Fettering the Markets

Vince Cable recently said that corporate behaviour was murky, bankers were greedy, capitalism was a competition-killer. Well, Mr. Cable gets certainly no points for eloquence, yet there was nothing particularly offensive about the substance of his remarks. We have known for a long time that unfettered markets do not deliver the social good. So, why is there such a huge backlash from the city and the media.

Through the history, unfettered markets have delivered the society to disastrous consequences. Slavery being the best known example. We associate prosperity with a government that has a strong fiscal capacity (ability to tax and spend) and an ability to deliver market supporting public goods, i.e., regulate the markets effectively so that they deliver the social goods. (Besley and Ghatak, 2001, 2003)

There seemed to have been a surprising back lash at what Mr. Cable said. What surprised me was how organised and orchestrated it seemed. Mr. Cable’s tone was certainly irreverent and emotional. After all, why bring the words murky, greed and capitalism into it. But to understand the precise reason for the backlash, we have to think of the role regulation plays in maintaining market competition in the services industry.

Regulating the services sector (banking, law industry etc.) is not easy. The services sector produces an output that has significant information problems associated with it, i.e., the consumers are not able to assess the quality of the good before buying it. The information problems are circumvented by the service producers developing reputations for producing reliable services. Cost of acquiring reputation is often steep in these industries. This makes entry into these markets become extremely costly and the industry naturally gravitates towards a monopolistic competition environment.

In a monopolistic competition environment, the firms pays an upfront fixed cost to the enter the market before it can start producing in the market. The fixed cost could be the cost of setting up the factory, the cost of acquiring the correct permits, cost of researching and developing a particular product or the cost of acquiring a reputation for reliability. The size or the volume of the markets and the fixed cost of entering the market together give you the number of firms that the market would be able to support.

In the services sector, given the problem of reliability, the up front fixed cost is often the cost of acquiring the reputation. An entrant that does not have sufficiently deep pockets would not able to enter such a market. See Banerjee and Duflo for an excellent study on the software sector in India and specific cost of developing reputation in this sector. (A. Banerjee and E. Duflo, 2000)

Does monopolistic competition deliver the social good for the society? The answer is a definite yes. There are a lot of sectors that have monopolistic competition and deliver the social good.

But, there is another level of complication here. What is the relationship between regulation and cost of acquiring the reputation. Regulation reduces the cost of acquiring reputation. If the firm meets the regulatory requirements, the consumer does not have to worry about the reliability of the firm.

If the regulation is sufficiently stringent, the significance of regulation decreases driving down the cost of entry. As the fixed cost of entry decreases, there are more players in the market and price of output decreases as a direct result of a lower initial fixed cost that needs to be recovered by the firms. With monopolistic competition per se, the firms are not really able to charge any kinds of rents. The price of the output is sufficiently higher than the variable cost so that it allow the firm to recover the initial fixed cost.

When does monopolistic competition become bad for the society? Essentially, this happens when the firms in the economy are able to collude with each other and influence the regulation that effects that sector. Think of the political economy of regulation. If the market incumbents are able to influence the regulation, what kind of regulation would they like. They would like to drive up the potential cost of entry into the market. This would ensure that only the collusive incumbents remain in the market. If the set of incumbents are stable, their ability to collectively influence the policy becomes greater over time, leading to a vicious circle.

The are many ways to drive up the fixed cost of entry. You could burden the firms that are entering the market with all kinds of regulation that put the new entrants to a disadvantage compared to the incumbents. The most extreme case of this was the “license raj” in India till the mid 80s. The firms had to obtain a license to produce. The regulators (bureaucrats and politicians) would compare the payoffs from the new entrants and incumbents before deciding on the license. Over time as the incumbents grew strong, the new entrants found it difficult to outbid the incumbents and the entry virtually stopped in the market. The oft quoted example of this is the car industry in India, where for decades there were only two players in the market. The market over time grew so lucrative that the government itself entered into the market as the third player in the early 80s.

Of course, if the quality of particular output is not obvious from the start, only firms with reputation for reliability would be able to operate in that market. In that case, lowering the regulation may prove of beneficial as it increase the need for reputation and increases the fixed cost of entry into the market. Thus, counter-intuitively, in these markets, the incumbents could argue for lower regulation.

Ironically, by singing praises of free markets, the services sector has limited the number of players in the market and ensured lack of effective ex post competition. This has been a two-pronged strategy. The first strategy has been to influence the regulators directly and convince them that there is no need for regulation. The second strategy is to build a narrative for the society through an extensive media campaign. In both cases, these market fundamentalist are using the using the free market slogan to effectively reduce the competition in the market.

Vince Cable’s observations were not off the mark. He of course underestimated the ability of the service sector incumbents to use the media to discredit anything that deviates from the narrative. It is indeed puzzling that four decades on after Akerlof’s lemon’s paper, we as society still think that free markets work and anybody who interferes with it is evil. (Akerlof, 1970)

As a society, collectively empowering our regulators to deliver the social good is extremely important. We often talk of regulators that are influenced. The bigger problems is that the society can collectively be influenced by vested interests to think that unfettered markets are always good for us. It is thus extremely important for the social scientists to challenge the free market slogan and explain the precise caveats the markets come with.

References:
A. Banerjee and E. Duflo (2000). Reputation effects and the limits of contracting: A study of the indian software industry. Quarterly Journal of Economics, 115(3):989–1017.

T. Besley and M. Ghatak (2003). Public goods and economic development. Prepared for Policies for Poverty Alleviation (ed.) Abhijit Banerjee, Roland Benabou, and Dilip Mookherjee.

T. Besley and M. Ghatak (2001). Government versus private ownership of public goods*. Quarterly Journal of Economics, 116(4):1343–1372.

G. Akerlof (1970). The market for” lemons”: Quality uncertainty and the market mechanism. The quarterly journal of economics, pages 488–500.

Spatial Peer Effects Among Children

First day of the Econometric society World Congress meeting. Interesting paper by Helmers and Patnam this morning. The paper tries to disentangle peer effect of and common (covariate) effects on children’s reading and writing achievements. The paper was interesting because it was using networks to disentangle these effects and not through the usual experimental framework. It is a neat idea. Using the Young Lives survey from Andhra Pradesh, the paper maps spatial (strictly geographic networks). Then it uses the networks to identify the the clusters. Certain individuals have multiple links within the clusters whereas certain other individuals are linked to the cluster through just one link. This variation allows the authors to identify the peer effect. They also look at the insurance component of the peer group. For this, in a really neat trick, they use idiosyncratic shocks are IVs.

The paper is very useful and shows us that we can use observation data and social network maps to disentangle various effects. Of course, it takes the spatial network as given. It may (may not be) be a reasonable assumption. After all, there may be some strategic relocation by the household. The other caveat is that it does not map the network completely. The network mapped (or the information available) is only for the children’s spatial peer network. The paper is not able to distinguish the effects that run through the children’s peer network from the effects that run through the adult’s network. In spite of these caveats, I really like the paper, not for what it is right now, but more for what it maybe lead to.

Looking forward to John Moore’s presidential address this afternoon. The title of the talk is contagious iliquidity. Very topical and may have a flavour of his credit cycles paper. I am sure it is vintage John Moore stuff. Entertaining with lots of stories involving red and blue stuff. More on Moore later on in the evening.

Reference:
Christian Helmers and Manasa Patnam. Does the Rotten Child Spoil His Companion? Spatial Peer Effects Among Children in Rural India

Progress in Rwanda

Just read an interesting account of Rwanda 16 years on from the ethnic conflict that brutalised and fractured the civil society. The visible progress that Rwanda has made is note worthy and impressive. The economic growth, albeit from a low base, has led to the incomes tripling in the last 16 years. There is considerable interest from the global business community in the country. The question is whether economic progress can reduce the probability of future violence in the country or may actually increase the probability of violence. We need a framework to think about this.

Lets take the tunnel effect described by Hirschman and Rothschild (1973). If you are sitting in the a traffic jam in a tunnel and you suddenly find that that the other side starts moving, you get excited thinking that the movement indicates that things are getting resolved and you would move soon as well. If the other side keeps moving and you are stuck, frustration increases and may reach a boiling point where you decide to crash you car and stop the other side from moving. This describes the aspect of political violence seen across the world when the economic gains are concentrated and not shared widely.

Lets look at it from Krugman’s “History versus Expectations” perspective. Krugman shows that equilibrium could either be determined by either historical factors or by the expectations of the future. The shared history in the tunnel example is the fact that you got stuck with your fellow passengers in the tunnel. The shared expectations is the based on the information you have about when things would improve. Whether the shared history or the shared expectations determine the outcome depends on which one dominates. The information you have about what the future has in store comes from the movement of the vehicles on the other side. At first when the vehicles start moving, the shared expectations of the problem getting resolved very soon dominates. As the other side keeps moving and you remain stuck, your and your fellow traveller’s expectations about the future changes, leading to either a small subset crashing their car to stop the other side from moving.

There is an obvious behavioural explanation for why stopping the other side from moving increases you perceived utility. There is also an non-behavioural explanations, which comes from the membership of social networks or communities. Social networks or community ties emerge as a way to facilitate the societies’ activities in the absence of a wider effective government and functioning markets. It solves the information and enforcement problems associated with public goods. An effective government can make the need for these social ties obsolete by providing the public goods and access to market. In the absence of the public goods and markets, need for social ties increases. There is clear relationship between the strength of social ties and acess to markets and public goods. The members of a community choose the investments they make in social ties given the state of effectiveness of government. Given a weak or absent state, crashing the car may be the investment that community members are required to make in order strengthen their own social ties and in turn strengthen their social identity. There are interesting papers from across the world that show that local public goods provision is easier in the areas where the ethnic diversity is lower. (Alesina, Baqir, and Easterly, 1999) I am not aware of papers that take social ties as endogenous and show that the strength of these ties depends on other exogenous factors, which in turn leads to government’s effectiveness in providing public goods and market access.

The solution to ethnic violence lies in an government’s ability to co-ordinate the respective communities’ expectation about the future. This needs to be done in such a way that gains from the future economic progress outweighs the problems of the past. The incentives should be such that there is no gains for even a small sub-group to under-take the violent route. People speculate that it was economic progress both in Ireland and United Kingdom that led to the Northern Island conflict getting resolved. Of course, the expected gains from future economic progress needs to be sufficiently wide spread for this to happen.

In Rwanda’s case, it would be interesting to see whether the progress hitherto has resulted in the benefits from the economic growth of the last 16 years being concentrated in the urban areas where the emerging middle class live or it has had a wider impact in the country. It would be important to get a sense of what different part of the Rwandan society expect from the future. Kagame certainly seems to have improved the public goods in the urban areas but the relevant question is whether his government has allocated sufficient public funds to improve the public goods and facilitate access to the markets in the rural areas?

One obvious way to eliminate the source of the past conflict is for the government to act as a co-ordination device and to dramatically increase the future economic gains from peace so that the groups collectively choose the peace strategy over the violent strategy. So, the future equilibrium can be driven by expectations and overwhelm the difficult history in the country. The government needs to ensure that expectations starts dominating the history in Rwanda.

With this in mind, it would be very interesting to see how the incomes, pubic goods and market access have fared in the rural countryside across the country. Actually, looking at the micro data it may be possible to predict the future trouble spots, if any. Gujarat was racked by politically motivated violence along religious lines in 2001. Pande, Field, Levinson and Visara (2008) is a interesting retrospective econometric study that carefully looks at the pattern of violence in Gujarat’s capital city, Ahmedabad. It explains that pattern of violence in the terms of historical economic factors, i.e., neighbourhood’s proximity to derelict textile mills. The subtext is that historical economic shocks determined the pattern of violence in the city.

Recent Articles in the Press:

Rwanda’s other genocide, Foreign Policy, 2 September 2010.

Revisiting the killing fields, Economist, 2 September 2010.

References:

A. Alesina, R. Baqir, and W. Easterly (1999). Public goods and ethnic divisions *. Quarterly Journal of Economics, 114(4):1243–1284. Link.

Albert O. Hirschman and Michael Rothschild (1973). The Changing Tolerance for Income Inequality in the Course of Economic Development. The Quarterly Journal of Economics, Vol. 87, No. 4 (Nov., 1973), pp. 544-566. Link.

Paul Krugman (2001). History Versus Expectations. The Quarterly Journal of Economics, Vol. 106, No. 2 (May, 1991), pp. 651-667. Link.

Rohini Pande, Eric Field, Matthew Levinson and Sujata Visara (2008). Segregation, Rent Control, and Riots: the Economics of Religious Conflict in an Indian City. American Economic Review Papers and Proceedings, May 2008, Vol. 98 (2): pp. 505-510. Link.

Naxal Violence in India

There was another naxal attack in Chhattisgarh today. The naxal violence has had a secular upward trend in the last couple of decades. The violence has also spread geographically. The government response has often been local, confined to the state governments. There has never been a coherent national strategy to deal with the naxal violence. This may partly be due to the fact that policing is a state subject and the problem by default is percieved to be a law and order problem. Historically, the central government gets only involved once the political conflicts in the country become significant enough to start having impact beyond the boundaries of the state in question. Home Ministry, the ministry responsible for internal affairs in India is a fairly opaque body with very little accountability. It controls the country’s resources for policing yet tends to not consider itself accountable for any lapse that may occur. The national strategy for most political conflicts in the country have had a predictable cycle where it is initially perceived to be a law and order problem for almost a decade before the government starts thinking of political solutions.

The response to the recent upsurge in the naxal violence has been mainly a militaristic on, both at the level of state and central government. The chattering classes seems to be of the opinion that it is a problem that needs a political solution. Yet, the response hitherto seems to be mainly in terms of increasing the resources allocated to the police marginally. Since the naxal problem has been perceived as a law and order problem by the government, the responsibility of dealing with it has fallen on the police by default.

Lets look at pattern of violence. It is clear that the naxal violence is confined to the tribal areas in India. By no means all tribal areas have been affected. The pattern seems to be that in the afflicted states, the intensity is much greater in the tribal areas. Further, the newly formed states like Jharkand and Chhattisgarh have bore the brunt of the naxal attacks in the recent years. These are states that were formed in 2000 and thus are just 10 years old. It is possible that when the boundaries of the new state were being drawn, the bigger states parted with under-developed areas more easily. The bottom line is that the government in these new states are less effective administratively as well as less muscular than in states with longer history.

Further, the naxal violence dominates the mining belt. Mining is a significant proportion of India’s export basket. Mining requires land acquisition and it is not difficult to imagine that the unfairness in land acquisition maybe be one of root causes of the naxal violence.

Moving on from root cause, it is useful think about the organisational structure of these organisation. It seems that there is a very dedicated upper management cadre that guides the naxal movement. What is also striking is that there is no branding in terms of the name. There seems to be significant amount of decentralisation in the actual execution of the violence. At the local level, there seems to be a local coalition of people, some with clear criminal intent, that seems to act like the psuedo-state at the local level in the absence of effective local government machinery. This local coalition seems to get material support from the upper management, yet it does not have the rigid organisational structure that we associate with terrorist organisation in the 70s and 80s. As a result, the movement can lose the local organisational structure and yet preserve its upper management that goes on to create other local organisation structures. Peter Bergen in his 2001 book Holy War, Inc. claims that it is exactly the strategy made it so difficult to penetrate Al-Qaeda. He claims that in Al-Qaeda information flows down but does not flow up. As a result it is very difficult to the pin down the upper management of Al-Qaeda.

The other interesting element seems to be that hitherto the funding for the naxal movement has been very local. There is no evidence as yet that there is any flow of resources either from outside the India or from institutions within the country. The arms naxal movement uses are the ones captured from the police. In their attacks, they have often targeted places which would give them access to resources that they can use to perpetrate more violence. Recall the attack on Nalco’s Daman Jodi mines in 2009.

The current militaristic strategy seems futile. The strategy seems to be take on the problem locally through policing. Yet, it seems that breaking down the naxal coalition will involve the empowering the local administration and making them accountable to the local population. Of course that is easier said than done. Further, there needs to be some kind of national strategy that fights the problem both locally and nationally. The problem can be fought locally by strengthening the local administration through a combination of the state and non-state actors. The non-state actors could be given the responsibility of providing public goods. The state actors along with the local community become monitors and give signals that have an impact on the payoff to the non-state actors. Bolivia, through its social funds has implemented this kind of decentralised problem quite effective (See Faguet, 2004).

Of course, this on its own would not be enough. In any peaceful society, the state has a monopoly over violence. How peaceful the society is depends on how judicious the state is in using violence. The upper management of the naxal movement are competing very hard with the government to take over this role by using violence judiciously to protect the local population. Breaking down the upper management is critical, with the understanding that if the problems at the local level are not solved, a new upper management cadre would come up very soon to the replace the old management cadre.

Reference:
Bergen, Peter (2001). Holy war, Inc.: Inside the secret world of Osama bin Laden. Free Press.

Faguet, Jean-Paul (2004) Does decentralization increase responsiveness to local needs?: evidence from Bolivia. Journal of public economics, 88 (3-4).

Education and threshold effects

According to Malcolm Gladwell, to make it big you have to put in 10,000 hours. This is irrespective of any profession. It is a bold claim and has got me wondering. Can anyone put in 10,000 hours and expect to succeed. Or does it depend on certain other factors as well. And if so, what are these other factors?

First of all, it should be clear that Malcolm Gladwell seems to be reporting what he has observed from looking at the lives of the people who have succeeded. He is not counting the people who put in the 10,000 hours and did not make it. These are the invisible people who are difficult to find. Further, he is presumably talking about highly skilled people with sufficient human capital. After all, it would be very difficult to imagine that an unskilled worker can make it big by putting in 10,000 hours. There are hundreds of millions of unskilled workers across the globe that have put in 10,000 hours and yet remain poorly paid with no significant chance of progress in sight. If we were to believe the premise, the relevant question is what are the prerequisites that need to fulfilled before 10,000 hours start counting.

Lets think of this in the context of the debate on whether the quality of education counts. Does a good teacher have a positive impact on the students. The fadeout effect has always puzzled the economist. The impact of good quality education in kindergarten fades out as the student’s grade drop to average level. Chetty et. al. (2010) look at this using data of 12,000 children from a well know Tennessee education experiment Project STAR which randomly assigned students to kindergarten classes. Some classes did better than others but this effect disappeared by the high school. Surprisingly, the initial positive effect revisits in later years. Students that did better in kindergarten were more likely to go to college, less likely to become single parents, more likely to save for retirement and earn more.

The study does illuminate the contribution that educators and schooling environment makes. What it does not tell us how it affects it. Does it give each person a step up jump or does it increase the amount a person can extract from a given set of fortuitous circumstances. It also leaves me wondering if there are threshold effects. To put it more specifically, does the income increase with quality of education through at level effect or does it have an affect through various interaction terms. Further, are these effects continuously increasing in the quality of education or are there thresholds beyond which earning jumps suddenly.

These questions are very important from a policy perspective. If there are threshold effects, then providing education that does not reach the threshold is infructuous. This maybe a the story of a lot of education. It may also explain why systematically poorer people across the opt out of education. The returns to education do depend on other factors like health, public goods, infrastructure, economic activity and credit markets. These are factors that are all inter-connected and conspire together to provide an environment where the returns from education are high or low. This in turn determines whether markets can be used to deliver education or not. If returns are very high and people have an ability to pay, then the schooling can provided through the market. People would pay for the schooling in anticipation of high future earnings. People would be able to pay either if they (or their parents) have sufficient wealth or people can borrow against their future earnings. When the factors conspire to keep the earnings from education low, the state (government) needs to take the burden of education. Education here maybe helpful socially because of its external effects but individuals may not have the incentive to acquire education. This in turns leads to the vicious circle which keeps areas poor persistently as people do not have the incentive to acquire education and economic activity is limited due to low average level of education in the area.

One cannot think about education without thinking about it in terms of quantum as well as its interaction with other factors in the local economy. These links are complicated and it is not surprising that even though there is a large literature that shows education’s impact in micro studies, its impact in macro studies is yet to be discovered.

Reference:
Raj Chetty, John Friedman, Nathaniel Hilger, Emmanuel Saez, Diane Schanzenbach and Danny Yagan (2010). How Does Your Kindergarten Classroom Affect Your Earnings? Evidence from Project STAR.

Solow’s take on DGSE

Solow writes an interesting piece on deficiencies of DGSEmodels in giving us insight about the economy. He points that since the economy is populated with “representative agents”, these models do not take into account the strategic interaction between the agents in a realistic way. The fact that these models are not able to give us a decent explanation for unemployment is particularly striking.

2009 Nobel Prize in Economics

Here is something I wrote last year about the work of Elinor Ostrom and Oliver E. Williamson, the 2009 Nobel prize recipients in Economics. Link.

Food prices in India

There has been an fairly sharp increase in food price inflation in the India in the last one year. The politicians are busy trying to strengthen the public distribution system to bring the food price inflation under control. It would be a miraculous if that has any impact on the food prices.

To hone in on the source of the inflation, it would be useful to examine the issue that affects the supply and the demand for food. Even though the urban(e) India seems to be sceptical about NREGA, it is potentially a radical change as far as the poorer half of India, geographically concentrated in rural parts, is concerned.

Guaranteeing 100 days of labour for everyone raises the reservation wage (the best alternative) and thus should impact the rural or agricultural labour market. Faced with higher labour costs, the land-owning farmers may either reduce or change the pattern of food production across the country. It is too early to pin down the new pattern of food production in the country. Though, this could be a potential supply shock for the food market in the country, pushing up the prices.

On the demand side, we know that the food elasticity of income is very high for the poorest of the poor. We also know that the very poor tend to derive their calorific intake from staples like cereals or lentils. As income increases, they diversify their intake and move towards the nutrient rich foods like vegetable, milk and meats.

NREGA’s affect on the demand side is two folds. It increases the labour endowment of the poor unskilled workers. It also reduces the income uncertainty for the poor by giving them a steady predictable employment for 100 days in a year. Given the high income elasticity of food, we would expect this to increase the demand for food across the country.

Food demand could also be impacted by the 6th Pay Commission — the body that determines the salaries of the all the central and state government employees in India. The 6th Pay Commission, like its predecessor, has been extremely generous. These generous payoff to hitherto relatively impoverished government employees has been financed by a ballooning budget deficit.

Inflation being confined to mainly food is unusual and the high income elasticity of food for the poor maybe useful in providing an explanation for this phenomenon. Would be interesting to see how this pans out. What is certain is that with the price rise, the relative prices for staples and cash crops has changed dramatically and would lead to radical changes in crop pattern across the country in years to come. Interesting times.

Howard Davies in Delhi – speaking on Financial Crisis

Who could resist such a title. Howard Davies was speaking in Delhi on the 9th. And the title was Financial Crisis: Who is to blame?

Howard Davies has been a regulator (as the head of FSA) as well as a central banker (Deputy Governor of Bank of England) in the last decade. I went hesitantly, bracing myself for the kind of mind numbing defence of their respective roles we have seen from the likes of Greenspan and Bernanke off late. What I instead encountered was a really pleasant mannered man, who took a fairly comprehensive look at the past decade.

Ken Rogoff’s article

Ken Rogoff’s article on future government policy for the economies dealing with the recession.