Categories
World

Forgetting Why You Won

The New York Times tells us that “China has laid the groundwork to dominate the market for protective and medical supplies for years to come[]” because it has pursued a policy of subsidizing strategically important industries, like PPE, including by protecting them from foreign competition.

History tells us why China does that. It’s the reason for which the victim tends to remember how a fight was won better than the victor. For about a century ending in 1949, China came close to being wiped off the map repeatedly because it couldn’t control access to its own markets and didn’t have dominance in any strategically important industries to use as a bargaining chip. Foreign powers used their control over strategically important industries, not least those relating to defense, to prize open Chinese markets to foreign goods, wiping out local production. It’s not for nothing that one reads in an economic history that “British competition de-industrialized most of Asia . . . .”

That didn’t come about because a large gap in technology or industry existed between China and the rest of the world when China’s fall started in the early 19th century. On the eve of the industrial revolution, China was a wealthy country and could defend its borders. It was a difference of degree that mushroomed into near destruction. The Chinese never forgot their lesson in the foundations of modern power.

But we did. Did we really think that after more than a century of struggle to regain control over their own markets, at the cost of millions upon millions of lives, the Chinese were going to throw their markets back open to the rest of the world, laissez-faire-style, and run the risk that domestic industry would be out-competed once again? Did we think that the Chinese would not sit down and think carefully about how to take advantage of the rest of the world’s fleeting, pie-in-the-sky romance with free trade silently to achieve dominance in strategically important global industries? Did we think the Chinese didn’t learn their lesson?

Whatever you may think of the Chinese government, this is no kakistocracy happily selling its people out for a bit of short-term gain and a life of luxury in future exile, whatever the Times may once have wanted us to believe with its deep dive on Chinese princelings. Whatever it might have been for a spell decades ago now, today China is no North Korea, hobbled by corruption, operated as an extension of a few personalities. It is a government that knows and jealously guards the national interest.

It would be nice if ours did too.

Categories
Inframarginalism Miscellany Monopolization Regulation

Damages as Personalized Pricing in Favor of Wrongdoers

All courts do all day in civil cases in which the remedy is money damages is to engage in personalized pricing in favor of consumers. The plaintiff is the producer, the defendant is the consumer. And the damages amount is the price charged to the defendant for whatever it is that the defendant has taken from the plaintiff in violation of law, whether dignity, reputation, an arm or a leg.

When private enterprise personalizes prices, it chooses the highest possible prices: price equal to the maximum that the consumer is willing to pay. That is, firms strive to engage in perfect price discrimination.

Courts do the opposite. They personalize the prices of legal wrongs to be the lowest possible prices consistent with compensating victims: price equal to the cost to the plaintiff of the violation of law, and not a penny more. That is, courts strive to engage in what I have called perfect cost discrimination.

That’s weird, when you think about it.

All lawbreaking amounts to a forced sale. The defendant who shoots off the plaintiff’s arm forces the plaintiff to sell his arm to the defendant, or at least to sell the defendant the service of having an arm shot off, and whatever attendant satisfaction that provides the defendant, whether in the form of a feeling of security, the pleasures of power and domination, revenge, or what have you.

The law, in prohibiting battery, recognizes in the plaintiff a right to payment for the service. And if the transaction were not forced, and the plaintiff were to have any amount of market power, which we would expect to exist in spades with respect to the subject of many prohibitions–very few people are willing voluntarily to part with their arms, for example–then the plaintiff would almost surely charge a price for the arm above the bare minimum necessary to compensate the plaintiff for the harm. That is, if the exchange were voluntary, the price would in many cases be much in excess of cost, and indeed much closer to the maximum that the defendant would be willing to pay. Indeed, it seems reasonable to suppose that the defendant forces the transaction precisely because the defendant hopes to avoid being charged a price equal to the maximum the defendant is willing to pay.

So you would expect the law to provide the plaintiff with something closer to the bargain that the plaintiff would have struck voluntarily with the defendant. That at least would ensure that the defendant enjoys no gain from breaking the law and forcing a transaction.

But the law doesn’t see it that way.

The “rightful position” principle in remedies teaches that courts should measure damages in order to put the plaintiff in the position that the plaintiff would have occupied if the defendant had not engaged in the bad act. That causes courts to set the lowest possible price for breaking the law, rather than a price that approximates the voluntary price. For the position that the plaintiff would have occupied without the bad act is assumed to be the one in which no transaction takes place at all and the harm of the transaction has therefore not been inflicted. So damages under this measure just equal the amount necessary to compensate for harm. That is, the cost of the transaction to the plaintiff.

Law and economics scholars have made much of this cost-based baseline, arguing that it leads to optimal deterrence. The idea is that it forces the bad actor to internalize the costs of his actions. And so he will only act to break the law if the gains to him exceed the costs, which is to say, only if cost-benefit analysis shows that the action is efficient.

But that ignores something rather important about optimally-deterrent pricing: there isn’t just one optimal price. So long as the price the defendant pays for the forced sale is personalized, which it must be in a legal system in which judges award damages on a case-by-case basis, any price between cost and the maximum the defendant is willing to pay for the harm is optimally deterring.

Only a price above the maximum that the defendant is willing to pay–as opposed to cost–prevents the defendant from forcing the sale when the benefit exceeds the cost. So only such an extraordinarily high price is non-optimal. The maximum the defendant would be willing to pay is a measure of the benefit to the defendant. So only a price above that maximum drives the defendant away. There isn’t one optimally deterring price, but a range, that from cost all the way up to the maximum the defendant is willing to pay.

Where the courts set the price of illicit conduct within that range matters, because price determines the distribution of wealth between the plaintiff and the defendant, the victim and the injurer. By setting the price equal to cost, courts today achieve the perverse outcome of allowing the injurer to retain all of the gains associated with the forced transaction.

To fully appreciate this perversion, imagine that you decide voluntarily to sell your house. You could sell it at cost, including a reasonable return on investment. But that would be disappointing. What you’d like to do is sell it at the highest price anyone is willing to pay for it. If you do, then you extract all of the value created by the transfer. The buyer obviously places a higher value on the house than you do, otherwise he wouldn’t buy and you wouldn’t sell, and because you charge the highest price the buyer is willing to pay, you cause the buyer to pay out all of that excess value over to you.

By contrast, if you sell at a price equal to cost, including a reasonable return on investment, you don’t extract any of the excess value buyers place on the house. What you paid plus a reasonable return is the value you place on the house, the reasonableness of the return being enough to make you sell at that price. So when you sell at that price, the buyer pays you your valuation, and not a penny more.

Selling at a price equal to cost, including a reasonable return on investment, doesn’t therefore enrich you at all. It just lets you break even in a sense: you give up your house in exchange for a price equal to the value you place on the house.

But now suppose that you decide not to sell the house. You don’t like the price the buyer is offering. You believe the buyer is willing to pay more and you want to hold out until he does. And the buyer responds by bursting in your door one morning, holding a gun to your head, and telling you to clear out permanently, which of course you do, before filing a lawsuit. Now the buyer has forced a sale, and the law of trespass allows the court to dictate to the buyer the price that he must pay for your house.

Under current rules on the measurement of damages, the court would award you cost plus a reasonable return on investment, and not a penny more! The buyer could walk away with all of the gains from trade.

(Let’s put aside the fact that almost any court would issue an injunction here allowing you to repossess your house. Perhaps you’re emotionally scarred and don’t want to live there anymore, so all you demand is money damages. And let’s suppose also that your lawyer commits malpractice and fails to request punitives or damages for emotional distress.)

Which means that current damages rules turn over the entirety of the surplus generated by a violation of law to the wrongdoer! They embody the policy that the wealth generated by illegal transactions should be allocated to the scofflaw.

Which, again, is weird.

Now, you might object that courts award damages equal only to costs because the maximum that the wrongdoer would be willing to pay for the privilege of breaking the law is a thing difficult to calculate.

But so too are costs.

For costs are themselves maxima that someone would be willing to pay. The cost of an injury is the maximum that the victim would be willing to pay to avoid the injury. The cost of your house is what you paid for it plus a reasonable return on investment only because that is the maximum that you would be willing to pay to avoid having it destroyed or taken from you. More than that and you could buy a better house. And there is a subjectively element in that cost calculation: the reasonableness of the return is subjective. Current rules in theory should force courts to take that subjective element into account in awarding you compensation for harm equal to cost. And if courts can do that, they should be able to answer the question what the maximum that the wrongdoer would be willing to pay might be, including any subjective element thereof. (Indeed, courts should already do this in restitution cases, of which more below.)

You might also object that the maximum that the wrongdoer would be willing to pay is always less than the cost to the victim, because otherwise the wrongdoer would just be able to enter into a voluntary transaction with the victim to inflict the harm.

But I don’t think that’s right, at least if we want to maintain the fiction of rational decisionmaking that is all of the fun of law and economics and which itself underpins the whole theory of optimal deterrence I wish to complicate here.

The wrongdoer knows that undertaking the bad act will result in liability, and so when the wrongdoer acts, he does so knowing that he will pay a price. If the price is too high, which it will be if he inflicts a harm for which he would not be willing to pay, then he will not act. The courts therefore never can extract damages from wrongdoers in amounts above those which wrongdoers are willing to pay. If they do, wrongdoers simply will not act.

The economic problem for the courts is precisely to find the price that is high enough to ensure that the wrongdoer will not act unless he values the harm more than the victim, but not so high as to prevent the wrongdoer from acting when he does value the harm more than the victim. The trouble is that under current damages rules the courts always choose the lowest possible price.

Now, I don’t mean to suggest that the law is entirely deaf to the problem of gains from trade. One can almost always bring an unjust enrichment action and obtain the remedy of restitution, which does provide the plaintiff with the gains from trade.

But here’s the thing: restitution is an alternative remedy. Either you get restitution, or you get damages, but you don’t get both.

So a plaintiff can receive compensation for the costs to the plaintiff of illegal activity, or the gains enjoyed by the defendant, but not both. Whether the plaintiff opts for one or the other, therefore, the plaintiff will never receive a price for what he gives up equal to the maximum that the defendant is willing to pay, because the maximum that the defendant is willing to pay must equal both the cost to the plaintiff–the value the plaintiff placed on the harm–and the gains to the defendant of inflicting the harm, the excess over plaintiff’s valuation that makes the rational defendant willing to break the law in the first place.

Do punitive damages pick up the slack? It’s true that the pleasure a wrongdoer derives from inflicting harm is in itself probably sufficient to convert an intentional tort into one of malice, and that in turn can lead to punitive damages. But the doctrine of punitive damages suffers from terrible incoherence; we know that it is meant to punish, but does that mean to take some of the ill-gotten gains, or all of them, or to take more than those gains? Unless we are very lucky, punitive damages will either leave some gains with the wrongdoer or charge the wrongdoer a price in excess of willingness to pay, preventing the wrongdoer from engaging in efficient conduct.

Only a reconceptualization of the “rightful position” principle to require that courts measure damages by the maximum the defendant is willing to pay, rather than the cost to the plaintiff, would ensure that defendants do not enjoy gains from the illicit trade that is every offense under the law.

In closing, a word on the relevance of personalized pricing. Why does it matter here that, in engaging in case by case adjudication, judges effectively personalize the price of offenses?

It matters because personalized pricing is efficient whether the price charged is equal to cost or to the maximum the buyer is willing to pay. When prices can’t be personalized, and price is therefore one-size-fits-all for an entire market of buyers and sellers, then there is likely only one price that does not price some buyers or sellers willing to engage in mutually beneficial trades out of the market. That’s the price equal to marginal cost, the competitive price. And that price distributes the gains from trade between all buyers and sellers in the market in a single unique way. Try to change that distribution, by raising or lowering the price, and efficiency suffers: some buyers or sellers will be priced out of the market.

With personalized pricing, however, the court can vary the price charged to one buyer-seller pair–the defendant and plaintiff before the court–without changing the price charged to other pairs, so regardless the price the court chooses in one case, buyers and sellers won’t be priced out of the market in other cases. So the case-by-case character of adjudication opens up a world of distributive options with respect to the market for illegal activity that would not exist if the courts were to engage in one-size-fits-all damages calculations.

It’s a world that the law has failed so far fully to recognize and exploit.

Categories
Miscellany

Another Way to Fight the Virus

Why be different from your parents? . . . . [P]arasites evolve rapidly: they have short lifespans and heaving populations. It doesn’t take them long to adapt to their host at the most intimate molecular scale—protein to protein, gene to gene. Failure to do so costs them their life; success gives them the freedom to grow and replicate. If the host population is genetically identical, then the successful parasite has the run of the entire population and may well obliterate it. If the hosts very among themselves, however, there is a chance, indeed a probability, that some individuals will have a rare genotype that happens to resist the parasite. They will thrive until the parasite is obliged to focus its attention on this new genotype or face extinction itself. And so it goes on, generation after generation, cycling genotype after genotype, forever running and getting nowhere, as the Red Queen herself. So sex exists to keep parasites at bay.

Nick Lane, Life Ascending: The Ten Great Inventions of Evolution 135 (2009).
Categories
Antitrust Inframarginalism Monopolization Regulation

Wherein Henderson and Kaplan Confuse Value and Cost

Or Why We Need More Inframarginalism

Todd Henderson and Steven Kaplan commit one of the more basic economic mistakes I have encountered, one all the more embarrassing because they are Chicago lawyers and economists.

They write that the private equity industry should not be judged based on its low returns net of fees because “[w]hile this is the appropriate metric for the decision about whether an individual should invest, what matters for society is how much wealth they create above the next-best alternative.” If you don’t net out the fees, they argue, then private equity shows large returns, and those returns reflect the creation of social value.

What Henderson and Kaplan have done here, in case you missed it just now, is to argue that an industry is productive by redefining a cost—and not just any cost, but that sacredest of sacreds, the fund fee—as social value.

But if they really mean to do that, which I doubt, then they’re actually making the case that private equity earns excess—read unnecessary—profits. Profits that represent a redistribution of wealth from consumers to private equity firms.

Unfortunately, Costs Are Costs

Let’s say that you decide to build a fence, but you’re terrible at it. You nail in all the slats askew and some of them fall off on the way to market. The cost to you was $50 in materials and $30 in labor, judged by the wage in your next best alternative line of employment.

Because your fence is a disaster, however, you are only able to sell the thing for $70, resulting in a loss of $10. Economics teaches that your fence business is a waste of economic resources. You expended $80 in combined value of resources to generate a product that created only $70 of value for consumers.

But Henderson and Kaplan say no. You have created $20 in value, the difference between the price of $70 paid by consumers and your materials costs of $50, because, well, if we ignore your $30 in labor costs, then you did!

What they don’t seem to realize is that the only way you can actually make that $30 in labor costs evaporate is if you don’t actually have an opportunity cost there for your labor; no one would have paid you a dime at any alternative employment. But if that’s true, and your costs really are just $50, then you didn’t need to charge $70 for the fence in order to have an incentive to build it. You just needed to charge $50, and so your $20 in profits are pure and unnecessary appropriation of surplus.

Which means that Henderson and Kaplan are inadvertently arguing that private equity is overpaid.

The Distinction between Value and Cost

But I really don’t think that’s what Henderson and Kaplan mean to argue. I think they are just confused about the relationship between value and cost, a confusion that is, alas, all too common in debates regarding law and economics, as I outline in a recent law review article.

The distinction between value and cost turns in fact on another distinction, that between utility and value.

The fence, even a badly constructed fence, has some utility for consumers, and that utility is measured by the maximum price that consumers are willing to pay for the fence: $70. In trying to avoid netting out costs and focusing instead on gross magnitudes, Henderson and Kaplan seem to be trying to say that utility and social value are one and the same.

But that $70 doesn’t represent value for society, because it does not account for the costs—the disutility—associated with generating it. If society must give up $80 in order to make a $70 fence, then society loses. Utility and social value just aren’t the same thing, as any careful undergraduate economics student should know.

To figure out how much value a business creates, you have to compare the utility the firm generates for those who use its products with the disutility—the costs!—the firm must create in order to produce those products. That is, value is a net quantity, it’s the difference between the maximum that consumers are willing to pay for the product and the cost of producing it. So the social value of private equity isn’t measured just by the gross returns that it generates, but by the returns it brings in net of costs.

All costs.

Fund Fees Are Costs

Including fund fees.

Costs in the economic sense are all harms that must be suffered in order for production to take place. The lost fees associated with not engaging in their next best alternative mode of employment outside of the private equity industry represent a cost, a harm, incurred by private equity funds in pursuing their work of privately acquiring and running firms. The fees that private equity firms charge must therefore be high enough fully to compensate them for this harm, otherwise they would not do private equity.

Henderson and Kaplan simply cannot ignore those fees in calculating the social value of private equity. They measure the harm of opportunities foregone to engage in private equity, the very harm of not sending physicists and engineers into physics and engineering, but instead allocating them to private equity funds, that critics of private equity decry.

If private equity can’t generate a decent return after netting out those costs, then private equity is social waste.

Unless They Represent Redistribution

The only way private equity fees don’t count as costs is if they not only fully compensate private equity firms for not engaging in some other line of business, but go beyond that to provide additional compensation. In which case some portion of the private equity fee can only represent one thing: an appropriation by private equity of the social value that private equity generates.

That is, private equity fees can only be ignored in the calculation of social value, as Henderson and Kaplan argue that they should be, if they represent an appropriation, by the private equity industry, of social value, defined as the value generated by their activities in excess of costs. And because Henderson and Kaplan appear to argue that we can count all private equity fees as social value, they are arguing that all private equity fees represent pure redistribution of social value from consumers to firms.

But precisely because social value is value in excess of cost, defined as the minimum necessary to compensate for all harms, it is value that does not need to be paid to firms in order to induce them to create social value. (Okay, it is necessary to pay private equity a penny more than cost, so that doing private equity makes firms strictly better off than they would be in their next-best alternative employments. Or just a ha’penny. Or a mill. But you get my point.) So what Henderson and Kaplan are arguing, in effect, is that private equity is taking more out of markets than is necessary to induce them to do private equity.

Government could, if Henderson and Kaplan are right, therefore dictate lower private equity fund fees without reducing social value one bit. Which sounds like a great idea to me.

Inframarginalists Don’t Make This Mistake

What really seems to have gotten Henderson and Kaplan into hot water is a lack of attention to the distribution of wealth between buyers and sellers in individual markets, what Michael Guttentag once described to me in conversation as “inframarginalism,” in contrast to the “marginalism” of a microeconomics that focuses on problems of efficiency.

What matters for efficiency-oriented lawyers and economists is that all units of output for which buyers are willing to pay marginal cost actually get produced. Which means that marginalists are interested in the cost-benefit analysis of the marginal unit of production.

Inframarginalists, by contrast, are interested in how the aggregate social value created over all of the other units produced by the firm—the inframarginal units—is distributed between buyers and sellers.

So social value is a bread and butter concept for inframarginalists. If they can’t define it properly—by netting costs out of willingness to pay—they can’t do their work.

And because inframarginalists know where social value begins and ends, they are unlikely to make the same mistake as Henderson and Kaplan.

Categories
Philoeconomica

Economics as Cultural Tell

Why do economic explanations feel so much more insightful than humanistic explanations? The answer may be that economists take social types as their axioms, the unsplittable atoms of the economic universe, whereas humanists take mental states to be their atoms. And we have lost the capacity to believe–really, truly believe–in the inner life.

Consider economist A.O. Hirschman’s argument that monopoly may be better for consumers than the sluggish competition of highly concentrated markets if “exit is ineffective as a recuperation mechanism, but does succeed in draining from the firm or organization its more quality-conscious, alert, and potentially activist customer or members.”

One immediately has the experience of insight here. Yes! If the competitors are already so large that most customers can’t abandon an underperforming firm, but there remain enough options that activist consumers can still bail on underperforming behemoths and buy from some scrappy startup on the competitive fringe, then the behemoths won’t be subject to voice–to the pressure campaigns that only activists are likely to bring–and so the big firms may well perform worse than if there were a single monopoly and the activists were to have nowhere to go but into the streets, onto the message boards, and to Congress to compel change.

What’s driving this experience of insight? The answer is the division of the consumer group into types. Hirschman posits the existence of an activist type, and a sleeper type who does not complain about poor quality. This typology does all of the work in his argument, as the sleepers bail out of underperforming firms when competition persists, depriving all consumers of the massive positive externality that is their activism applied to big firms.

Now consider a humanistic explanation of the same phenomenon. The sociologist, for example, might argue that competition is sometimes worse for consumers than monopoly because the absence of alternatives to a monopoly focuses consumers’ minds on using complaints and activism to induce the monopoly to reform. Whereas the existence of competition leads to apathy, because consumers know that they have the option to buy elsewhere in response to bad behavior, even if they do not exercise that option.

This humanistic explanation does not produce the same experience of insight as Hirschman’s account, at least for me. And yet it is saying exactly the same thing.

Hirschman doesn’t actually know that there are activist types, human beings who have fixed personalities that make them prone to activism in ways not true of other people. But Hirschman does know that there is a human tendency toward activism that is expressed more under some conditions than under others. The mechanism of expression is simply unclear to him and to us all. It could be that there are fixed activist types, as Hirschman suggests, but it could also be that people do change, there are no types, and activism is really a contingent mental state, called forth by monopoly buying, as the humanist suggests. Both Hirschman and the humanist are describing the exact same phenomenon, but imposing upon it different preconceptions regarding the causes of social behavior.

The humanist ties the explanation to an intellectual worldview in which mental states are the axioms, the first principles that produce the experience of insight when applied to observed phenomena. Whereas Hirschman ties the explanation to an intellectual worldview in which personality types are first principles.

But why is Hirschman’s type-casting move so intellectually irresistible?

The reason may just be that we feel more comfortable on an intuitive level dealing in human types than in mental states. If Hirschman had said that monopoly makes us complain, or makes us angry, we would have dismissed him as fishing in the soup of introspection, conjuring up emotions to suit his explanatory tastes. We would not hear “the feeling of being trapped” and say: yes! That’s why consumers discipline monopolies!

But when we hear that activist types can’t bail on monopolies, we feel a veil pulling from our eyes because we already think in terms of types informally. We all already know that there are activist types out there in the world. We have seen them with our own eyes marching in the streets. Economics is satisfying because we intuitively accept its axioms.

In other words, our love of economics should teach us that we do not really, truly, fully believe in the inner life. We feel more comfortable, as a cultural matter, with the immutable personality type than with the notion that the human is a vessel the contents of which are constantly changing as circumstances change, as new thoughts and emotions pour in and old ones pour out. Feelings are, to us, arbitrary, untrustworthy, a kind of magic trick or supernatural spirit conjured up by lazy thinkers to gloss a reality that lies elsewhere. We don’t actually believe in feelings despite all the lip service we like to pay to them.

Somehow I’m reminded of an experience watching a couple of movies with foreign friends in graduate school. One of the films was an American romcom. The other was a film by Almodovar: Women on the Edge of A Nervous Breakdown. I’d seen the romcom before and it was one of my favorites; I’d felt that it was all about the human condition, feelings, and so on.

But watching it with this crowd, and back to back with the Almodovar, was, well, embarrassing. I realized that the entire romcom was a vehicle for the expression of a single emotion at one discrete moment in the film, a kind of exhausting, Herculean effort to get in touch with feelings by a culture for which feelings remain distinctly unnatural to this day. My friends were bored out of their minds.

By contrast, the Almodovar, which for me was dizzying and inscrutable in the way that its characters seemed constantly buffeted by unseen forces, was engrossing and deeply insightful for my friends. I realized that unlike my romcom, the Almodovar film didn’t struggle to present a feeling so much as it took feelings for granted, making of them a vast ensemble of principal players in a drama that unfolded almost entirely on the plane of the inner life. With respect to that plane, that film was like the Mona Lisa standing next to the stick figure of my romcom.

All of economics is a tell regarding this type-casting value system of ours. The economist’s basic model of human behavior is the immutable preference function. When economists model individual behavior, they write down a single function, the utility function, which defines the consumer’s preferences, and then they model the consumer as acting always in a manner consistent with those immutable preferences. Thus for economists, people are always just types. The rise of so-called behavioral economics has not changed this one bit; it has just changed the menu of types.

The economist has no defense for the type-casting approach, anymore than Hirschman could possibly have been prepared to defend his attribution of activism to types as opposed to the changing mental states of consumers. It is simply in the nature of economics to approach the world in this way. You are asked to take it or leave it. And we take it, and have taken it, to a far greater extent than we have embraced any other field of social science, because economics creates for us a more visceral experience of insight.

That tells us something ultimately about ourselves.

Categories
Uncategorized

Serpico

Came across this article by the Serpico in Politico in 2014. Makes fascinating reading in light of current events.

[A]n even more serious problem — police violence — has probably grown worse [than it was when Serpico was in the NYPD in the early 1970s], and it’s out of control for the same reason that graft once was: a lack of accountability.

. . .

Today the combination of an excess of deadly force and near-total lack of accountability is more dangerous than ever: Most cops today can pull out their weapons and fire without fear that anything will happen to them, even if they shoot someone wrongfully. All a police officer has to say is that he believes his life was in danger, and he’s typically absolved. What do you think that does to their psychology as they patrol the streets—this sense of invulnerability? The famous old saying still applies: Power corrupts, and absolute power corrupts absolutely.

. . .

And with all due respect to today’s police officers doing their jobs, they don’t need all that stuff anyway. When I was [a] cop I disarmed a man with three guns who had just killed someone. I was off duty and all I had was my snub-nose Smith & Wesson. I fired a warning shot, the guy ran off and I chased him down. Some police forces still maintain a high threshold for violence: I remember talking with a member of the Italian carabinieri, who are known for being very heavily armed. He took out his Beretta and showed me that it didn’t even have a magazine inside. “You know, I got to be careful,” he said. “Before I shoot somebody unjustifiably, I’m better off shooting myself.” They have standards.

Frank Serpico, The Police Are Still Out of Control, POLITICO Magazine, Oct. 2014.

Categories
Antitrust Monopolization Regulation

Getting Big

The realization that a tight monopoly is preferable under certain circumstances to a looser arrangement in which competition is present comes hard to a Western economist. Nonetheless, the preceding argument compels recognition that a no-exit situation will be superior to a situation with some limited exit on two conditions:

(1) if exit is ineffective as a recuperation mechanism, but does succeed in draining from the firm or organization its more quality-conscious, alert, and potentially activist customer members; and

(2) if voice could be made into an effective mechanism once these customers or members are securely locked in.

There are doubtless many situations in which the first condition applies . . . .

Albert O. Hirschman, Exit, Voice and Loyalty: Responses to Decline in Firms, Organizations and States 55 (1970).
Categories
Antitrust Monopolization Philoeconomica

Economic Plotting

The assumption that people behave rationally does a lot of work in economics, but perhaps its most important function is to allow economists to assume that mutually beneficial deals always get done. If a seller places a value of a $5 on a good, and a buyer a value of $10, the assumption goes, the seller and buyer will agree on a price somewhere between $5 and $10, and trade will take place, simply because the exchange is mutually beneficial.

Economists and their detractors have spent at least half a century tearing apart the assumption that good deals always get done, first through the lens of transaction costs, and later through behavioral economics. Transaction costs dealt only a glancing blow to the assumption, however, because additional costs don’t really undermine it. One can certainly accept that some deals do not get done because the cost of negotiating them–the legal fees, the time required to induce the other party to accept a particular share of the benefits generated by the deal, and so on–are too high, without giving up on the notion that good deals, defined to be those that are mutually beneficial after transaction costs are taken into account, still always do get done.

Behavioral economics has turned out to be harder to dismiss because it suggests that neither party to a transaction may actually want to execute mutually beneficial trades. If the seller doesn’t place the right value on his good, thinking it is worth $20 to him when instead it is worth $5, and the buyer thinks the good is worth $5 to him when instead it is worth $10, then the two will not be able to agree on a price, and so a mutually beneficial trade will not take place. But objections based on behavioral economics are not what interest me about the assumption that good deals always get done.

What is really interesting about the struggle over whether good deals get done is that economics has always needed the fact that some good deals do not get done to create the tension that gives economic inquiry its meaning. An economics in which good deals always get done is an utterly uninteresting, unrealistic, and indeed solipsistic undertaking. And economics has always understood that. Long before transaction cost economics and behavioral economics, economists were careful to build into their models discrete loci of irrationality in order to give the models meaning. Without these areas of irrationality, the models would lack what a creative writing teacher would tell you is the essential element of any story: conflict.

But if a novelist were to try to introduce tension into a plot this way, by asking the main character to treat similarly situated supporting characters differently for arbitrary and unexplained reasons, the novel would be panned.

Consider, for example, as doctrinaire and orthodox a model as the general equilibrium model of Arrow and Debreu. If these men had really taken the assumption that all good deals get done seriously, they would have started with a bunch of households and firms, written down their utility and production functions, and then: bam! The model would have been done. For the assumption that all good deals get done would then have ensured that all trades that, according to the utility functions and production functions they had written down, are mutually beneficial, would then immediately be carried out.

To give the story the conflict it needs to be of interest, Arrow and Debreu added another assumption: that prices are uniform in all markets. (This assumption does not of course originate with them, but their model represents a sort of apotheosis of orthodox economics, making it useful to frame the discussion around it.) Uniform pricing creates tension because when prices are uniform a seller can make more money by intentionally refusing to sell to certain buyers, even when those sales would be mutually beneficial. This is the classic problem of the inefficiency of the uniformly-pricing monopolist.

Consider a seller who places $5 of value on a good and has two prospective buyers, one who places $100 of value on the good and the other who places $10 of value on the good. Without the uniform pricing restriction, the seller would always sell to both buyers, because whatever profits he happened to generate from his sale to the first buyer he could always increase by selling to the second buyer as well.

That changes with uniform pricing, because then the price the seller charges the first buyer must be the same as the price the seller charges the second buyer. If the seller is able to negotiate a price of $95 with the first buyer (a price the first buyer will, under the all-good-deals-get-done assumption, accept because he places a value of $100 on the good, and so would enjoy a net gain of $5 from the deal), then the seller will not sell at all to the second buyer, who is only willing to pay up to $10 for the good and therefore won’t buy at a price of $95. So a deal with the second buyer becomes impossible, even though, if a lower price could be charged to the second buyer, a deal would be mutually beneficial. If the seller and the second buyer could agree on a price of $7, for example, the seller would earn an additional $2 of profit.

But that price is impossible under uniform pricing, because to charge the second buyer $7 would require that the seller charge the first buyer $7 as well, eliminating $83 of profit from the deal with the first buyer relative to the $90 earned at a price of $95, in exchange for a paltry gain of only $2 in profit on the second deal. The seller could still ensure that all good deals get done, by charging that $7 price, or any price between $5 and $10, but it is not in the interest of the seller to do that.

Now the Arrow and Debreu model has the opportunity to become interesting, by giving the conditions under which all mutually beneficial deals will still get done, in spite of the uniform pricing restriction and therefore in spite of the failure of the assumption that all good deals get done as a general matter. In particular, the Arrow and Debreu model makes clear that perfect competition, or some other mechanism that leads to competitive prices, is required for all good deals to get done when prices are uniform. Competition ensures that if one seller tries to charge $95, the $90 in profits generated thereby will induce other sellers to enter the market and steal the buyer’s business by charging a slightly lower price, and as competition intensifies that price will be bid down to the $5 of value that sellers place on the product, ensuring that the second buyer is able to purchase the product as well. All good deals get done after all. By circumscribing the assumption that good deals always get done using a restriction that is realistic–many goods are sold at uniform prices–the model poses a problem that has a certain verisimilitude–how to ensure that all good deals get done when prices are uniform–and then gives the conditions sufficient to solve the problem (e.g., competitive markets).

All economic models follow the same playbook: all economic models create tension and practical interest by limiting the general economic assumption that all good deals get done in some way (usually, but not always by assuming that prices are uniform), and then trying to show what legal rules or policy interventions might be needed to ensure that all good deals do get done anyway. (Another example is the assumption of risk aversion in insurance economics.)

What is so peculiar about this rhetorical posture of economics is that the baseline assumption is always that good deals do always get done, and the model is then built around the introduction of some discrete deviation from that assumption. The model never starts from the assumption that good deals never get done.

Which gives all economic models an internally discordant character.

Why, for example, should I assume that when the monopolist charges $95 to the first buyer, that buyer will magically trade at that price, simply because trade is mutually beneficial, but at the same time I should also accept that the seller won’t try to charge a lower price in order to be able to engage in mutually-beneficial trade with the second buyer? Yes, the seller generates more profit by charging the higher price and selling only to one buyer. But by the same token, the first buyer could enjoy a greater net gain from the transaction by insisting on paying no more than $80 for the good, as opposed to the $95 price that I am asked to assume that the buyer will accept. The buyer does better insisting on a lower price, and if the seller insists on a higher price, then the two might never reach a deal, as Robert Cooter so insightfully pointed out years ago. I am therefore asked to accept that the profit motive is not the be-all-and-end-all for the seller and the first buyer, otherwise I could not assume that the good will sell at $95, and yet I am asked to accept that the profit motive is the be-all-and-end-all for the seller in relation to the second buyer, which is why the seller won’t think twice about pricing the second buyer out of the market and missing an opportunity for mutually beneficial trade with the second buyer. Why ever would that be the case?

Of course, it is in the nature of the introduction of a deviation from the assumption that good deals always get done to have such dissonance. But that just begs the question: does it make sense to rely upon inconsistent behavioral assumptions within the same model?

Keep in mind that in order for uniform pricing to give rise to tension in the Arrow and Debreu model, the same individual seller must be willing to compromise profits for the sake of completing mutually-beneficial transactions with buyers who are willing to pay high prices–inframarginal buyers, they’re called–but not be willing to compromise profits for the sake of completing mutually-beneficial transactions with buyers who are able to pay only lower prices–marginal buyers, these are called. There seems to be no basis for assuming that sellers are socially oriented with respect to inframarginal buyers but rapaciously-profit-driven with respect to marginal buyers, other than the rhetorical need of model builders to introduce tension into the stories they are telling about economic activity.

But if a novelist were to try to introduce tension into a plot this way, by asking the main character to treat similarly situated supporting characters differently for arbitrary and unexplained reasons, the novel would be panned. The trouble for economists is that if they start adding content to the personalities of economic actors, they end up falling down the behavioral economics rabbit hole. There are too many different personality types from which to select , and the mathematics required to build models in any case becomes intractable. But if economists stick with the basic assumption that all good deals get done, then they paint a Panglossian portrait of economic activity that leaves them unable to identify economic problems or solve them. The result is an economic theory built on arbitrary and self-contradictory assumptions about when deals get done.

A more tenable theoretical approach would be to accept that good deals don’t always get done, all the time, in all circumstances. That means that even in competitive markets, sellers will fail to sell to buyers at the market price. That also means that in monopoly markets, sellers may fail to sell to inframarginal buyers at the monopoly price. Laying off absolute assumptions regarding whether deals always get done should also release economics from going to the opposite extreme: assuming that when good deals do not always get done good deals must therefore never get done. Which means that we should not be surprised to come upon monopolists that charge competitive prices.

Jettisoning absolute assumptions about whether good deals get done would prevent economics from making grand claims, such as the claim of the Arrow and Debreu model that competitive markets are always efficient. But it would not make economic theory useless. Economic theory could still tell us plenty about potentials: such as the amount of gain that would be created were policymakers to encourage buyers and sellers to strive to make mutually beneficial deals whenever possible. (Guido Calabresi makes a similar point when he argues that economics should focus less on how to expand the production possibilities curve and more on how to get the economy to that curve.) It would also help explain economic institutions that economics has so far been unable to penetrate.

Like advertising. The classic economic explanation for advertising is that it provides consumers with useful product information, something that is almost impossible to believe in the information age, if it ever was credible. But in a world in which good deals don’t always get done, there is another potential economic justification for advertising: that it seeks to overcome whatever cognitive or bargaining failures otherwise prevent good deals from getting done. In a world in which mutually beneficial transactions don’t always happen, because consumers are irrational, one would expect to find sellers spending large amounts of money trying to cajole buyers into buying, even in situations in which the deals on offer are good for buyers and so in theory they should embrace them without needing to be persuaded to do so. (That would go some ways toward undermining my own argument here that persuasive advertising must be bad for consumers, because absent advertising rational consumers always purchase the products that are best for them.)

There’s nothing wrong with the use of simplifying assumptions in economics, or in thought of any kind. But the use of inconsistent assumptions about behavior in the same model–often in relation to the same economic actors in the model–is a different story.

And all of economic theory is based upon doing just that.

Categories
Antitrust Monopolization Regulation

Fairly Balanced

Ben Smith must be congratulated for writing one of the few accounts in the Times of the battle between Big News and Big Tech even to acknowledge that there are two players in this fight, and that both are pursuing their own private interests, not necessarily the public interest.

Smith gets it right when he observes that: “The battle between [tech] platforms and publishers is . . . an old-fashioned political brawl between powerful industries.” Contrast that to “To Take Down Big Tech, They First Need to Reinvent the Law,” the headline of a story that appeared in the Times last summer, and you see why there is cause to celebrate this tick back in the direction of balanced journalism.

Of course, there’s still a long way for the Times to go before it stops using its bully pulpit to advance the industry’s own narrow pecuniary interests, and starts giving its readers a complete picture of what’s at stake in the battle between the media industry and Facebook, Google, and Amazon.

Smith follows a popular playbook in the press’s attempts to drum up political support for smashing its tech rivals: lionizing those who help them. No doubt this is the first time that Australian competition regulator Rod Sims has been called a “pugnacious 69-year-old” defending the public against “railroads, ports, and phone companies.”

And no doubt American regulators get the message: take the media’s side and the media will talk you up too.

But Smith really does deserve kudos for trying to be balanced. After all, he comes out and says it: “politicians remain eager to please the press that covers them.”

And: “[T]he power of the press, even nowadays, makes it a formidable political force. Rupert Murdoch’s bare-knuckled News Corp . . . has long led the fight to claw back revenue from the tech giants, and hostility to Google bleeds through the pages of The Times of London and Fox News’s airwaves.”

Of course, the same hostility “fairly bleeds” through the pages of the The New York Times as well. But it would be asking too much for the Times itself to acknowledge that.

I do wish though that Smith would drop a link when he goes on to observe that “much of the American media rejects the idea that it is crusading in its pages to support its publishers’ business agenda.” Last I checked, no one of any prominence had even called out the media for the brazen, self-interested, savaging of big tech that has been running above the fold in newspapers across the country for several years now.

Much less have I read a rejection of such criticism authored by any editorial page anywhere. The press is still a long way away from coming clean to its readers about this issue. All the more reason to thank Smith for finally acknowledging that there is a conflict of interest.

You also have to admire this bit of very journalistic commentary-through-juxtaposition in Smith’s piece: “Facebook, after taking a huge public beating for its role amplifying misinformation . . . has moved to give publishers what they want: money, mostly . . . . writing checks in the seven figures to publishers.” You’d have to be a very dull reader indeed not to see “shakedown” blinking here in red, all caps.

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But I haven’t said a word yet about the actual subject matter of Smith’s piece.

It’s this: the media industry has been arguing that Google and Facebook should pay newspapers for the links to news stories that Google provides on its search engine and that Facebook users spend endless hours sharing and discussing on Facebook. And the industry has made some headway in convincing government regulators in Australia and France to mandate such payments.

But is there a good argument for making Google and Facebook pay? Although there have been attempts to spin the problem of compensation into a copyright question — is a snippet of text from a news article included in a Google search result subject to copyright by newspapers? — the basic argument is that Google and Facebook would be a lot less valuable to their users if there were no journalism out on the internet for Google to help users find and for Facebook to help users share.

It follows that newspapers are contributing value to Google and Facebook, and should therefore receive compensation for that value.

The trouble with this argument is that there is no general rule that anyone who receives value from someone else should pay compensation for it. Imagine if you had to pay every pretty face you encountered on the street for the pleasure you take in a glance. There’s no doubt that Google and Facebook would be a lot less useful if there were no world for Google to reproduce in search results or for Facebook users to discuss on Facebook. That doesn’t mean that Google and Facebook should be made to pay all of their revenues out to the whole world in exchange for the value the whole world contributes to Google and Facebook’s websites.

The rule that policymakers actually do follow is to try wherever possible to ensure that those who produce value are paid enough to cover their costs of producing that value. That’s not at all the same as requiring full compensation for all the value producers confer on others.

That is, the basic rule on when to recognize a right to payment–otherwise known as a property right–is that producers of value should have enough of a right to payment to cover their costs. Because that is enough to ensure that they have the resources necessary to continue to produce the valuable things that they make. But beyond that, no one has, or should have, a right to payment simply in virtue of having conferred value on others.

Otherwise, no one could get any enjoyment out of the works of others! If a firm creates $10 of value for you, you would then be required to pay $10 of value back to the firm, for a net gain of zero. Clearly, a rule that value conferred must give rise to compensation simply because value has been conferred is unworkable.

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The newspaper industry may be wrong to argue that value conferred gives rise to a right to payment. But the industry does, however, have a good case that at present it is not receiving even enough compensation to pay its costs of production, which suggests at least that it should have a right to more compensation from someone. Local newspapers across the country are shuttering. And the big papers that remain have had to sacrifice care and balance in their reporting in order to attract readers and protect their bottom lines. While the industry still takes in enough revenue to produce news, it no longer takes in enough to produce news of optimal quality.

But it is far from obvious that Google and Facebook should be the institutions to pay the costs of better journalism. True, those two companies now earn the advertising revenues that once sustained the media industry. But that’s because Google and Facebook distribute advertising better than do newspapers, not because Google and Facebook have used monopoly power to strike down more-innovative newspaper rivals.

And anyway the vulnerability of the newspaper industry to competition from Google and Facebook–two companies that don’t, actually, produce any news of their own–points to a deeper problem that can’t be solved by forcing these firms to subsidize the newspaper industry: that the market in which the media industry generates its revenues isn’t actually the market for news.

It’s the market for advertising.

That has always been a huge problem for newspapers, because a newspaper’s core mission is to tell the truth, whereas advertising’s core mission is to manipulate consumers into buying products they would not buy otherwise, and the more so in the information age. It makes no sense to fund an industry devoted to arming the public against manipulation–political and otherwise–through the distribution of commercial attempts to manipulate the public.

Which is why addressing the current jeopardy of journalism by tying newspapers back into advertising revenue streams, generated now through the medium of Google and Facebook, would represent a lost opportunity–to wean the newspaper industry off of dirty money.

What governments should be doing to save journalism is to set up direct government subsidies for newspapers, the way many Western European countries, and Britain, have long subsidized television news through a dedicated tax.

Detractors of this approach warn that government support could compromise journalistic independence. But here’s the thing: if Congress rides to the industry’s rescue by passing legislation advocated by the News Media Alliance that would allow the industry to negotiate compensation from Google and Facebook, that too would be a government subsidy. Few are under any illusions about that fact, not least the journalists who are currently busy rewarding friendly politicians with positive news coverage. A hostile President, or Congress, won’t think twice about demanding good press in exchange for support for such legislation. Indeed, that’s exactly what politicians who are backing the legislation are already getting in exchange.

If we’re getting government-subsidized media either way, we should at least get it without the advertising, and the additional layer of conflicts with commercial interests that entails.

Of course when, as Smith reports in a different piece, “[t]he most heated debate in places where . . . nonprofit news executives gather . . . is whether it’s ever safe or ethical to take government funding,” not whether it’s safe or ethical to take money from corporate interests in exchange for running corporate propaganda, there seems to be little hope for this approach.

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Smith writes that the war between Big News and Big Tech is not just about private interests but also about “economic principle.” He’s right that the newspaper industry has tried to cast itself as the nation’s last line of defense against monopolization of the economy by the tech giants. But this craven and profoundly disingenuous appeal to the public interest was belied from the start by the industry’s advocacy of legislation that would allow newspapers to cartelize in violation of the antitrust laws in order to negotiate payments from the tech giants.

Demanding a cut of a monopolist’s profits is not the modus operandi of an industry committed to competitive markets. A News Corp. executive’s quip to Mark Zuckerberg about Facebook’s capitulation to modest payments–“what took you so long?”–says it all.

Of course, newspapers have also pressed for breakup of the tech giants, which is more like what one would expect from genuine antimonopoly advocates. But that, like all the bad press newspapers have heaped on Big Tech over the past few years, has just been about maintaining a bargaining position, the stick required to scare Google and Facebook into opening their wallets.

Once Big Tech does cut in the newspapers, don’t hold your breath waiting for the newspaper industry to continue the crusade for greater competition in America.

Categories
Civilization Regulation

Read It in the Sands

Anyone still skeptical about the usefulness of regulation as a general matter ought to consider the contrast between archaeology and treasure hunting. By which I mean, the triumphs of Twentieth Century state-sponsored archaeology and the failure of the preceding millennia of free-market treasure hunting.