I'd make a good capitalist after all

Here is an interesting online game you can play with your friends. It models the Market For Lemons scenario that I've been blogging about a lot in the past week.

Screenshot:

The way my classmates and I played, 4 sellers were pitted against 6 buyers. The first 4 rounds we (the buyers, I was a buyer) had symmetric information, meaning we knew exactly what the quality of each product was and its price. Grade 1 had value equal to a price of $4.00, Grade 2 had $8.80 and Grade 3 had $13.60.

As shown in the screenshot - the last 4 rounds we (the buyers) had asymmetric information, meaning we had no idea what the quality of the products were; we only knew the price. In that case, just as George Akerlof described, no seller would put Grade 2 or 3 on the market because no buyer could be sure he or she wasn't losing money on the trade. Each buyer would be safest assuming that each product was Grade 1 in that case and then make purchases accordingly. This drives out Grade 2 and 3 products and the market is flooded with Grade 1s, or "lemons". CONCLUSION: there'd be no good products in this market without symmetric information.

At the end of the rounds I made more money from buying than the other capitalists, so, hey, yay for asymmetry! I still plan on keeping my "SHOPPING PRIORITIES" straight.

idea: next time we should model collusion by allowing buyers and sellers to communicate via IRC chat.

Smash Certainty, Become Famous

One of the most important economic articles of the past forty years is George Akerlof's discussion of the used-car market in the article The Market for 'Lemons': Quality Uncertainty and the Market Mechanism (.pdf), as mentioned previously.

The fact that this article is the seminal article in the New Institutional Economics genre blows my mind. Maybe it's because the ideas are now already so absorbed into the culture that its conclusions seem painstakingly simple. The article has been cited 4,605 times according to Google Scholar.

Because after all, Akerlof did not establish any iron laws or reach any definitive conclusions about used-car versus new-car markets. Rather, from the very beginning of the article, he showed that economists had left out a key element of consumer decision making in past theorizing - the difficulty of verifying product quality.

But it hadn't taken extraordinary insight on Akerlof's part to understand that the problem of verifying product quality existed - shit, I mean, any ordinary consumer had to deal with lemons all the time. Akerlof also did nothing to make the problem of ensuring product quality any simpler or easier for consumers to resolve in the future. No fancy maths, no complicated calculus. I think he even tried to make the variables look more exciting than they would otherwise be.

The article's contribution to economics was that it pointed out product-quality issues and the consequences for neoclassical theologians who never considered such a simple fucking problem as part of the picture. Akerlof made the argument that his economist peers should talk about this more, because including it would lead to a more accurate and realistic portrayal of capitalism in the classroom.

After it was given some thought for a while, and in light of subsequent writings by other economists, his point was accepted and he went on to become a famous economist who won the Nobel Prize in economics in 2001.

What I want to say is this. The lemon article is typical of the way economics advances. After something fairly obvious gets by unnoticed for a time, a friendly dissenter takes aim and recasts the old paradoxes (Zeno's, Gresham's, etc.) in new terms. Publishers then jibe around thinking about whether it is "interesting" or not, and then if it is, lots of subsequent academics think about the world as seen in the development of the new economic idea, and include this in their citations. If you make a strong effort to communicate the breadth of your conclusions and the advantages of your research program, you will be immortalized through citation. That is the critical element in achieving professional interest and recognition.

In the Market for Institutions

"Over time, some institutions survive and others do not, while new ones are created. Institutional Darwinism suggests that only the fittest institutions survive."

- Jaya Sil, Organizing Ideas

I have further ideas following the short introduction to New Institutional Economics in the last post. The marketplace is supposed to be a place where valued products survive and sub par products fail. Adding to this, some say that good institutions are supposed survive and bad ones fail. I find this "meta" Darwinian view about institutions in the marketplace essentially invalid. Or at the very least unsophisticated.

Bad institutions are harder to change out than bad products. The rules of capitalism are firmly established, so a lot must be done to supplant its various institutions.

But this is exactly Jaya Sil's point. It is the New Institutional point: that Institutional Darwinism is just more residual from neo-classical thinking. According to the neo-classical analysis if an institution is clearly not the fittest, it would not survive the challenge from another institution poised to take it over. But why is that not true? Jaya Sil lists the 5 reasons given by the New Institutional paradigm.

1) the costs are too high to switch.

2) there is uncertainty over who gains from the switch.

3) there is lack of credibility regarding whether compensation for losses by redistributions from gainers to losers will occur.

4) there is a coordination failure.

5) there is a high sunk cost to the institutional switch.

But we should identify another one, because all five of these reasons so far assume that costs in some form or another are the only stumbling block to changing up the institutions, and therefore that analysis is still naive when it comes to Darwinian thinking. I would suggest

6) regulatory capture; if the failing institution is holding its power through governmental mandate, especially when the regulating institution itself has been "captured" by lobbyists for the institutions in question.

It's the Institutions, Stupid

I am currently taking an economics course with a professor whose primary research areas are Fair Trade Coffee, economic organization in agrarian communities, and New Institutional Economics, or NIE. Here is a 2007 article (.pdf) about some of Matt Warning's work from Fresh Cup Magazine.

I thought I would survey some of the important theorists who are known for their work in the NIE perspective because I find it fascinating and I'd like to know more about it myself. The underlying focus of NIE is to show that "neoclassical" models which demonstrate institutions as either 'efficient' or 'inefficient' may not predict actual market preferences when we take into account other concepts that neoclassical models take for granted.

The success of NIE in many ways is the discovery of the many exogenous institutions that neoclassical economics took for granted, and providing modeling tools which have developed to accommodate concepts hitherto unfriendly towards models. This has sparked research in lots of areas, and spawned a new generation of researchers with NIE tools at their disposal. The the addition and contemplation of effects like 'transaction costs' and 'informational economics' are probably NIE's greatest contributions.

Here are just a few names from various disciplines within economics that have been effected by the NIE perspective.


Economics of Information


George Akerlof, Michael Spence and Joseph Stiglitz won the 2001 Nobel Prize in economics "for their analyses of markets with asymmetric information". Akerlof is probably best known for his "Market For Lemons" (.pdf) article in which he showed that owners of better products are less likely to sell their products in 'used' markets because of asymmetric information problems. The market for "lemons" is supposed to not exist according to a neoclassical analysis. But with an institutional analysis (with institutions like warranties) the problem is allegedly solved. Stiglitz, former Chief Economist at the World Bank wrote a series of diatribes against the Bank and the IMF, but is known in academic circles for his research on screening and information asymmetry. The breadth of his work is far-reaching as his latest book (and blog) about the Iraq War testifies. Spence is most known for developing the "job market signaling"(jstor) model which discusses ways that agents (employees) can convey information to principals (employers).


Transaction Cost Economics (TEC)


The first time the notion of "transactions costs" came up was in Ronald Coase's book The Nature of the Firm (1937). There it was explained that a firm would decide to 'outsource' production or services, etc. when the cost of providing them within the firm were too high. These costs were identified primarily as transaction costs, and the concept has since migrated to lots of other places in economics. Oliver Williamson was actually the first economist to call what these academics do "Institutional Economics". A student of Coase, Williamson pioneered concepts like information impactedness and the incomplete contracts approach to microeconomics and corporate finance. Finally, the other big name here is Douglass North. He is just an amazing economist who among other things brought the department of economics at the University of Washington fame for economic historianism.


Social Capital


Social capital theory in economics came largely out of transaction costs economics. One way to measure it is by looking at the depth of contracts and strength of social networks. For example, if a contract specifies every possible breach one can think of, then the context in which the contract arose is probably low in social capital. If a contract specifies very few possible breaches, social capital may is probably high. The key point: the cost of low social capital is a transaction cost. Though he is not an economist, Robert Putnam, author of Bowling Alone, is the leading pioneer of this perspective.


New Social Economics


An economist from the Chicago School is most known for pioneering this work. In 1992 Gary Becker won the Nobel Prize in economics for various applications using the NIE methodology, including ideas like the microeconomics of fertility, which dissected the decision to produce offspring into questions about old age security, altruism and manipulation. He also came up with the "rotten kid theorem", the "economics of discrimination", and was given the Presidential Medal of Honor in 2007 by George W. Bush. The work of Becker and many others spurred an interest in family economics, the economics of suicide, and other subjects formerly talked about only in psychology or sociology departments.


Critique of the Neoclassical Paradigm


The research of NIE has consistently over the years demonstrated that neoclassical models of economic behavior are insufficient. When we analyze decisions essentially in terms of price and marginal utility alone, without considering their institutional context, we yield results that are often nonsensical. In the market for lemons example, the neoclassical model suggested that nobody would buy or sell cars because of the problems it generated. But the institutional models add the context necessary to understand why markets are actually possible.

There are plenty of other theorists in this perspective not discussed here. Topics in the New Economic History include Robert Fogel's analysis of slavery as an institution. Topics in Political Economy are covered by Malcolm Rutherford.


For further reading:


International Society for New Institutional Economics -->
Ronald Coase Institute -->