Oliver Hart: Incomplete contracts and the theory of the firm

This article was originally published at VoxEU.

Oliver Hart and Bengt Holmström have been jointly awarded the 2016 Nobel Prize in Economic Sciences. The prize was so well deserved that the news was received with comments from fellow Nobel laureates such as “Didn’t they have it already?” (Paul Krugman) and “Nobel prize at its best” (George Akerlof). In this column, I focus on Oliver Hart’s contributions to contract theory, in particular to our understanding of incomplete contracts. Continue reading

Angus Deaton: Life after Stockholm

This piece first appeared in the quarterly newsletter of the Royal Economic Society. It is part of Angus Deaton’s ongoing ‘Letter from America’ column.

In these letters, which now stretch back two decades, I have only occasionally interrupted accounts of serious issues with cameo personal appearances (even though my shape is now remarkably similar to that of the late Alfred Hitchcock). But in the last six months, both Anne and I have been in the news in a rather serious way, and I thought it might be entertaining to write about our experiences, some of which are of more than local interest. In October, I learned to my delight that I was to be the recipient of the 2015 Nobel Prize, or more precisely-and there is no end of pedants and people who dislike economics who want to insist on it — the recipient of the Sveriges Riksbank Prize in Economic Sciences in memory of Alfred Nobel. As many previous recipients have told, the experience is both exhilarating and overwhelming; l have often thought of the story of the dog who liked to chase buses, but had little idea of what it would be like to catch one. The Nobel is not just catching the bus, but being run over by it.

While the bus was driving back and forward on top of me, Anne Case and I published a paper in early November in the Proceedings of the National Academy of Sciences, showing a reversal of the long-established decline in mortality among middle-aged whites in the US, especially those with only a high school education or less, and that the fastest rising causes of death were suicides, accidental poisonings (mostly from drug overdoses, both legal and illegal), and alcoholic liver disease. We had established those findings in May 2015, and every time we showed them to economists or physicians, jaws would drop. Even so, we failed to interest either of the major medical journals, one of whom rejected it so quickly that I thought I must have sent the paper to a bad email address. But once it appeared in the PNAS in early November, the storm of publicity exceeded by an order of magnitude the still ongoing publicity about the Nobel. Now there were several buses driving back and forward over both of us. Pleasant enough, but we were gasping for breath.

 

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Angus Deaton won the Nobel Memorial Prize in Economic Sciences in 2015 ‘…for his analysis of consumption, poverty and welfare’. Picture: Wikimedia Commons/Holger Motzkau (CC-BY-SA 3.0).

Of course, the Nobel and ‘the paper’ became entangled. Although the authors were listed as Anne Case and Angus Deaton, the order was typically reversed, and in several cases, became ‘Nobel economist Angus Deaton and his wife, Anne Case, who is also a researcher’, a designation that the Alexander Stewart 1886 Professor of Economics and Public Affairs was less than happy with. Justin Wolfers eventually wrote a piece in the New York Times on similar cases of blatant sexism in economics, including Ralph Nader’s extraordinary suggestion that Janet Yellen sit down with her Nobel Prize winning economist husband (George Akerlof) before she decided what to do about interest rates. But some of the entanglements were entirely positive. A splendid tradition in the US is that American Nobelists are invited to the Oval Office, so we went with two remarkable chemists who work on DNA repair-one of whom, Aziz Sancar, was born in Turkey to illiterate parents-and the infinitely charming Bill Campbell, born in Ireland, who found a cure for river blindness. Three out of the four are immigrants to the US, and the fourth, Paul Modrich, is the son of an immigrant. For Anne and me, the highpoint was when President Obama opened the door to the Oval Office, took our hands, and said ‘we have got to talk about this paper that you have written.’ He had clearly read it in detail, he had comments about earlier similar events in the African American community, and even some suggestions. Unusual attention for an academic paper, and all of this before we had been to Stockholm.

One of the most surprising reactions to ‘the paper’ has been the extent to which the newspapers, especially the New York Times and the WashingtonPost,  checked and extended our work. The Times downloaded the 36 million individual death records since 1999 in order to run their own analyses. The Post, very recently, correlated the ‘deaths of despair’ across counties with the voting patterns in the primaries showing, as many had surmised, that the deaths are correlated over space with votes for Donald Trump. We have also, of course, been horribly misquoted, including by Hillary Clinton who bizarrely claimed that middle-aged whites in America now have lower life expectancy than their parents. And there has been a good deal of hostility from some in the ‘health inequalities’ part of the space, upbraiding us for working on white mortality rates while blacks are still suffering. Indeed, at least part of why our finding had not been noticed was an excessive focus on inequalities, so that much attention had gone to the narrowing of the black white gap, without noting that some of the narrowing had come from increased deaths among whites.

Many have written about the splendors of Stockholm, and the videos and photographs on the Nobel website give a good idea of the colors, the flowers, the pomp, the dresses (Anne’s scarlet sheath could be seen from outer space), the jewelry, the King and Queen, and the princes and princesses. Being treated like a head of state, even for a week, is a memorable experience. It was a week to celebrate with my family — a nine-year old grandson in white tie and tails was a truly memorable experience —and with several vintages of coauthors. Perhaps what will stay with me the longest is that, for the Swedish people, the Nobel ceremony and the banquet that follows play the same role as the Oscars do in the US. People make dates with friends, they buy food and drink, and they watch everything on TV. All of this, amazingly, is to honor, not movie star charisma, or athletic prowess, but intellectual achievement. Alfred Nobel himself had the unusual opportunity to read his own obituary after his brother had died in an explosion, and been mistaken for him. He was so horrified by the descriptions of Dr. Death and the destruction he had brought to mankind that he determined to be remembered for something more positive, and the Swedish people have long honored his vision. And although the Swedes have their share of suicides, they have among the lowest mortality rates in the world, with no signs of rising mortality in middle-age.

Structure and change in economic history: The ideas of Douglass North

Douglass C. North was among the most important and influential economic historians and economists of the late 20th century. This column highlights four of his major contributions: his pioneering work in quantitative economic history, or ‘cliometrics’; his similarly fundamental work using neoclassical economics to understand institutions; his critique of theory for explaining long-term economic and institutional change; and the distinction he drew between institutions and organisations.

 

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Co-recipient of the 1993 Nobel Prize in Economic Sciences Douglass North.

 

Douglass C. North recently passed away at the age of 95 at his home in Benzonia, Michigan. He was among the most important and influential economic historians and economists of the late 20th century. He will be deeply missed by his family, friends, colleagues, and students.

North was a leader of the generation of economic historians who brought neoclassical economics directly into the study of history – the ‘new’ economic history. And then realising the incompleteness of the neoclassical tools for understanding long-term change, he was a leader of a generation of economists and social scientists who brought the importance of institutions into a central position within economics – the ‘new’ institutional economics.

North long emphasised the importance of history and of neoclassical economics. He criticised both disciplines for their complacency about the adequacy of the current conceptual and methodological consensus on how history or economics should be done. He always operated within a framework of individuals who act intentionally (neoclassical economics matters) and who perceive the world through cognitive lenses that are part inherited from their culture and part derived from their own experience (history matters).

Individual actions are governed by interests shaped by relative prices, endowments, and constraints (institutions) as well as by perceptions of how the world around us works (cognition and beliefs). Social outcomes are the sum of individual actions, but the summation process is not a simple adding up, since interactions between individual decisions and beliefs critically influence the behaviour of everyone. Here, I want to highlight four of his major contributions.

The evolution of North’s thinking continuously shaped his willingness to pursue the interesting questions he was unable to address in his last book or paper, not by what was currently hot in the profession. Testimony to the power of his insight is that the profession has followed him, for he certainly didn’t follow the profession.

Cliometrics

His first book (North 1961) was one of the first examples of quantitative economic history or ‘cliometrics’, North’s first major contribution to economics and economic history. The book presented a very neoclassical theory of economic development that emphasised the importance of geographic specialisation and division of labour, and which led him to investigate the sources of falling transport costs over the 19th century.

In North (1958), he laid out a technology-based neoclassical framework for thinking about declining freight rates. But ten years later, in North (1968), he concluded that: “The conclusion one draws is that the decline of piracy and privateering and the development of markets and international trade shared honours as primary factors in the growth of shipping efficiency over this two-and-a-half-century period.” (p. 967). Essentially, the costs of shipping were falling because costs other than the costs of operating ships were falling. Those cost reductions were the result of institutional change. The paper marks North’s turn towards both transaction costs and institutions as important elements of economic change over time.

Transaction costs and institutions

The turn towards transaction costs and institutions did not mean a turn away from neoclassical economics, however. The assumption of zero transaction costs and unchanging institutions could be relaxed within the context of neoclassical theory. As North (1971) argued: “What we need is a body of theory which encompasses the traditional models of the economist and both widens its scope and allows us to include an explanation of the formation, mutation and decay of organisational forms within which man cooperates or competes.”

North was moving towards a neoclassical theory of institutions in which the form of institutions or organisations was itself determined by traditional neoclassical rationality and constraints. The idea that neoclassical theory could be used to explain why institutions functioned as they did was a fundamental breakthrough and North’s second major conceptual contribution. The idea was implemented in a series of papers with Lance Davis and with Robert Paul Thomas, which led to two books (Davis and North 1971, North and Thomas 1973).

Both books argue that we can explain changes in the organisation of human interaction (institutions) on the basis of the rational interests of individuals attempting to structure the world around them in ways that maximise net benefits. The classic application of the technique is North and Thomas’s explanation of how the rising price of labour in fourteenth century Europe as a result of the Black Death, led to the institution of wage labour in western Europe and a return to the institution of serfdom and slavery in Eastern Europe. The same relative price shock led to two different, but both rational, institutional changes.

Two lines of thinking emerged from the idea of neoclassical institutions, and they were not entirely consistent with one another. In one line, institutional change occurs because of short-run variations in relative prices that create, at some point in time, the incentives to restructure human organisations. For some reason, these changes persist.

This led North to investigate both path dependence and transaction costs. Transaction costs play a key role, because they are both a reason to change institutions to reduce (or increase) transaction costs, and because transaction costs subsequently can make it difficult to change institutions and so contribute to institutional persistence.

The other line of thinking was a growing dissatisfaction with neoclassical economics altogether as a way to understand the process of economic growth specifically, and more broadly to understand the process of economic change over time. His third significant breakthrough was the realisation that neoclassical theory was not just inadequate, but that it was unable to explain long-term economic and institutional change in any society, growing or not.

North directed his first clear criticism at economic historians, while acknowledging the important contribution that economic theory and quantitative techniques made to advancing our understanding of historical processes, nonetheless. “From my quite subjective perspective, the new economic history has made a significant contribution to revitalising the field and advancing the frontiers of knowledge. Yet I think it stops short – far short – of what we should be accomplishing in the field.” (North 1974, p. 1).

Criticism of neoclassical theory in economic history

His criticism of neoclassical theory in economic history, development, and growth would culminate in North (1981), which many (including myself) believe to be his best book. The introduction and second chapter extend the argument that we must have more than a history of markets to understand economic change. The third chapter titled “A Neoclassical Theory of the State”, lays out a logical neoclassical argument for why, in the presence of transactions costs, political systems do not inevitably evolve institutions that promote economic growth. Indeed, as long-term economic history suggests, the tendency is for political systems to evolve that do not support growth. Chapters four and five argue that we need a theory of organisations as well as a theory of beliefs and ideology if we are to understand long-run change, particularly long-run change that does not inevitably produce growth and development.

The contradiction between the two lines of thinking is clear in North (1981). On the one hand, there is a strong argument that neoclassical economics is incapable of delivering the full range of explanations necessary to understand economic change, particularly ideologies and beliefs. On the other hand, there is a strong argument that rational individual behaviour is consistent with institutional choices that retard, rather than promote, economic growth. One wonders whether the question is to be neoclassical or not to be neoclassical?

The real question the book is trying to grapple with is: Persistence or change? Going back to North and Thomas (1973), institutions change when there are gains from doing so, but then persist because of the high transaction costs of changing them.

In North (1981), beliefs and ideologies persist. Because beliefs (and norms and culture) are based on the cumulative experience of society passed down through culture and formed through repeated interactions of many people through norms of behaviour, beliefs do not change quickly and it is extremely difficult to for social actors to manipulate beliefs in current time.

As a result, beliefs are always a function of what happened in the past and can impede change in the present for good or ill. It is the persistence of beliefs and institutions from the past (culture) that explain why changes in the present often produce results that impede rather than promoting growth and development. The importance of beliefs in this framework plays a major role in North (1990) and it is the central focus of North (2005).

The framework in North (1981) includes two different time patterns of institutional change. One is episodic and discontinuous, like the move towards wage payments after the Black Death in Western Europe; the other is continuous and marginal. Changes in beliefs and ideologies, in norms, and in informal and formal rules occur constantly and, while changes sometimes persist, they need not. Neither continuous nor episodic institutional change is necessarily persistent.

Fleshing out these ideas in the 1980s produced a classic example of change during a crisis that persists: the analysis of constitutional institutions in seventeenth-century England in North and Weingast (1989). This paper’s emphasis on institutional mechanisms explains why particular institutions are self-enforcing and persist over time. At the same time, North was writing his 1990 book Institutions, Institutional Change, and Economic Performance. Persistence plays a large role in this book, which regularly emphasises that the function of an institution is to provide stability and predictability to human behaviour.

The big contribution of the 1990 book, however, is the definition of institutions that North called the sports analogy. Institutions are the rules of the game and the means of enforcement, and organisations are the teams that play the game. The definition motivates three behavioural choices that organisations can make: one is to maximise under the rules; the second is to devote resources to changing the rules; and the third is to cheat. The alternatives are not mutually exclusive, and they comprise a framework for understanding the dynamics of institutional change.

Institutions and organisations

North’s fourth major contribution was to separate institutions and organisations. Since his earliest books, North always included a discussion of organisations as important, but organisations were treated as manifestations of institutions. Organisations usually disappeared from the conceptual framework, which was always neoclassical in its focus on individuals.

By defining institutions as the rules of the game and means of enforcement, and then separating the rules from the organisations that actually play the game, it became possible to have a dynamic relationship between the interests and incentives facing the organisations and the structure of the rules. The descriptive concept that comes out of the dynamics is ‘adaptive efficiency’. In some societies, the interaction of institutions and organisations produces a series of institutional changes that get incrementally better, rather than a sequence that is sometimes good and sometimes bad for economic performance.

Rather than resolving (or integrating) the tension between the long- and short-term forces leading to institutional change, North (1990) exacerbated it. The rules of the game include formal rules, informal rules, and norms of behaviour. By stressing the function of institutions as providing stability and predictability, and emphasising the importance of beliefs and norms, the book effectively claimed that the persistence of institutions was not a matter of real-time economic and political forces, but an outcome of the natural limits to human capacities for cognition and culture.

North pressed farther down this road with his 2005 book. The interaction between organisations and institutions was a central focus of his last book with Barry Weingast and myself (North et al. 2009). I will leave it to others to evaluate that book.

Personal reflections

I was lucky to have known Doug for most my life, beginning as his advisee for my undergraduate honours thesis in 1975. He was an exceptional human being, with a full appetite for life in many dimensions. He owned his own plane, sailboat, two ranches, and loved food, wine, and music.

He profoundly appreciated how little we know about how societies actually work and how, as individuals and social scientists, we interpret what we see and experience through the ideas – theories, histories, and frameworks – we construct for ourselves. This appreciation not only gave him a life-long interest in cognition, but it was also a wellspring for his continuing ability to question what he and we believe.

All four of his major contributions came because he probed what we did not understand, obviously important questions for which we had no answers. His unerring sense of what best next question to ask flowed from his awareness of our collective ignorance. Not knowing and a willingness to admit it are personal characteristics rarely in evidence at the level of intellectual accomplishment that Douglass North reached. We all are better for his unique combination of confidence and humility.

References

Davis, Lance E and Douglass C North (1971), Institutional Change and American Economic Growth, Cambridge, UK: Cambridge University Press.

North, Douglass C (1958), ‘Ocean Freight Rates and Economic Development 1750–1913’, Journal of Economic History 18(4): 537-555.

North, Douglass C (1961), The Economic Growth of the United States 1790–1860, Englewood Cliffs, NJ: Prentice-Hall.

North, Douglass C (1968), ‘Sources of Productivity Change in Ocean Shipping, 1600-1850’, Journal of Political Economy 76(5): 953-970.

North, Douglass C (1971), ‘Institutional Change and Economic Growth’, Journal of Economic History 31(1): 118-125.

North, Douglass C (1974), ‘Beyond the New Economic History.’ Journal of Economic History 34(1): 1-7.

North, Douglass C (1978), ‘Structure and Performance: The Task of Economic History’, Journal of Economic Literature 16: 963-978.

North, Douglass C (1981), Structure and Change in Economic History, Cambridge: Cambridge University Press.

North, Douglass. C (1990), Institutions, Institutional Change, and Economic Performance, New York: Cambridge University Press.

North, Douglass C (1993), ‘Douglass C. North, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1993: Autobiography’, Vol. 2010, The Nobel Foundation.

North, Douglass C (2005), Understanding the Process of Economic Change, Princeton: Princeton University Press.

North, Douglass C, and Robert Thomas (1973), The Rise of the Western World: A New Economic History, New York: Cambridge University Press.

North, Douglass C, John Joseph Wallis, Steven B. Webb, and Barry R. Weingast (eds) (2013), In the Shadow of Violence: The Problem of Development in Limited Access Societies, New York: Cambridge University Press.

North, Douglass C, John Joseph Wallis, and Barry Weingast (2009), Violence and Social Orders: A Conceptual Framework for Interpreting Human History, New York: Cambridge University Press.

North, Douglass C, and Barry R. Weingast (1989), ‘Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England’, Journal of Economic History 49:4.


This article was first published at VoxEU.

2015 Nobel Prize in Economics: Consumption, great and small

Angus Deaton of Princeton University has been awarded this year’s Nobel Prize in Economic Sciences ‘for his analysis of consumption, poverty, and welfare’.

‘Deaton’s work has bridged theory and data; it has also bridged individual behaviour and aggregate outcomes; and it has helped to transform the fields of microeconomics, macroeconomics & development economics’, said Jacob Svensson, a member of the Prize Committee, in his announcement of this year’s laureate.

 

 

And George Mason University economics professor and blogger Tyler Cowen wrote, ‘“Understanding what economic progress really means” I would describe as his core contribution… Think of Deaton as an economist who looks more closely at what poor households consume to get a better sense of their living standards and possible paths for economic development. He truly, deeply understands the implications of economic growth, the benefits of modernity, and political economy.’

Deaton himself has summarised his research as follows: ‘Much of my work has been concerned with household behaviour, with demand systems, with consumption and saving, and with intra-household allocation. I have tried to work on these topics broadly, at both microeconomic and macroeconomic levels, and using data from developing as well as industrialised countries. I have been concerned with using theory to interpret data, and with methods for organising data that will cast light on issues of theory or policy.’

 

 

The Nobel citation focuses on three areas of achievement in Deaton’s research.

How do consumers distribute their spending among different goods?

When governments plan changes to their tax systems – proposing, for example, to raise VAT on food – they need to be able to forecast which social groups will gain and lose and how large the gains and losses will be. To do this, they need to understand how individual choices depend on prices and incomes and how consumption might change in response to the reform – they need to understand what is known as the ‘demand system’. Deaton’s early work sought to capture these real world demand patterns, to compare them across countries and to assess their implications for policy.

 

How much of society’s income is spent and how much is saved?

Stabilisation policy – government efforts to manage the ups and downs of the business cycle – depends on understanding the links between income, consumption and saving – how much is spent and how much is saved. Aggregate measures of these variables are of course determined at the individual level, but Deaton found that analysing aggregate data often yields the wrong results, suggesting that consumption varies more than income when in fact the opposite is the case. His work showed that it is essential to study consumption and income at the individual level and then to aggregate.

 

 

How do we best measure and analyse welfare and poverty?

In his recent work, Deaton has been concerned with measuring living standards and poverty in developing countries. In particular, he has demonstrated the difficulties of setting a poverty line as a way of assessing the extent of global poverty – for one thing, it is vital to know the prices and quality of the goods and services that are available to people. His use of household surveys has helped transform development economics from a theoretical field based on aggregate data to an empirical field based on detailed individual data.

His most recent book is The Great Escape: Health, Wealth and the Origins of Inequality. Stanford historian Ian Morris says it ‘tells the two biggest stories in history: how humanity got healthy and wealthy, and why some people got so much healthier and wealthier than others… he tells us how the billion still trapped in extreme poverty can join us in this great escape.’

 

Angus Deaton

Born in Edinburgh in 1945, Deaton was awarded his doctorate in economics by Cambridge University in 1974 before spending seven years as a professor of econometrics at the University of Bristol. Since 1983, he has been at Princeton University.

Speaking by telephone to the press conference in Sweden shortly after the announcement, Deaton said, ‘as someone concerned with the poor of the world, how they behave and what gives them a good life, I am delighted that this kind of research has been recognised’. As one of the great proponents of the importance of measurement in economics, he added, ‘the work done by me and my colleagues relies on data collected by statistical offices around the world. The people working in these roles, especially in poor countries, are the great unsung heroes of economic analysis’.

 

 

The Lindau Nobel Laureate Meetings offers sincere congratulations to the new laureate and hopes to hear from him in person about his research at the next Lindau economics meeting in 2017.