Monday, August 20, 2018

Productive and Unproductive Error

The list of new working papers this morning from nep-his contained one by Richard Langlois, “The Fisher Body Case and Organizational Economics”, which examines the case of Fisher Body. Mary and I also examined the case in our paper “The historian’s craft and economics,” This blog post is both a concurring and dissenting opinion on the Langlois paper.

Fisher Body was an early manufacturer of automobile bodies that merged with General Motors in the 1920s. Both our paper and Langlois paper are, however, less about the story of the merger than they are about the story about the story. The story about the story begins when Klein, Crawford and Alchian published a paper in 1978 that used Fisher Body as an example of vertical integration driven by the holdup problem arising from asset specificity. For non-economists the terms may be unfamiliar, but the intuition is straightforward. The relationship between the automobile manufacturer and the manufacturer of bodies will be most profitable if they make investments that are fitted to each other. For example, the assembly plants are close to the body plants, or the body plants are designed to produce the sort of bodies the automobile company uses. In other words, you have assets, factory and equipment that are specific to a particular use and much less valuable in alternative uses. Hold up is the idea that once such investments have been made one side can try to exploit the other. “We are going to lower the price we pay for your automobile bodies, and you will have to accept it because no one else is going to buy those bodies that are designed for our cars.” That is a really simplified version, but you should get the idea.

In 1988, Klein described this explanation for the merger
“Fisher effectively held up General Motors by adopting a relatively inefficient, highly labor-intensive technology and by refusing to locate body-producing plants adjacent to general Motors assembly plant” (Klein, 1988: 202).

In 1988, Coase began to question this explanation, and he and several other researchers presented considerable evidence that the sort of holdup described by Klein never took place and that the merger was motivated by other concerns. Klein and Coase argued back and forth, and several other people jumped in. Ultimately Klein acknowledged that the hold up he described never took place.
Both Coase and Hansen and Hansen present the case as an example of economists’ failure to give sufficient attention to empirical evidence. Langlois on the other hand sees the entire episode as an example of the process of developing economic knowledge. Here is the conclusion of his paper

I agree with the overall thrust of Langlois argument but disagree with his specific case. I think there are numerous examples of cases where economists have developed explanations that turned out to be incorrect but were important because they generated debates and stimulated research that led to better understanding.

For instance, Doug North’s explanation for economic development in the antebellum period prompted research into agricultural production in the South and industrial development in the North that overturned his explanation and led to a better understanding of antebellum development. I think a similar thing is going on with Pomeranz’s work on the Great Divergence. Academics should not be criticized just for being wrong, especially if it leads to research that improves our understanding of something. 

So what is the difference between North and Pomeranz, on the one hand, and Klein et al, on the other. First, Klein et al simply use Fisher Body to provide a little color to the theory. Their primary objective is not to understand the history of Fisher Body and GM. The work of North and Pomeranz on the other hand was driven by the desire to understand history. Second, North and Pomeranz based their theories on the available evidence, and some of their claims were later challenged by new and better evidence. The initial claim of Klein et al was not based upon the available evidence. There was already evidence in support of a contrary claim and no evidence in support of their claim that Fisher held-up GM. Finally, the responses to North and Pomeranz took us beyond where we were before they wrote. In contrast, the responses to Klein et al largely took us back to where we were before. According to Langlois

The use of Fisher by Klein et al is an example of trying to cram history into a theory rather than using theory to understand history. When I was studying economic history at the LSE in the early ‘80s I became increasingly interested in the use of economic theory in economic history. My advisor, Geoff Jones, told me that theory could be very useful but that I had to be careful not to try to make a historical story fit into a theory. Theory might help guide the search for evidence, but you have to go where the evidence leads you even if that doesn’t fit your theory. And you must tell the story honestly.  Although I went on to get a Ph. D. in economics rather than history, I have always tried to keep Geoff’s advice as a guiding principle. I think Klein et al would have been less likely to follow the path they did if they had been driven by a desire to understand Fisher Body.

Wednesday, August 15, 2018

That's Just Econ 101

The other day my wife and I were talking about how people like to use phrases like “that’s just Econ 101”. Unfortunately, statements that precede that phrase are almost never Econ 101. It’s just whatever the person happens to think. I said that fairy tales should be re-written to include the phrase. “If you don’t make the shoes, elves will do it at night. That’s just Econ 101.” "He spins straw into gold. That's just Econ 101."

Bill Gates provided support for the claim that people to tend to say things about basic economic theory that are not part of economic theory.

He says that it costs as much to build the 1,000th unit as it cost to produce the 10th. Economists call the additional cost of producing another unit of a good marginal cost. What he is describing is constant marginal cost. The problem is that he drew an upward sloping supply curve. An upward sloping supply curve means that higher and higher prices are required to get suppliers to provide additional units of the good. Why are higher and higher prices required? Because of increasing marginal cost. Gates description of constant marginal cost is thus inconsistent with his graph. This is actually a small problem because Gates could have just as well said that economists assume increasing marginal cost when drawing typical supply and demand curves.

His real point seems to be that there are now many goods for which there are large startup costs and near zero marginal costs. That is how he describes software production. He suggests that this is a new development that arises from the intangible nature of goods like software.

It is not actually a new situation, it does not arise from the product being intangible, and undergraduate economic textbooks have models of this situation.  There are many examples of products for which there are very large start up costs and relatively small (near zero) constant marginal cost. Railroads are not new, and they are not intangible, but they required large expenditures on construction and, once built, the additional cost of another passenger or another bushel of wheat was practically zero.  Insurance is intangible, but it is not obvious that it can be produced at zero marginal cost.

This is a graph from McCloskey’s Applied Theory of Price, which, by the way, is available to you at the amazingly low cost of your time to download it.

Gates concern that the rules have not kept up with the changes in the economy is also not new. People said the same thing in the late nineteenth century with the rise of railroads and other big businesses with high start up costs and low marginal costs. 

Gates does not address the demand side but these are generally firms that have some degree of market power. They face a downward sloping demand like the firm in the graph. Because other people do not regard other goods as perfect substitutes the firm won't lose all of its customers if it raises its price. The more the firm can convince people that other goods are not close substitutes for its good the greater its ability to raise its price above marginal cost. I some ways the more important thing is whether it can keep other companies from offering close substitutes. In other words, can it create what economists call barriers to entry. You can have a great idea, but if you can't keep other people from copying it you are not going to make great profits.

In short,

1. If you want to charge a price that is greater than marginal cost you need to convince people that other goods are not close substitutes for yours. Think of the old Porsche slogan: "Porsche. There is no substitute."

2. If you want to make more than an average rate of profit you need to keep other people from copying you, that is introducing substitutes for your good (or you need to keep coming up with new things that don't have close substitutes).

Those two ideas actually are Econ 101.