Saturday, January 29, 2005

Socialism at the Office

Stumbling and Mumbling thinks that left-wing ideas about economics have "lost" and wants to turn that around. He's "sick and tired of getting the impression that leftism and economic illiteracy are coterminous." Unfortunately, he then writes the following:
1) Answer the question: why exactly do we want redistribution?.. 2) Recognize bounded rationality – and use it... First, it gives us a reason to oppose capitalist hierarchies in the workplace. We all know a centrally planned economy is a stinking idea. So why is a centrally planned company a good one? 3) Face the facts – markets work. Markets are the least bad mechanism we have for allocating scarce resources. Many of the problems the Left associates with markets are not, strictly speaking, problems with markets per se. Instead, some – such as the insecurity they bring – are the result of missing markets.
Some good points here, but also some bad ones. First the bad.

Recognize bounded rationality – and use it

The standard left wing use of bounded rationality (sometimes called Behavioral Economics, but not here I think) is to argue against markets. If individuals are not rational actors, the argument goes, how can markets be efficient? Among other things, this argument fails because the alternative to markets, committees, are also made up of non-rational actors.

The author's point is different -- he's arguing against central planning and companies are the epitome of central planning. Of course, this apparant paradox has been spotted by economists as well, U Chicago Nobel Prizewinner Ronald Coase wrote about exactly this in The Nature of the Firm. Wikipedia does an OK job at explaining Coase's ideas:
The Nature of the Firm is a brief essay in which Coase tries to explain why the economy is populated by a number of business firms, instead of consisting exclusively of a multitude of independent, self-employed people who contract with one another. Given that "production could be carried on without any organization [i.e. firms] at all", Coase asks, why and under what conditions should we expect firms to emerge?

Since modern firms can only emerge when an entrepreneur of some sort begins to hire people, Coase's analysis proceeds by considering the conditions under which it makes sense for an entrepreneur to seek hired help instead of contracting out for some particular task. The traditional economic theory of the time suggested that, because the market is "efficient" (i.e. those who are best at providing each good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire. Coase noted, however, that there are a number of transaction costs to using the market; the cost of obtaining a good or service via the market is actually more than just the price of the good. Other costs, including search and information costs, bargaining costs, and policing and enforcement costs, can all potentially add to the cost of procuring something with a market. This suggests that firms will arise when they can arrange to produce what they need internally and somehow avoid these costs.

There is a natural limit to what can be produced internally, however. Coase notices a "decreasing returns to the entrepreneur function", including increasing overhead costs and increasing propensity for an overwhelmed manager to make mistakes in resource allocation. This is a countervailing cost to the use of the firm.

Coase argues that the size of a firm (as measured by how many contractual relations are "internal" to the firm and how many "external") is a result of finding an optimal balance between the competing tendencies of the costs outlined above. In general, making the firm larger will initially be advantageous, but the decreasing returns indicated above will eventually kick in, preventing the firm from growing indefinitely.
But it is true that firms are a centrally planned environment, and anyone who has ever worked in a firm or consulted to one knows what a bureaucratic, whimsical, heirarchical, insane they are. If capitalism is a mall -- anonymous transactions where you are free to do as you please, everyone is trying to be nice to you, and their ability to please you determines their success or failure, then socialism is definately the firm -- group decision making, consensus unless someone pulls rank, bureaucracy, politics, susperstition. Makes the choice easy.

Now for the good points:

Face the facts – markets work. Markets are the least bad mechanism we have for allocating scarce resources. Many of the problems the Left associates with markets are not, strictly speaking, problems with markets per se. Instead, some – such as the insecurity they bring – are the result of missing markets.

I think a key aspect of this is housing. Look, everyone needs a house in a way everyone does not need IBM stock, so we are born short housing but neutral IBM stock. I mean that people who don't own anything nevertheless have a short position on housing (will be hurt if prices rise), and owning a house actually makes one neutral on real estate (if prices rise you are richer, but other houses cost more too, so your gains will just be eaten up by your next purchase).

The goal of every young person should therefore be to put money into housing until one gets neutral, probably through some sort of local, regional, or national residential REIT. Robert Shiller, whom I met at Chicago, has similar thoughts on our current housing bubble
[Robert Shiller] has now added a chapter on real estate to his book and is also launching a company that will sell futures allowing people to hedge against movements in housing prices in a given city.

NEWSWEEK: What can you say about your outlook for housing prices. Is it a bubble?
Robert Shiller: I’m not objective any more because I will have a financial interest [when the new company is launched]. I can’t be objective so I won’t say. If people talk about a bubble, they think in terms of deflating or bust. But the real question is, how it will look longer term? As I’ve said in the past, I don’t think housing prices will be higher five to 10 years from now.


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