Sunday, 26 October 2014

Railway links: or how does one solve the problem of monopoly in infrastructure?

Here is a map showing the service of Amtrak train company, America's government subsidized passenger railroad company.


The map depicts Amtrak's stations across the US, where the size of the circle corresponds to the number of passengers circulating on the given station. This was taken from a summer blog at the Economist (they got it from here) where they questioned the justifiably of some of Amtrak's regular lines across the country when almost a third of their passengers use the service across only three cities (New York, Washington and Philadelphia). 

The Economist concludes:
"...Amtrak's long-haul routes (you can see them on the map as the tiny blue dots stretching across most of the country) are money pits. But America's bizarre constitutional structure, which gives outsized influence to states with small populations, creates an incentive for Amtrak to maintain unprofitable services that keep influential senators happy. 
If its long-haul trains were cancelled, Amtrak would serve just 23 states, down from the current 46. That would make it more profitable, allowing it to improve services in areas where it actually has riders—Mr Hicks suggests increasing train frequency between major midwestern cities. But an Amtrak that served just 23 states would likely be politically unsustainable—and that's exactly the problem."
This is the classical problem with any state-owned service that offers some sort of a public good. The public post service faces the same issue - because they have to offer the service even in the remote parts of the country they face high loses in such areas. A publicly owned train company is similar. Amtrak has to travel across all these routes to perform its public good function, in addition to making a few senators and congressmen happy. If it were to close down some of its unprofitable routes it would perhaps eliminate the need for such high government subsidies, but it would cause distress to local residents where the train lines have been cancelled. In economic terms the issue is pure cost-benefit, where the benefits for the many (lower subsidies and hence lower public spending, or perhaps better targeted public spending) outweigh the costs for the few. 

But politics doesn't work this way unfortunately. Very often for precisely such local issues the benefits to the few outweigh the costs for the many. That's essentially the reason why in many countries small, well organized groups, usually of a local origin, get what they want from the state budget, even though such decisions usually come at a high cost for the taxpayers. They successfully solve the collective action problem, whereas the taxpayers as a dispersed group cannot do anything about it. This is in fact one of the biggest problematic features of democracy, that needs to be solved on a constitutional level.

But I digress. The point was that in many countries large public sector companies are maintained (and by that I mean heavily subsidized) because they offer a unique service even to those areas and customers to which the 'market' wouldn't  offer the same service, or would offer it at a very high price. This is an example of the classical market failure argument

However the argument doesn't make a compelling case that by closing some of the inefficient routes there would be no market participant to provide the alternative. The costs are high, sure, however on a local level if the demand for some means of transportation is high, there will be a subsequent supply. Some entrepreneur will design a way to surpass the lack of supply and offer an alternative. Perhaps the trains across country are unpopular due to the length of travel which is why the people choose planes instead? Perhaps the primary mode of transportation in local areas are cars and buses? Perhaps the demand for taking the train in some areas is low, so the supply must simply adjust. If this means no more train services in a certain areas, this is purely the decision of the customers. The customers probably don't take trains because other modes of transportation are better and more efficient. If the company doesn't adjust to the needs of the consumers, it fails, or in a publicly-owned company scenario, it gets heavy subsidies. 

Another factor we should control for is the role of technology. Why aren't Amtrak's trains super-fast Maglev trains like in Japan? If they were, if it were possible to get from New York to LA in 8 and a half hours (2700 miles for a train traveling at 320 mph) instead of 2 and a half days, then perhaps many would take this opportunity. There is talk of magnetic technology that can make transportation even more efficient and even faster. If this ever becomes true than this type of a technological breakthrough in the railway system would be a huge disruptive technology for the airline industry. And then the airline companies will have to be subsidized as the less efficient mode of transportation.

Returning back to the initial question from the title, governments should provide only the basic, essential public goods such as the proper justice system, private property protection, enforcement of contracts, and the basic infrastructure, all of which equally benefit everyone. The basic infrastructure does not imply having large, inefficient public companies being granted a monopoly on a certain service (btw monopolies should never be classified as market failures since it is the government that offers a licence for a company to be a monopoly). It implies that the government builds the roads and railways for the market participants to take advantage of. Literary and figuratively speaking. It is up to the entrepreneurs to seize the opportunity and satisfy the specific demand for a certain service. Heavily subsidizing public companies for inefficient services is never the solution. In terms of technology (building super fast Maglev trains), because its early implementation can bring about extremely high costs (just like the initial railways and roads had enormous costs), this too can be justified as a necessary, basic public good that brings an equal benefit to all the citizens, not just the selected few. 

Tuesday, 14 October 2014

Jean Tirole wins the 2014 Nobel prize in economics

It's that time of the year again - the Nobel prize announcements. As always, the last in line is the Sveriges Riksbank Prize in Economic Sciences in Memory of Albert Nobel, or colloquially the Nobel prize in economics, awarded yesterday. This year the honorary recipient was Professor Jean Tirole from Toulouse, France, one of the most cited economists in the World. He is only the third Frenchmen to receive the prize, first one since Maurice Allais in 1988. In addition, this ended an almost 15 year domination of US-based economists (at least one recipient each year was a US-based economist - they still dominate the field, as in every other science btw). Also he's one of the rare economists who got the honor as a single recipient (which became particularly rare in the past 15-20 years).


The award was given for his contributions in the "analysis of market power and regulation". Basically Tirole studied monopolies and oligopolies (since most industries are actually dominated by a few big firms), and how to regulate them to produce more socially-optimal outcomes. 

Here's a paragraph from the Nobel committee:
His analysis of firms with market power provides a unified theory with a strong bearing on central policy questions: how should the government deal with mergers or cartels, and how should it regulate monopolies?

Before Tirole, researchers and policymakers sought general principles for all industries. They advocated simple policy rules, such as capping prices for monopolists and prohibiting cooperation between competitors, while permitting cooperation between firms with different positions in the value chain. Tirole showed theoretically that such rules may work well in certain conditions, but do more harm than good in others. Price caps can provide dominant firms with strong motives to reduce costs – a good thing for society – but may also permit excessive profits – a bad thing for society. Cooperation on price setting within a market is usually harmful, but cooperation regarding patent pools can benefit everyone. The merger of a firm and its supplier may encourage innovation, but may also distort competition.
The best regulation or competition policy should therefore be carefully adapted to every industry’s specific conditions. In a series of articles and books, Jean Tirole has presented a general framework for designing such policies and applied it to a number of industries, ranging from telecommunications to banking. Drawing on these new insights, governments can better encourage powerful firms to become more productive and, at the same time, prevent them from harming competitors and customers.

Very applicable stuff! Here is a more detailed explanation (slightly technical), and here is a very reader-friendly explanation

All in all, a well deserved prize for Professor Tirole. Personally, I'm mostly familiar with his contributions to game theory (the textbook he and Drew Fundenberg wrote on game theory is a state-of-the-art piece of work, I recommend it to any PhD student). However his biggest contributions are, obviously, in the field of market regulation (where he also has a very influential textbook: "The Theory of Industrial Organization"). Even though, as Tyler Cowen noted, his research extends to a variety of fields, and he is particularly good in formalizing propositions and assumptions, and in mechanism design. Since his papers and their results are usually very complex, he hasn't been particularly present in the media, despite his ideas significantly influencing public policy. For example, here is an old text of his from 2007 published at VoxEU called "Four principles for an effective state". Read it, it's excellent and ever more applicable in today's situation. He advocates restructuring, competition, evaluation and accountability in order to turn big, useless states into efficient ones focused on the quality of the public service they offer. It's all very clear and straightforward. And yes, even in 2007 Tirole called for reforms. What does that tell you?

The contributions he has made in industrial organization theory are particularly important in terms of understanding how 'imperfect' markets work. We are surrounded by such imperfect markets, suffering from asymmetric information and monopoly and oligopoly power (this means that one big firm or a group of big firms dominate the market - there are so many industries today where this is a fact: from the automobile, telecommunications, energy, to even some aspects of finance and even some fast consumer goods). For regulators it is often very hard to evaluate all the details of the firms, particularly in terms of costs and benefits of improving quality of the offered product or service. The regulators, just as consumers, also tend to suffer from an asymmetry of information, since firms between themselves enter into a variety of games and interactions, all which would be far too complex to model and particularly to regulate and supervise. Tirole and his range of co-authors have used game theory and contract theory to explain how particular tools can be used to overcome these difficulties. The scope of his contributions is thus monumental for industrial policy and the market failure problems in general. He helps us understand how one can avoid both market and government failures in producing an optimal outcome for societies. 

Finally, have a look at some reactions and comments from notable economists: Tyler Cowen has a great post celebrating Tirole's achievements, so does Alex Tabarrok at the same blog, The Economist offers a series of links where they touched upon some of his ideas, the WSJ blog explains who he is and why he deserves it (my former LSE professor Torsten Persson explains it in an interview), Mark Thoma provided a series of other links, etc. 

Most notable (selected) works: (all available here)

Books:
Papers: 

Sunday, 5 October 2014

Imports and exports - two sides of the same coin

International trade seems to be one of the most misunderstood areas of economics for the average layman (the leading position of the most misunderstood area of economics is still being held by monetary policy, and the international monetary system in general. Why, I'll never know). People like to simplify things in order to understand them, and by doing so they often look at things from a one-dimensional lens, very often succumbing to Hazlitt's economic fallacies of focusing policy solutions on one area alone without taking into consideration the widespread effect on all groups nor the long-term impact.

I've written on international trade many times before, emphasizing its importance in wealth creation, and I've also written on the persistent mercantilist fallacy, where people can't seem to shake off the notion that exports are 'good' while imports are 'bad'. How ridiculous! Almost as ridiculous as claiming that selling is good while buying is bad, or in other words that only those who sell stuff will profit, while those who buy stuff are losing out. Nonsense.

Imports and exports are nothing more and nothing less than transactions of sales and purchase, except that the buyers and sellers are from two different countries. People buy products to satisfy their preferences, while sellers of goods aim to satisfy these preferences by supplying the goods the people want to buy. Both buyer AND seller will always profit from such a transaction. A matter of buying and selling is a matter of free will. A consumer will only buy a product if the value of that good is equal or greater than its price. If the good carries a price higher than how much you value a certain good you won't buy it. Voluntary transaction and individual expression of value is at the heart of every transaction, which implies that both the buyer and the seller must always be satisfied after a trade. Whether this implies buying food at the local supermarket, buying a pair of pants at a department store, or ordering stuff online, regardless of which countries the buyers and sellers reside in.

After all, governments (countries) don't import nor export. Companies do. They sell (export) and buy (import) on the international market. To be more precise the indirect determinant of the demand for imports comes directly from the consumers themselves. Or companies buying intermediary products that are cheaper abroad. If we as customers have a greater benefit from consuming foreign rather than domestic goods, then there will be a company that will offer them to us. It will import them from abroad since they know someone will buy them. Therefore, we as consumers determine the demand for imported, foreign goods. Whether it's clothes or food, that almost any country can produce on its own, or cars and IT goods that most countries can't. 

Should we forbid citizens from buying certain brands of clothing when we can produce perfectly fine shirts and pants domestically? Of course not. One cannot put limits on other peoples' preferences. Consumers will buy the goods they prefer. If someone has a particular taste for foreign expensive brand clothes, he or she will buy them. If a person finds that foreign meat, beer, chips, candy or apple juice taste better than their domestic counterparts they will buy them. And hence encourage imports. If a company can cut costs by buying an intermediary good from abroad rather than on the domestic market, it will do so. And also encourage imports. In today's globalized world, aggregate categories of imports and exports are becoming more and more obsolete. 

Thursday, 2 October 2014

Liberty in the long run

Back to blogging after a short break. I recently came across an older, 2010 article from Scot Sumner on Econlog, where he discussed the neoliberal revolution that began in the late 1970s. A very good text, explaining first of all the confusion over the term 'liberal' and what 'neoliberal' stands for (it "combines the free markets of classical liberalism with the income transfers of modern liberalism"), the confusion of associating neoliberal policies with right-wing political views (since most European countries that have actually been the best neoliberal reformers were social-democratic Nordic countries like Denmark - all hail the Nordic model!), to the very substantial evidence on how the most adamant neoliberal reformers quickly caught up the lost growth of the previous decades, particularly in terms of income p/c. From Britain's success in Thatcher times (where it grew much faster in the 80-ies and the 90-ies than most other European economies), to Australia, Canada, Hong Kong, Singapore, Sweden and of course the US, all of which grew much faster than their relatively more statist counterparts. 

He also explains the problems of perception of and implementation of neoliberalism in Latin America and the transitional economies of the former Soviet bloc. One particularly important issue with transitional economies is an introduction of democracy (free elections) before establishing an effective rule of law and the judicial system (a mistake many of the Arab spring countries are repeating today - elections are not a sufficient condition for a democracy). Because of this, the privatization process in transitional economies became subject to distortions and criminalization, which is at the very center of the critique against neoliberal reforms in transitional economies - that they favor big capital and run over the 'little man'. This is far from the truth, as Sumner also points out: 
"A few years ago, I researched the relationship between cultural attitudes and neoliberal reforms among the developed countries. It turns out that, between 1980 and 2005, those countries with more idealistic or civic-minded cultures (as indicated by surveys on attitudes toward the common good and by indices of corruption) tended to reform their economies much more rapidly than countries with less civic-minded attitudes. Interestingly, Denmark has by far the most civic-minded culture in the group of 32 developed countries, and, as noted above, ended up with the least statist economic system in the Heritage's 2008 rankings (excluding the two size-of-government categories). Greece has the least civic-minded attitudes and ended up with the most statist economy in 2008. Far from being a right-wing plot to enrich corporations, the neoliberal revolution was liberal in the truest sense of the term: a rational response by idealistic policymakers to the increasingly obvious failure of statist economic models in the 1970s and 1980s."
Finally, the results are clearly visible today. More economic freedom (a model close to that of the Nordic economies) implies higher per capita income, i.e. higher living standards. It all comes down to incentives for wealth creation. If the country has build (reformed) its institutional system to support wealth creation, success will not be eluded (but it will always be a rough and long process - see here, here, or here)
Source: Sumner (2010) The Unacknowledged
success of neoliberalism, EconLog
This entire story reminded me of a text published on VoxEU a few months ago, measuring the long term impact and presence of economic liberty.

Here are the results (read about the methodology here):

Source: Prados de la Escosura (2014) Economic liberty in the long run:
Evidence from OECD countries. VoxEU
Observing this long run pattern of economic liberty one can't help at noticing a strong correlation between economic freedom and positive development patterns (higher growth, rising living standards, technological improvements etc.). Whenever economic freedom even slightly declined there were problems for societies. Naturally more research needs to be done to start inferring any causal relationship here, but intuitively it makes a lot of sense. 

Notice the huge drop in economic liberty between the two World Wars (particularly on the lower, bar graph; the period between 1910 and 1950 was characterized by a huge decline in free trade). This reinforces an argument I was making in my essays on democracy (see here, here and here) - back then the people blamed liberalism and laissez-faire capitalism in a desire to achieve an alternative to their existing pattern of democracy. However, that period remains as one of the darkest in the 20th century and arguably in human history. Particularly after the start of the Great Depression where the world emerged into protectionism and state interventionism. Economic freedom was wrongfully accused of triggering crises. 

In the 1960s and the 1970s the same pattern of state interventionsim reemerged, under fears that the Soviet bloc is winning the battle of ideas. However in the 1980s, as Sumner's text shows, the clear victor emerged. And economic growth and living standards once again skyrocketed. 

Sunday, 14 September 2014

Corruption and re-election: the curious case of Croatia

First of all apologies to my regular readers as there hasn't been a lot of blogging activity during the past two weeks. The reason for that is primarily my busy schedule as the academic year has started, in addition to a few papers I have in the review process, but mostly it was the media attention that has caught up with me lately. 

The reason for that was a research paper I did for the Croatian Banking Association on the topic of corruption in public procurement in Croatia and the relationship between local corruption and re-election (the research paper will be available soon on their website, and I'll post it on the blog as it happens; note: the paper is in Croatian - I do intend to translate it though). 

Almost all domestic media outlets (even the local ones) covered the story. After the main results of the study were presented in the monthly financial/business magazine Banka (where I tend to have more or less regular columns), all the major newspapers (Jutarnji list - the biggest domestic newspaper where the story made the cover last week, Vecernji list, Novi listSlobodna Dalmacija, Poslovni dnevnik), the most popular internet news portals (index, tportal), and even the national television (HRT) reported the story. Apparently corruption in Croatia is always a hot topic. 

The theory behind the idea

So what was the research all about? It was an empirical verification of a part of a model from my earlier paper Persistent electoral success with endogenous rents, where I theoretically made the case for long-lasting politicians in power. In addition I used the main findings of the selectorate theory by Bueno De Mesquita, Smith, Siverson and Morrow, to clarify my argument and turn it into a testable hypothesis. The basic idea is that politicians tend to create a stable, small coalition of supporters which enable them easy electoral victories and leave them virtually unaccountable to the general public. In that case the politicians in power no longer use public goods to satisfy the voters that brought them to power, but private goods they distribute to their cronies (coalition members) that keep them in power and who are simultaneously dependent of the politician for their continued rent-seeking. Even though this scenario more likely resembles a dictatorship rather than a democracy (where the small winning coalition of the dictator are usually the army generals), on a local level in democracies politicians can stay in power for decades without ever having any real accountability towards their voters. Bueno De Mesquita and Smith in the popular version of their argument (the book "The Dictator's Handbook") mention numerous examples of both autocracies and democracies where as soon as accountability and scrutiny are missing politicians get complacent and turn dishonest, regardless of the institutional setting surrounding them. This can happen in the United States (recall gerrymandering) as well as in any African dictatorship. After all the logic of political survival is always the same: stay in power! 

The methodology and results 

Using Croatian data on local level public procurement I was able to generate a testable hypothesis out of the theory, as I created eight proxy measures for corruption based on identifying suspicious and fraudulent procurement cases. I linked them across Croatia's local municipalities and cities and designed a measure of corruption as a ratio of suspicious procurement cases over total procurement cases. The term 'suspicious' was defined in many categories (companies with no employees getting vast sums of money in legal tenders, companies with profits from public procurement 10 times as much as their annual revenues, companies in losses getting indirectly financed by the government, etc.). 

The source of data are official government reports on procurement cases and companies involved in them. However they weren't openly available on any of the official government institutions, but had to be collected by independent activists aiming to increase transparency of the public procurement process (some of them received funding from the EU to support this cause). The years observed in the paper were 2009 and 2010, and the sample contained data on around 4600 cases across 300 municipalities and cities. This amounted to a total of 26bn kunas being observed (around $5bn), which is a quarter of all public procurement being done in those two years. There was a problem in creating the sample as a lot of the data wasn't suitable for linking the company with the procurement case they were involved in, since in many cases the key numbers (the financial ID of the company that needs to be reported in the procurement) were missing. This could imply that the sample actually underestimated corruption in public procurement, as the missing numbers could have been removed deliberately. 

Even in that case the results were outstanding. They even surprised me. I managed to show that the higher the level of corruption (the proxy for corruption at least), the higher the probability the politician gets re-elected (see figure below). However only up until a certain point where further corruption decreases the probability of winning. From eight measures of corruption that I made, six of them confirmed my hypothesis (the other two showed the same direction but weren't statistically significant). 


Basically this implies that voters do punish corruption but only if its exaggerated. According to the graph above (fitted values predicted from a logit model), after around a quarter of public procurement allocated in a suspicious way, the probability of re-election goes down. The politician gets thrown out of office only when he/she allocates more than half of the public funds in a suspicious manner (other things held constant). This suggests that the tolerance level the voters have for corruption is still way too high. 

The remedies 

Being able to calculate precisely how much a politician needs to steal in order to stay in power, I was risking of being accused to having provided the politicians a framework upon which they may operate. However they knew this without my research - after all that's how they managed to stay in power for all these years. 

Nonetheless I needed to make a series of normative implications and reform proposals aimed at reducing the scope of local corruption in Croatia. My first immediate reform was to introduce a term limit for local politicians (a maximum of two terms in office, i.e. 8 years). This way we can immediately get rid of all those politicians who are in power for over a decade and have created a corrupt, crony system centered around them. Simultaneously with the term limit electoral rule, the number of local municipalities has to be reduced, or more precisely we need to increase the number of voters necessary for electing the politician into office. This goes directly in line with the selectorate theory and increasing the minimum winning coalition. In many local municipalities in Croatia it takes a few hundred voters to get re-elected. By increasing the size of the municipality, we put the politicians in a completely new environment thus destabilizing their currently held concessions. 

However implementing the two reforms won't necessarily solve the problem. Eight years can be more than enough to build a corrupt system and a cronyist network of supporters (after all the term limit political economy literature suggests that when politicians are facing their final term in office they tend to steal more; see Besley, 2006 and Ferraz and Finan, 2011), while operating in a new environment is only a temporary setback to which the politicians can quickly adjust. This is why a third reform is crucial, and should also be applied simultaneously. In the next phase of the research I intend to construct an index of local corruption in Croatia ranking the cities and municipalities from the most corrupt to the least corrupt. This way it could be easy to adjust the flow of funds from the central government budget to the local budgets on the basis of their corruption rankings. Those on the bottom of the list get no money from the central budget (these funds contribute to around a fifth of the local budget). This will then send a clear signal to the voters that because of their local politician being corrupt they couldn't afford to solve some of the local problems they tend to encounter on a daily basis (garbage disposal, schools, kindergartens, hospitals, basic infrastructure, etc.). By having this information the voters will react and vote the politician out of office. 

All three reforms must be applied simultaneously. Exposing the corrupt practices of current local politicians may not yield them out of office as they still have a strong support group backing them in their municipality. However after throwing them out via a term limit, the new politicians won't have this luxury. They will immediately be prevented from engaging into similar corrupt actions. Such reforms, if implemented correctly, will become irreversible as the voters would possess more knowledge and demand more accountability and transparency. It will be impossible to remove this right from them in a democratic society.