Econ 450

Tag: Econ 450

Nobel Prize Agency

Oliver Williamson, Physicist?

This year’s Nobel Memorial Prize in Economic Sciences once again goes to some folks doing the heavy lifting on organizational theory.   You may recall that not too long ago, Elinor Ostrom and Oliver Williamson shared the award for their work on “governance mechanisms” — Ostrom on collective governance of natural resources, Williamson for organizational structure.

This year’s winners are Oliver Hart from Harvard and Bengt Holmström from MIT for their work on “contract theory”.    Contract theory is pretty encompassing, and includes the classic “principal-agent” problem, along with the “incomplete contracts” problem.

For the uninitiated, An agency problem arises when you as a principal delegate a task for some agent to carry out for you.  For example, you might own a business and hire someone (or someones) to work for you. That seems simple enough, except things can get all mucked up if output comes from a combination of effort and random factors, if you have several workers and can’t figure out who’s responsible for what (team production), if your workers have a bunch of things to do (multiple-task agency problem), and a host of other things.

Hart and Holmström have made fundamental contributions in getting to the heart of some of these matters, and were duly rewarded with the prize. Remarkably, Kevin Bryan from University of Toronto says that though Hart won the prize on the back of his contributions to “incomplete contracts,” he actually has not done much on incomplete contracts since two other Nobel winners — Eric Maskin and Jean Tirole, characterized the limitations of that approach:

Hart’s response, and this is both clear from his CV and from his recent papers and presentations, is to ditch incompleteness as the fundamental reason firms exist…. To my knowledge, Oliver Hart has written zero papers since Maskin-Tirole was published which attempt to explain any policy or empirical fact on the basis of residual control rights and their necessary incomplete contracts.

Professor Bryan has remarkably prescient characterizations of Hart and Holmström‘s work A Fine Theorem blog (incidentally, he often has excellent review and commentary on recent IO papers).   The post on Hart is essentially a short history of the economics of the firm and organizational economics, which many of you will be seeing next term in Econ 450.    There are a million other descriptions of their contributions (google it), including this critical piece by Arnold Kling.

And, congratulations to Milhouse!   Well done.

A Principled Agent?

As I wrapped up Econ 450 today, I told the class that the basic theoretical frameworks, including agency theory, should continue to pop up for as long as we both shall live.  And here, from Wired, we have an agent (allegedly) trying to bilk the principal.   The players should be familiar.

The Obama administration accused Sprint today of overcharging the government more than $21 million in wiretapping expenses…

Sprint… inflated charges approximately 58 percent between 2007 and 2010, according to a lawsuit the administration brought against the carrier today.

The Agent says it was just doing what it was told:

Under the law, the government is required to reimburse Sprint for its reasonable costs incurred when assisting law enforcement agencies with electronic surveillance,” Sprint spokesman John Taylor said. “The invoices Sprint has submitted to the government fully comply with the law. We have fully cooperated with this investigation and intend to defend this matter vigorously.”

It seems that the Principal gave the Agent plenty of opportunities:

According to records, the number of domestic federal and state wiretaps reported in 2012 increased 24 percent from the year earlier. Overall, a total of 3,395 wiretaps were reported in 2012. Of those, 1,354 were authorized by federal judges, and 2,041 by state judges. The number of federal orders jumped 71 percent. State orders increased 5 percent.

Economic Organization of Lawrence University

Oliver's Army

On Monday night students in the Economics of the Firm class (Econ 450) will be showing off their work on the economic organization of Lawrence University.  You can check this out in Briggs 223 on Monday at 6 p.m.  I am impressed with the quality of the students in this course, and I am confident that they will put on a good show.  If you aren’t careful you might even learn something about LU. Indeed, this should be of interest just for the descriptive statistics.

‘Selling’ Yourself Short?  The Promise and Pitfalls of Income-Contingent Loans:  With graduation just a few days away for the Lawrence University class of 2012, the time has come to embrace a looming reality: college loans.  Most of us have them and they need to paid back.  According to, more than 65 percent of four-year undergraduate students in America take on debt in the form of government and/or private loans to finance their education.  Loans are generally issued by institutions or individuals with available money in return for a premium in the form of a fixed interest rate.  An alternative option exists, however, whereby students instead offer investors a share of their future earnings, similar to the capital-raising efforts employed by firms.  The idea is by no means new; in fact, Milton Friedman advocated the use of income contingent loans in 1955.  Our project explores the benefits and concerns associated with issuing equity to finance education and analyzes whether this alternative option is viable for Lawrence University.  We will discuss the adoption of an income contingent loan program at Yale University in the 1970s to provide an experiential understanding of this practice. (David Caprile, Oscar Koberling, Rana Marks, Stuart Smith).

Are Excess Endowments a Problem? Monitoring and Agency Problems among the Associated Colleges of the Midwest   Economic discourse on the theory of the firm developed while trying to understand the for-profit firm; however, the last few decades have witnessed an increase in research on the not-for-profit  firm.  There is considerable variability among the two categories, for-profit and non-profit.  One intriguing non-profit is the university.  Unlike most non-profits and all for-profits, universities keep large cash surpluses.  The reason for these large endowments has remained a puzzle (Hansmann 1990)  One proposed explanation for large endowments is agency problems.  We draw on data from a pool of small private liberal arts colleges to examine the relationship between “excess endowments” and high monitoring and agency costs. (Molly Ingram, Regina Hammond, James Maverick).

Why Does Lawrence University Have So Many International Students? Lawrence University has the highest percentage of international students of any college in the Associated Colleges of the Midwest.  Indeed, the percentage of Chinese students on campus is higher than the percentage of all international students at several ACM schools.  The “awkward” economics of higher education suggests that “colleges can buy important inputs to their production only from the customers who buy their products; colleges  buy important inputs to their production only from the customers.” Lawrence procures these inputs by providing generous financial aid,  lower initial deposits, and through other avenues.  In turn, international students help provide language instruction, promote campus diversity, and contribute significantly to campus cultural activities.  Our regression results are consistent with our contention that LU has an unusually high percentage of  international students. (Linlin Liang, Yue Jia, and Zhan Guo).

Food catering services: Dine in or dine out? This project looks at data collected from 100 top liberal arts colleges ranked by U.S. News and World Report to determine factors that contribute to college’s food services make- or-buy decision.  Consistent with the empirical work on make or buy decisions (e.g., Monteverde & Teece 1982; Joskow 1987, Anderson & Schmittlein 1984), we examine potential conventional microeconomic as well as transaction-cost theories for Lawrence’s recent outsourcing of food services.  We provide logistic regression on outsourcing as a function of based on endowment size, campus acreage, size of the student body, location relative to urban areas.  (Max Randolph, A.S. Darling, Andrew Kraemer, Brian Zindler).

Interview with Ronald Coase

Nobel Laureate Ronald Coase is foundational in both of my courses this term.  His 1937 paper, “The Nature of the Firm,” addressed the canonical question for organizational economics, and a mere 23 years later in 1960 he altered the trajectory of social science research with “The Problem of Social Cost.”  As Coase puts it:

Transaction costs were used in one case to show that if they were not included in the analysis, the firm has no purpose, while in the other I showed, as I thought, that if transaction costs were not introduced into the analysis, for the range of problems considered, the law had no purpose (p. 62).

Now he’s back pounding the pavement in support of his new book, How China Went Capitalist.  We spoke of his op-ed in the WSJ, and now here is an interview with him on NPR.

The interview is mostly a review of his career, including the famous lighthouse debate.

Happy Birthday Professor Coase

The intellectual founder of transaction cost economics, Ronald Coase, turns 100 today.  Coase is best known for two papers: “The Nature of the Firm” in 1937 and “The Problem of Social Cost” in 1960.  Both are about the importance of transaction costs.  The former shows that without transaction costs the firm doesn’t matter, and this serves as the starting point for Econ 450.  As The Economist‘s Schumpeter blog points out:

Today most people live in a market economy, and central planning is remembered as the greatest economic disaster of the 20th century. Yet most people also spend their working lives in centrally planned bureaucracies called firms.

Certainly, this has had a profound impact on organizational theory and industrial organization.

The latter paper shows that without transaction costs the law doesn’t matter, the foundation of the so-called Coase Theorem. , and this idea figures prominently in Econ 280. Indeed, the latter is one of the most heavily cited papers in all of social sciences, and is the centerpiece of the law & economics movement.

Coase also wrote the very provocative“The Market for Goods and the Market for Ideas,” arguing that the case for product regulation is no stronger than the case for regulating ideas — a good discussion starter to say the least.

For a pretty good portrait of Coasian ideas, check out his interview with Reason Magazine from back in the day.

The Yuan Also Rises?

For a variety of reasons, Chinese economic policy makers resist pressures to allow the yuan (or renminbi) to rise against the dollar.  On this side of the great pond (i.e., the Pacific Ocean), politicians (see H.R. 2378 Ryan-Murphy bill) and many economists clamor for explicit pressure that “forces” the Chinese to allow the yuan to appreciate.  What would happen if the yuan were to rise markedly against the dollar?  Several observations are worth making.

1.  Much of the trade deficit that exists between the US and China arises from the sale of final goods.  The value added by Chinese firms in these goods, however, is rather small.  So what?  If the yuan rises, it means that Chinese firms will be able to purchase intermediate goods more cheaply than at present; thus, the decrease in the cost of Chinese goods in yuan terms will counter the rise in the exchange rate and limit the change in prices to American consumers.

2.  It’s not clear that changes in the nominal exchange rate drive large changes in purchasing.  For example,  the Japanese yen was forced to appreciate against the dollar in the late 1980s.  Such a rise has had limited impact on trade with Japan.  The U.S. runs trade deficits with virtually all of its major trading partners.  This is a natural outgrowth of diminishing savings relative to (tangible) investment over past three decades.

3.  On a related point, Gillian Tett, in today’s Financial Times argues that the Japanese experience with a rising yuan could be replicated in China.  Unless China reforms its banking and financial system in a way that decentralizes the allocation of capital, it may suffer the economic stagnation that Japan has suffered for the past two decades.  Cheap capital, centrally allocated, tends to yield excess capacity in politically sensitive industries.  I have heard this argument on many occasions in China.  If China’s economy were to suffer a long period of weakness, demand for US, European, and Asia goods would diminish, not rise.

4.  The iron triangle or impossible trilogy restricts countries from having a) open capital markets, b) a fixed exchange rate, and c) independent monetary policy at the same time.  Different countries, based on the depth and breadth of their domestic capital markets and their social time preferences, as well as their desire to attract capital, make different choices.  China chooses some combination of capital controls and limited monetary independence along with a fixed exchange rate.  The US and Europe, with much more developed capital markets, choose to allow exchange rates to float.  Small countries, dependent on world trade and world interest rates, such as Hong Kong and Estonia, forgo independent monetary policy.  There is no right choice.  Each country manipulates the tools it believes give it the highest level of economic welfare.

My advice to US policy makers:  be careful what you ask for.

Make or Buy, Homework Grading Edition

Q: When are we going to get our tests back?

A: When I get them back from Bangalore.

The Chronicle of Higher Education has an interesting piece about outsourcing of homework grading to markers in India via the firm, Virtual-TA.  No, papers aren’t physically sent to India to be graded, but rather the transaction is done electronically.

Is that ethical?

Well, the story profiles Lori Whisenant, the director of business law and ethics studies at the University of Houston.  So the ethics professor thinks it’s ethical. Or maybe that’s just how they roll down in Texas?

That dimension aside, we spend a lot of time talking about the outsourcing/insourcing decision in Economics 450, and one of the main drivers for doing something yourself is the specificity, not necessarily the complexity, of the task.  And this comes out in the article a little bit:

Critics of outsourced grading, however, say the lack of a personal relationship is a problem.

“An outside grader has no insight into how classroom discussion may have played into what a student wrote in their paper…  Are they able to say, ‘Oh, I understand where that came from’ or ‘I understand why they thought that, because Mary said that in class’?”

On the other hand, it would be difficult to argue that the Virtual-TA is playing favorites.

The whole story reminds me of the opening of Ed Leamer’s classic review of Thomas Friedman’s The World is Flat:

When the Journal of Economic Literature asked me to write a review of The World is Flat, by Thomas Friedman, I responded with enthusiasm, knowing it wouldn’t take much effort on my part. As soon as I received a copy of the book, I shipped it overnight by UPS to India to have the work done. I was promised a one-day turn-around for a fee of $100. Here is what I received by e-mail the next day: “This book is truly marvelous. It will surely change the course of human history.” That struck me as possibly accurate but a bit too short and too generic to make the JEL happy, and I decided, with great disappointment, to do the work myself.

It was only a matter of time.

The Nobel-ist Triumph?

The economics Nobel selection committee evidently isn’t the only body impressed with Oliver Williamson’s Transaction Cost Economics (TCE). Personally, I have always liked transaction cost economics because I found the construct consistent with my own intuition.  Put succinctly, watch out because someone might be looking to screw you over.

Evidently, the students in my Economics 450, Economics of the Firm course, share my enthusiasm.

Here is a full accounting of their written responses from this term’s course evaluations:

Q:  What was the best topic in this course?


TCE! Williamson changed my life :-)


I love Williamson’s TCE forever and ever. I also really liked talking about McDonalds. I dont think the Innovation and Econ was particulary central to the class but I really enjoy it too!


Kicking Off I&E Week

Here’s a question from the recent economics 450 test that you might want to consider part or all of:

Discuss what people mean by entrepreneurship and explain how it fits into the theory of the firm. Things you might discuss:

  • What is an entrepreneur?  How is it different than being a manager?
  • Do entrepreneurs usually work for themselves?  What does that mean?
  • Is asset ownership necessary? Is that part of working for themselves?

Part of the inspiration from that question comes from an interesting piece by Foss and Klein from a few years back.

Not coincidentally, the economics department generally is pondering these very questions as we try to figure out our curriculum offerings.

Stay tuned.

The Bad Seed?

As students of 450 know, not all nonstandard contracts are designed to establish or maintain market power. That, indeed, is one of the central messages of Oliver Williamson’s work:

Transactions that are subject to ex post opportunism will benefit if appropriate safeguards can be devised ex ante

This is useful to keep in mind as we watch the antitrust suit against seed-giant Monsanto that is unfolding in America’s heartland. The case speaks to managerial v. entrepreneurial capitalism, contracting for innovation, and the role of a non-standard contract.
Continue reading The Bad Seed?

“in this, the most efficient of all possible worlds”

Following this past weekend’s performance of Candide on campus (with our own Alex Gmeinder in the leading role), I was reminded of this sight gag in a set of slides by Professor Richard Langlois of the University of Connecticut.

For those of you not in Economics 450, that’s recent Nobel Prize winner, Oliver Williamson, pictured delivering a lecture.  Professor Langlois appears to be chiding him about the rather strong efficiency implications of transaction cost economics.

You can read the full explanation at the Organizations & Markets blog.

Should You Take Out a Student Loan, Or Issue Equity?


Great post over at Cheep Talk about Kjerstin Erickson, who is selling a 6% stake in her lifetime income for $600,000.

Think of Kjerstin as a self-managed firm.  She could issue debt or equity.  The Modigliani-Miller theorem explains why most people in Kjerstin’s position choose to issue debt.  Her income is taxed, but interest on debt is often tax-deductible.

But a key difference between Kjerstin and a firm is that you if you acquire Kjerstin you cannot fire the manager.  So your capital structure is also your managerial incentive scheme.  Debt makes Kjerstin a risk-lover:  she gets all the upside after paying off her debts and her downside is limited because she can just default.  With equity she owns 94% of her earnings no matter what they are.

Why don’t Lawrence and other colleges and universities ask for an equity stake rather than providing student loans?  Evidently, economists from Milton Friedman to James Tobin have advocated such a system and it seems to work only too well.  Hence the beneficiaries opportunistically opting out of the deal.

Ah, well.

The End is Near

Many students find the end of the term the ideal time to break up with that not-so-special person they’ve been seeing.   Maybe your returns to scale in the relationship are constant or even decreasing.  Or maybe you really don’t have that much specific capital invested in the relationship (K is low).  Or, perhaps, you’ve found a relatively higher redeployment value for your affections.   If that’s the case, transaction cost theory suggests that you might consider outsourcing your break up.

That’s right, a mere $10, will get you into a “basic break up,” with escalating rates based on increasing specificity (engagement, divorce), but, interestingly, not based on increasing complexity.


Economics TBA — today at 4 p.m.

After a scintillating weekend up north, we are back for the home stretch of the second term.  And what better way to finish a Monday than TeaBA with the economics faculty and students?

Today will be the Oliver Zornow Tea, for his spectacular finish in the this weekend’s game theory tournament.  Today’s cookies are courtesy of Mr. Zornow.

We will also hear a presentation from a group in The Economics of the Firm (Econ 450), examining the role of the football coach in the division III schools.  Can we measure his performance in terms of wins and losses?  Or is it a multi-attribute principal agent model?

Should be a corker.  See you there.

Off to Björklunden

The faculty and students are headed to the great whitish north for its (first annual) departmental retreat, featuring presentations from Economics of the Firm (my personal favorite),  Game Theory, and Urban Economics courses.     It’s not too late to sign up.

Speaking for the economics of the firm course, there will be presentations on:

*** why Lawrence outsources its food service (can’t we do this ourselves?)

*** why Lawrence has its own campus security (why not use a professional security company?)

*** why Lawrence has its own vehicles for student use (why not use Enterprise?  They pick you up!)

*** why universities have endowments, and how reliant Lawrence is on its endowment (I’m not sure, and I don’t know… looks to be a good one)

    If you can’t make it this weekend, we hope to see you Monday for tea!

    Kudos to Professor Shober

    This looks interesting. The best way to foment effective policy outcomes is to allow administrative agencies to do their thing unfettered. How do they solve the agency problem? I guess we’ll have to read the book and find out.

    Order now!

    Splintered Accountability: State Governance and Education Reform

    Arnold F. Shober

    The No Child Left Behind Act declared that improving education in every school in the United States was a top national priority. However, this act did not acknowledge how state departments of education have successfully constructed reforms for the past few decades, despite the power struggle between governors, legislators, school districts, and state boards of education. Drawing upon archival sources, state budget documents, interviews, and statistical analysis, Splintered Accountability amply demonstrates that sustained education reform is best left in the hands of the relatively autonomous state departments of education in order to maintain curriculum standards, school finance, and teacher licensure systems. Comprehensive and successful education reform originates from within state education agencies, propelled by savvy state superintendents.

    Revisiting the Amazon-Macmillian Fracas

    The dust is settling on the, well, the dust up between Amazon and Macmillian over eBook prices. There are some excellent posts from Virginia Postrel, Lynne Kiesling, and Megan McCardle. Some great Industrial Organization topics here, like price discrimination, resale price maintenance, and why entry by Apple here is leading to higher retail prices. (Did he just say entry is leading to higher prices? Yes, he did).

    Well, as we try to sort that out, it appears the dust is on the rise again, as a third publisher is demanding the “agency model” in the pricing of e-Books.

    The future of the $9.99 e-book is in danger. A third major publisher, Hachette, is going for Apple’s agency model in order to sell e-books for up to $14.99 apiece, the company revealed in a memo to agents.

    Following Amazon’s public dispute over e-book prices with Macmillan early this week, Hachette is also seeking a shift to the agency model, which allows the publisher to set the price for the e-book, while the retailer keeps 30 percent of the sales.

    I wonder if that “agency model” bears any relationship to the “principal-agent” problem we will be covering in 450 after the break?

    Stay tuned.

    McOutsourcing in Moscow

    Solid New York Times piece on McDonald’s in Russia. To wit:

    The company celebrated a different milestone earlier this year by outsourcing the last product — hamburger buns — it had made at a proprietary factory outside Moscow called McComplex. It was built before the chain opened its first restaurant. Nearly everywhere else, McDonald’s buys ingredients, rather than making its own. But in the Soviet Union, there simply were no private businesses to supply the 300 or so distinct ingredients needed by a McDonald’s outlet.

    Everything — from frozen French fries to pie filling — had to be made from scratch at a sprawling factory.

    McDonald’s is always a good lens through which to view the 118 or so countries where it operates. In the 20 years since McDonald’s arrived in Russia, enough private enterprises have sprung up to supply nearly every ingredient needed to operate one of its restaurants.

    Today, private businesses in Russia supply 80 percent of the ingredients in a McDonald’s, a reversal from the ratio when it opened in 1990 and 80 percent of ingredients were imported.

    Fascinating stuff. I could probably write an entire final exam around that passage.

    There’s No “I” in “Normative Codes of Coduct”

    On the heels of our 450 test, there is an interesting post over at Organizations and Markets about some empirical work on Alchian & Demsetz’s team production problem. The issue at hand is, of course, how to enhance cooperative behavior.

    We find that neither verbal framing with company cues nor the recruitment test have a significant effect on cooperation enhancement whereas the introduction of normative codes of conduct significantly boosts cooperation. This effect is even stronger when codes of conduct are combined with the recruitment test.

    Looks like an interesting piece and a potential future classroom experiment.

    No mention of the effects of firing the grocer, however.

    The Rise and Fall of Investment Banking: Theory of the Firm Edition

    For those of you taking a break from trivia to study for a 450 Exam, Daniel Gross gives a broad brush account of the importance of ownership structure and agency issues. Here’s the basic argument: (1) investment banks go public (i.e., allow members of the public to buy ownership shares); (2) raising equity capital allows banks to expand and compete with international considerations; (3) growth in size correlated with a growth in clout, whereby banks effectively “captured” regulators; (4) growth in size led to acute agency problems, whereby management plundered shareholders a la Berle and Means.

    Whew, that was fast.