified, but they have made careful calculations and no mistakes.

No more seat of your pants entrepreneurship in New Zealand. No more entrepreneurial hunches – the essence of entrepreneurship is acting on hunches and other judgements that are incapable of being articulated to others and about which there is mighty disagreement in many cases. As Lavoie (1991) states:

…most acts of entrepreneurship are not like an isolated individual finding things on beaches; they require efforts of the creative imagination, skillful judgments of future costs and revenue possibilities, and an ability to read the significance of complex social situations.

The essence of entrepreneurship is your hunches are better than the next guy’s and you survive in competition by backing that hunch often to the consternation of the crowd. As Mises explains:

[Economics] also calls entrepreneurs those who are especially eager to profit from adjusting production to the expected changes in conditions, those who have more initiative, more venturesomeness, and a quicker eye than the crowd, the pushing and promoting pioneers of economic improvement…

The entrepreneurial idea that carries on and brings profits is precisely that idea which did not occur to the majority… The prize goes only to those dissenters who do not let themselves be misled by the errors accepted by the multitude

In many cases, those entrepreneurial hunches are sorted, sifted and selected on the basis of trial and error in the marketplace. Central to Hayek’s conception of the meaning of competition is it is a process of trial and error with many errors:

Although the result would, of course, within fairly wide margins be indeterminate, the market would still bring about a set of prices at which each commodity sold just cheap enough to outbid its potential close substitutes — and this in itself is no small thing when we consider the insurmountable difficulties of discovering even such a system of prices by any other method except that of trial and error in the market, with the individual participants gradually learning the relevant circumstances.

Remember Hayek’s conception of competition as a discovery procedure where prices and production emerge through the clash of entrepreneurial judgements and competitive rivalry:

…competition is important only because and insofar as its outcomes are unpredictable and on the whole different from those that anyone would have been able to consciously strive for; and that its salutary effects must manifest themselves by frustrating certain intentions and disappointing certain expectations

Errors are no longer permitted in the New Zealand labour market by the Employment Court. The Court has outlawed error in redundancy decisions.

This is despite the fact that the conception by Kirzner of the market process is that it is an error correction procedure without rival and a central role of entrepreneurial alertness is to correct errors in pricing and production:

It is important to notice the role played in this process of market discovery by pure entrepreneurial profit. Pure profit opportunities emerge continually as errors are made by market participants in a changing world. The inevitably fleeting character of these opportunities arises from the powerful market tendency for entrepreneurs to notice, exploit, and then eliminate these pure price differentials.

The paradox of pure profit opportunities is precisely that they are at the same time both continually emerging and yet continually disappearing. It is this incessant process of the creation and the destruction of opportunities for pure profit that makes up the discovery procedure of the market. It is this process that keeps entrepreneurs reasonably abreast of changes in consumer preferences, in available technologies, and in resource availabilities.

Rothbard made similar arguments about the centrality of discrepancies and error in entrepreneurship:

The capitalist-entrepreneur buys factors or factor services in the present; his product must be sold in the future. He is always on the alert, then, for discrepancies, for areas where he can earn more than the going rate of interest.

In Frank Knight’s conception of profit, there were temporary profits that arise from the correction of error:

In the theory of competition, all adjustments “tend” to be made correctly, through the correction of errors on the basis of experience, and pure profit accordingly tends to be temporary.

The Employment Court misunderstands the market process as a process of error correction. Those errors are identified through entrepreneurial alertness and trial and error. These errors are both of over-optimism and over-pessimism as Kirzner explains:

Errors of over-pessimism are those in which superior opportunities have been overlooked. They manifest themselves in the emergence of more than one price for a product which these resources can create. They generate pure profit opportunities which attract entrepreneurs who, by grasping them, correct these over-pessimistic errors.

The other kind of error, error due to over-optimism, has a different source and plays a different role in the entrepreneurial discovery process. Over-optimistic error occurs when a market participant expects to be able to complete a plan which cannot, in fact, be completed.

A considerable part of entrepreneurial alertness arises from the business opportunities created by sheer ignorance and pure error as Kirzner explains:

What distinguishes discovery (relevant to hitherto unknown profit opportunities) from successful search (relevant to the deliberate production of information which one knew one had lacked) is that the former (unlike the latter) involves that surprise which accompanies the realization that one had overlooked something in fact readily available. (“It was under my very nose!”)

The market process is a selection procedure where the more efficient survive for reasons that may be unknown to the entrepreneurs directly concerned as well as to observers and officious judges. Alchian pointed out the evolutionary struggle for survival in the face of market competition ensured that only the profit maximising firms survived:

  • Realised profits, not maximum profits, are the marks of success and viability in any market. It does not matter through what process of reasoning or motivation that business success is achieved.
  • Realised profit is the criterion by which the market process selects survivors.
  • Positive profits accrue to those who are better than their competitors, even if the participants are ignorant, intelligent, skilful, etc. These lesser rivals will exhaust their retained earnings and fail to attract further investor support.
  • As in a race, the prize goes to the relatively fastest ‘even if all the competitors loaf.’
  • The firms which quickly imitate more successful firms increase their chances of survival. The firms that fail to adapt, or do so slowly, risk a greater likelihood of failure.
  • The relatively fastest in this evolutionary process of learning, adaptation and imitation will, in fact, be the profit maximisers and market selection will lead to the survival only of these profit maximising firms.

The surviving firms may not know why they are successful, but they have survived and will keep surviving until overtaken by a better rival. All business needs to know is a practice is successful.

One method of organising production and supplying to the market will supplant another when it can supply at a lower price (Marshall 1920, Stigler 1958). Gary Becker (1962) argued that firms cannot survive for long in the market with inferior product and production methods regardless of what their motives are. They will not cover their costs.

The more efficient sized firms are the firm sizes that are currently expanding their market shares in the face of competition; the less efficient sized are those firms that are currently losing market share (Stigler 1958; Alchian 1950; Demsetz 1973, 1976). Business vitality and capacity for growth and innovation are only weakly related to cost conditions and often depends on many factors that are subtle and difficult to observe (Stigler 1958, 1987). The Employment Court pretends to know better than the outcome of the competitive struggle in the market for survival.

The Employment Court also believes employers have something akin to academic tenure. In 2010, the Court found that an employee’s redundancy was unjustified because the employer did not offer redeployment and there is no requirement that the right of the redeployment be written into the employment agreement (Wang v Hamilton Multicultural Services Trust). The particulars of this case were quite interesting:

  • A new management role was created with significantly more responsibility for training, supervision and decision making than the redundant finance administrator role, with a 50% salary increase to recognise the increased responsibilities and duties.
  • The vacancy was advertised externally but the existing finance administrator was encouraged to apply.
  • His experience and qualifications meant that he could fulfil the new role, albeit with some up-skilling.
  • He decided not to apply for it to avoid jeopardising a personal grievance claim that his redundancy was not genuine and therefore unjustified.

In the case at hand, the Employment Court held that the employer was obliged to look for alternatives to making the employee redundant. Given that he would be able to perform the new finance manager position with some up-skilling, the employer should have offered him the position rather than simply inviting him to apply for it.

The notion that an employee through training can quickly increase their marginal productivity by 50% to fill a more senior role contradicts the modern labour economics of human capital. A 50% salary increase through a bit of training would imply extraordinary annual returns on other forms of on-the-job training and formal education as well as the training at hand in the Employment Court case.

I would very much like to be in the position where I can get a 50% salary increase after a bit of training. As I recall, I required about 5-10 years of on-the-job human capital acquisition before my starting salary as a graduate was 50% higher through promotion and transfers.

In summary, the Employment Court stands apart from the modern labour economics of human capital and job search and matching as well as the modern theory of entrepreneurial alertness, and the market as a discovery procedure and an error correction mechanism. The Employment Court has fallen for both the pretence to knowledge and the fatal conceit.

A firm with no employees is not a firm

Business demographic statistics in New Zealand include companies with zero employees and calls them a firm.

Source: Statistics New Zealand.

Every definition of a firm that I have seen refers to a firm as a relationship between employers, employees and others. There is team production or some sort of nexus of contracts or dependent assets, something social.

The notion is that transactions that normally take place in the market are taken out of the market and take place within the firm. Most profoundly, as Ronald Coase explained in 1937 in his seminal work The Nature of the Firm is what needs to be explained is the existence of the firm, with its

distinguishing mark … [of] the supersession of the price mechanism.

If there’s only one person in the firm, there is no one to transact with within the firm that the parties would normally have otherwise done in the market at arm’s length. There is no suppression of the price system, because all the dealings of the one person firm is with others. There are no transactions outside of the price system. As Barzel and Kochin explain when contrasting Ronald Coase’s theory of the firm with that of Alchian and Demsetz:

Even though they offer an alternative to Coase’s theory of the firm, their firm, nevertheless, is fundamentally a transaction cost phenomenon – it arises in response to the costs associated with measuring and policing various inputs and outputs.

Doug Allen, along with Eugene Fama, argue that all economic organisations are designed to maximise the gains from trade net of transaction costs. Other forms of organisation, forms of organisation that do not maximise the gains from trade net of transaction costs as well would not survive in market competition.

Transaction costs are defined by Allen as the costs of establishing and maintaining property rights. Yoram Barzel  defines (economic) property rights (in this paper, p. 394) as:

… an individual’s net valuation, in expected terms, of the ability to directly consume the services of the asset, or to consume it indirectly through exchange. A key word is ability: The definition is concerned not with what people are legally entitled to do but with what they believe they can do.

A property right, according to Alchian (1965, 1987) and Cheung (1969), is essentially the ability to enjoy a piece of property, but this ability to benefit from an asset or commodity, either directly, or indirectly through market exchange, is seldom unhindered. Eugene Fama observed that:

The striking insight of Alchian and Demsetz (1972) and Jensen and Meckling (1976) is in viewing the firm as a set of contracts among factors of production. In effect, the firm is viewed as a team whose members act from self-interest but realize that their destinies depend to some extent on the survival of the team in its competition with other teams.

If the firm consists only of the owner, there is no internal constraints on the establishment and maintenance of property rights because no one else is in the firm to cause any conflict. There is no nexus of contracts between different suppliers of production inputs whose destinies depend on the ability of them as a team to survive in competition with other teams.

Whatever constraints might arise about the ability of the owner to actually exercise property rights, none of these constraints arise internally to the firm because of the presence of employees or partners.

If there are no employees, if the firm only consist of the owner, the purpose of the firm, which is to make the incentives of workers compatible with those of owners is lost.

Firms, to be a firm, must have employees. If not employees, there must be at least more than one party involved, such as in a partnership.

Firms exist because it is cheaper to organize inputs within a firm than buy and sell in many different markets. This buying and selling requires a continual negotiation, renegotiation, enforcement and monitoring of contracts at arm’s length with independent suppliers of inputs. Barzel stressed this enforcement of property rights in an unpublished paper:

I hypothesize that the firm is organized for the express purpose of creating rights that are more economically enforced by non-state rather than by state means.

Many of these firms with zero employees in the New Zealand business demographic statistics, a classification that accounts for over 60% of all firms in New Zealand, are shelf companies or property investment companies.

There is no measuring and policing of inputs and outputs in a firm that has no employees and only an owner. These entities are not firms. They meet none of the criteria for a firm in the economics of industrial organisation.

This failure to distinguish between a firm and other forms of organisation leads the Minister of Economic Development to say unfortunate things such as:

97 per cent of enterprises in New Zealand are small businesses and have fewer than 20 employees.

Two thirds of that 97% of enterprises has no employees. Any discussion that pretends to know that there are too many or too few small and large firms in New Zealand should not be confused with other forms of organisation of capital that have nothing to do with the topic at hand, which is usually workplace productivity and entrepreneurial competence.

Many of these zero employee firms are not even economic organisations. They are legal mechanisms for exercising legal property rights. Including these property rights in business demographic statistics on business organisations is confusing.

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.

Armen Alchian on the inconsistent treatment of the concept of cost in economic theory


Alchian and Demsetz on the moral stature of property rights


Second law of supply and demand alert: There is no such thing as a skills shortage – updated

Could you define both a severe skills shortage and a skills shortage?

  • How do these concepts differ from concepts such as rising demand, rapidly rising demand, and reduced and sharply reduced supply?
  • Are the phrases severe skills shortage and a skills shortage more precise than the phrases rising demand, rapidly rising demand, and reduced and sharply reduced supply?
  • Are the phrases severe skill shortage and a skill shortage more informative than referring to the short and long run elasticity of demand and supply as summed up in the second laws of demand and supply?
  • Why are rising demand, rapidly rising demand, and reduced and sharply reduced supply considered to be social problems. What causes rising demand, rapidly rising demand, and reduced and sharply reduced supply?
  • For whom are rising demand, rapidly rising demand, and reduced and sharply reduced supply considered to be problems? Employers? Employees? Others?
  • Should governments intervene to stop employers from competing to set wages to reflect increases in the marginal revenue product of labour?
  • Is not the purpose of short and long-term upward changes in relative prices or wages to induce people to buy less of a now scarcer resource and search for substitutes and additional sources of supply, and for new suppliers to enter the market in response to the higher prices or wages?

As a starter, I thought I would update Alchian and Arrow’s timeless 1958 analysis for the Rand Corporation of the purported shortage of engineers and scientists at the height of the missile gap in the cold war.

Alchian and Arrow tested the robustness of claims of a labour market shortage of scientists and engineers by investigating the sudden appearance of a servant shortage during World War II.

I will update this idea of a servant shortage to a purported shortage of nannies, as shown in figure 1 below which sets out the initial equilibrium and then an increase in demand.

Figure 1: the demand and supply for nannies by the old rich and power couples

In the diagram above, the initial equilibrium has the old rich hiring Q1 nannies at a wage W1 with demand curve D1, and the supply curve for nannies.

  1. Power couples then enter the nannies market pushing total demand out to D2 with wages increasing to W2 and quantity supplied increasing a little to Q2;
  2. The old rich can now afforded to buy only Qs in nannies and power couples hire (Q2 – Qs) in nannies.

By construction, the quantity of nannies supplied increases slightly in the short-run, with a large increase in wages for nannies! (Q2 – Q1) new nannies enter the market, lured in by the higher wages.

The old rich now face a shortage of nannies equal to the quantity (Q1 – Qs). These nannies having switched to work for power couples on much better pay. (In the case of the original analysis Alchian and Arrow analysis, they switched into defence work or backfilled jobs of those that moved into defence work).

As with the wartime servant shortage, the old rich are unwilling to admit they are no longer able to keep themselves in the style they were accustomed too because the demand for domestic labour has increased.

Better to blame their loss of social status on a skills shortage in a poorly functioning market rather than accept the rise of middle class power couples outbidding them in the hire of domestic help. As Alchian and Arrow (1958, pp. 39-40) explain:

… Many people who formerly consumed some of the commodity or service in question and now find the price so high that they no longer want as much (or any) would describe the situation is one of “shortage”.

Actually, this is merely one way of saying that they can’t get the given commodity at its old price.

We can think of many examples of this use of the word “shortage”. For example, the “servant shortage” during World War II was a case in point.

Those with whom the increase in household servants wages were more than they could afford to pay, apparently found it more convenient to describe their change in circumstances as a result of a “shortage” than to admit baldly that they couldn’t afford to keep the servants…

It seems reasonable to explain a good deal of the current complaint about a shortage of scientists and engineers is a variant of the “servant shortage” phenomena.

Employers who find themselves losing engineers to other firms and at the same time find it uneconomic to try and keep these employees by offering them substantial salary increases may see the situation as a “shortage” rather than recognise that other firms can put these skills to more valuable uses…

While we lack specific evidence, we have the impression that the firms who have complained most consistently about “shortage” have been those whose demand has not increased or at least not increased as rapidly as that of other firms in their industry.

Why are people priced out of any market? Given a fixed income and the many other alternative uses of their incomes, any rise in price makes buying the old quantity no longer the best bargain.

Who will admit that they can no longer keep themselves in the style they were accustomed to when they complain of market failure, skill shortages and lack of government investment in skill formation.

Alfred Marshall’s comparative statics of price adjustment

The analysis of the time path of price adjustment for any commodity was developed by Alfred Marshall in 1890. He was concerned that time was an important factor in how the markets adjusted to demand and supply changes:

… markets vary with regard to the period of time which is allowed to the forces of demand and supply to bring themselves into equilibrium with one another, as well as with regard to the area over which they extend. And this element of Time requires more careful attention just now than does that of Space.

For the nature of the equilibrium itself, and that of the causes by which it is determined, depend on the length of the period over which the market is taken to extend.

We shall find that if the period is short, the supply is limited to the stores which happen to be at hand: if the period is longer, the supply will be influenced, more or less, by the cost of producing the commodity in question; and if the period is very long, this cost will in its turn be influenced, more or less, by the cost of producing the labour and the material things required for producing the commodity.

Marshall divided the price adjustment process into the market period, the short run, and the long run.

In the market period, production is fixed; and all factors of production are fixed in supply during this time period. The burden of price adjustment is on the demand side.

As the supply is fixed in the market period, it is shown as a vertical line SMP. It is also called as inelastic supply curve. When demand increases from DD to D1 D1, price increases from P to P1. Similarly, a fall in demand from DD to D2 D2 pull the price down from P to P2.

In the short run, supply to be partially adaptable, in the sense that increased production can occur but capital equipment and certain other overhead items are held constant.

SSP is elastic implying that supply can be increased by changing a variable input. Note that the corresponding increase in price from P to P1 for a given increase in demand from D to D1 is less than in the market period. It is because the increase in demand is partially met by the increase in supply from q to q1.

The short run is the conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount. In the short run, a profit-maximising firm will:

  • increase production if marginal cost is less than marginal revenue;
  • decrease production if marginal cost is greater than marginal revenue;
  • continue producing if average variable cost is less than price per unit, even if average total cost is greater than price;
  • Shut-down if average variable cost is greater than price at each level of output.

In the long run, supply is fully flexible – there are no fixed factors of production. The Marshallian long-run allows for optimal capital stock adjustment.

The long period supply curve SLP is more elastic and flatter than that of the SSP. This implies the greater extent of flexibility of the firms to change the supply.

The price increases from P to P2 in response to an increase in demand from D to D1 and it is less than that of the market period (P1) and short period (P2). It is because the increase in demand is fully met by the required increase in supply. Hence, supply plays a significant role in determining the lower equilibrium price in the long run.

The market is cleared in the long run within a framework in which supply can be considered to be fully adaptable because all factors have adjusted to the new situation. Alfred Marshall explains:

In long periods on the other hand all investments of capital and effort in providing the material plant and the organization of a business, and in acquiring trade knowledge and specialized ability, have time to be adjusted to the incomes which are expected to be earned by them: and the estimates of those incomes therefore directly govern supply, and are the true long-period normal supply price of the commodities produced.

In addition, in the market period, the short run, and the long run, foresight is not perfect, information is not free, and the cost of adjusting something is not independent of the speed in which you wish to do so.

The 2nd laws of supply and of demand

Another way to discuss how time interacts with responsiveness of supply and demand are the second laws of supply and demand.

The Second Law of Supply states that supply is more responsive to price in the long run. The Second Law of Supply relates to how flexible producers are in terms of how much of a good they produce.

Supply is more elastic in the long run because given more time, producers can more easily adapt to the change in the price.

Within shorter periods of time, producers cannot as easily change the amount of a good they produce (since changes in production often require adjustments within factories, with workers etc.)

The Second Law of Demand states that demand is more responsive to price in the long run than in the short run. Initially, when the price of a good increases or decreases, consumption does not change drastically. However, when consumers are given more time to react to the change in price, consumption can either increase or decrease more dramatically. Demand is not only determined by price but also factors such as: income, tastes, and the price of related goods.

In the market period, any adjustment must be made through changes in price. This means that there could be initially a large price increase.

In the short run, there are some capability for more supply to come forward. This additional supply will temper the initial large price increase.

In the long run, producers are fully able to adapt their circumstances to the changing market conditions and higher prices. This will reduce prices as compared to the initial price spike when market conditions first changed.

In the long run, new firms can enter the industry and old firms can exit as required by the price change and their entrepreneurial expectations of the future of the industry.

Search and matching in a decentralised labour market

To cover off the bases, the simultaneous existence of vacancies and unemployed in a labour market is no evidence of either of surplus or shortage. It takes time for workers to locate vacancies and assess their competing job options. It takes time for employers to locate suitable workers to fill vacancies.

The simultaneous existence of vacancies and unemployed is the result of, as mentioned earlier, imperfect foresight, the fact that information is not free, nor freely available, and the costs of doing anything is not independent of the speed in which you wish to act. Searching for suitable vacancies, or suitable employees, is costly, and neither jobseeker nor employer knows whether any match will work out.

The one-price (one-wage) market that clears instantly will occur only where the cost of information about the prices (wages) offered by buyers and sellers is zero. As George Stigler observed in the opening paragraph of his famous 1961 paper The Economics of Information:

One should hardly have to tell academicians that information is a valuable resource: knowledge is power. And yet it occupies a slum dwelling in the town of economics.

Mostly it is ignored: the best technology is assumed to be known, the relationship of commodities to consumer preferences is a datum.

And one of the information producing industries, advertising, is treated with a hostility that economists normally reserve for tariffs or monopolists.

Job search cost are of two types: direct costs of gathering information about competing opportunities and the opportunity cost of being unemployed or staying in your current job at your current pay.

  • The benefit from job search is the expected gain in earnings that will result from waiting for a better wage offer.
  • The rational job searcher searches for better offers until the marginal benefit and cost of additional search are equal.
  • A significant cost of continued job search is the earnings foregone by not taking the previous best opportunity.

Unemployment can be a cost-effective method of searching for better employment opportunities and higher wage offers as David Andolfatto observed:

One frequently reads that “unemployment represents wasted resources.”

But if job search is an information-gathering activity, designed to locate a high quality job match, in what sense does such an activity necessarily constitute wasted resources? (Does the existence of single people in the marriage market also represent wasted resources?)

If the unemployment rate were to suddenly plummet because a large number of workers aborted their job search activity–accepting crappy jobs, or exiting the labour force–is this a reason to celebrate?

The behavioural responses of employers and workers to change are so pronounced because the cost of acquiring new information is profound (Alchian 1969). Many such costs impede wages from instantly fluctuating to rebalance labour supply with demand. Hicks (1932) explained this uncertainty and state of flux as follows:

For although the industry as a whole is stationary, some firms in it will be closing down or contracting their sphere of operations, others will be arising or expanding to take their place.

Some firms then will be dismissing, others taking on, labour; and when they are not situated close together, so that knowledge of opportunities is imperfect, and transference is attended by all the difficulties of finding housing accommodation, and the uprooting and transplanting of social ties, it is not surprising that an interval of time elapses between dismissal and re-engagement, during which the workman is unemployed.

A job seeker does not initially know the location of suitable vacancies, the wages for various skills, differences in job security and other factors. Job seekers must search for this information, keep this knowledge current and forecast whether better vacancies may open soon. Employers must search to learn the location, availability and asking wages of applicants. There is a tendency for unpredicted wage changes to induce costly additional job search. Long-term contracts arise to share risks and curb opportunism over sunken investments in relationship-specific human and organisation capital. These factors all lead to queues, unemployment, spare capacity, layoffs, shortages, inventories and non-price rationing in conjunction with wage stability (Alchian 1969; Alchian and Allen 1967, 1973; Klein 1984; Hashimoto and Yu 1980; Hall and Lazear 1979).

By acquiring more information, a job seeker learns more about their options and can improve their prospects of finding better-paid job matches. Job seekers and employers invest time and resources to find one another, size each other up and form a job match or try their luck elsewhere. A job match is a pairing of a worker with a particular employer.

Job seekers will apply for a portfolio of job vacancies that reflect their asking wage and their known alternatives. An asking wage is the minimum that a job seeker is willing to accept given their options.

  • The extent of job search depends on the costs of job-information production and acquisition, the income available to job seekers while searching, the frequency and the magnitude of shifts in the relative demand between different sectors, the costs of relocation and retraining, and the extent and frequency of declines in aggregate demand (Alchian and Allen 1967).
  • The more varied will be the potential job opportunities and the greater will be the gains to job seekers from continued job search, the greater are the rate of change in tastes and demand, the greater are the differences in the skills of job seekers and the requirements of job vacancies, and the greater are the costs of moving (Alchian and Allen 1967).

Employers face an information dilemma as well. If they wait a bit longer, hold a job vacancy open, a better job applicant may come a long and a more profitable and longer lasting job match may result.

Of course, the employer is taking a chance here on the job applicant pool improving with time. There are elements of luck involved for both employers and job seekers when filling vacancies and finding jobs.

The employer must balance the costs of holding the vacancy open with his estimation of the value and probability of a better applicant applying at a later date if he searches further the prospective recruits. But reducing your ignorance has costs as Stigler (1961) explained:

Ignorance is like sub-zero weather: by a significant expenditure its effects upon people can be kept within tolerable or even comfortable bounds, but it would be wholly uneconomical entirely to eliminate all its effects.

The rate at which job vacancies are filled and the rate at which people leave unemployment and change jobs is determined by the job search decisions of job seekers and the recruitment decisions of employers. The way in which the process works is well explained by Andolfatto’s analogy to the marriage market:

In many ways, the labour market resembles a matching market for couples.

That is, one is generally aware that the opposite side of the market consists of better and worse matches (we seldom take the view that there are no potential matches).

The exact location of the better matches is unknown, but may be discovered with some effort.

In the meantime, it may make sense to refrain from matching with ‘substandard’ opportunities that are currently available.

But since search is costly, it will generally not be optimal to wait for ones “soul mate” to come along. Furthermore, since relationships are not perfectly durable, there is no reason to expect the stock of singles to converge to zero over time

As in the labour market, there are marriages and divorces and young people come of age and look for the first time; people also link up for short-term relationships; and some relationships do better than others.

To say there is involuntary unemployment is to say there is also involuntarily unmarried people. But we can always marry the first person we meet in the street, if they’ll have us. Search and matching is a two sided affair. I doubt that our first encounter in the street would accept this offer of marriage from a stranger. I doubt that anyone would want to marry a stranger who would so willingly marry a stranger. I think both sides suspect that such a random pairing would not last long because the pairing occurred after so little mutual scrutiny and measured assessment of alternatives, current and prospective. The same principles apply to search and matching in the labour market.

Alchian and Demsetz define the classic capitalist firm


Armen Alchian on the difference between market equilibrium and market clearing


Armen Alchian on the discovery of property rights


Ronald Coase on Armen Alchian


Alchian and Allen on the role of mathematics in the education of an economic student


Alchian and Allen on investment advisors (and currency speculation too)


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