Property rights and natural resources

It is a firmly established conventional wisdom that natural resources are best preserved when there are well established property rights. It is the quintessential example of the tragedy of the commons that if everyone is allowed, say, to take water, water will be over-exploited. This wisdom takes, however, a crucial assumption: that once the resources is taken, property rights are well established and uncontestable. What would happen if not?

Louis Hotte, Randy McFerrin and Douglas Wills show that reverting this assumption can have a dramatic impact. Suppose that you took a freely available resource, but that now anyone can contest your ownership of that resource. Depending on the consequences, you may not want to extract in the first place. It thus matters in which way the state is weak. If it is weak in that it gives away rights to natural resources, then there will be over-exploitation. If it is weak in that it cannot enforce property rights in general, and in particular when it comes to bring product to the market, then it is the Wild West and under-exploitation may ensue. Theft is a powerful mechanism to kill markets.

Why should marriages be eternal contracts?

Risk sharing contracts are good contracts, and they can have an important welfare benefit. However, it is not quite clear that these contracts should be valid for a life-time. Indeed, this is what marriage is. Aside from the fact that these contracts are restricted to be signed between people of opposite gender, one can also question why not more people could be included in them. That would be good risk diversification. The problem is that a marriage contract is not just about risk sharing (and for that we have a market for insurance contracts nowadays), it is also about limiting sex choices and commitments to supporting children. But all this could be achieved without marriage.

Anyway, Stefania Marcassa and Grégory Ponthière ask whether marriage contracts should be eternal and find that in most cases they should not. Their argument has nothing to do with risk and uncertainty, rather with declining match quality and unequal bargaining power. Indeed, when one potential partner has little bargaining power, marriage gives an important veto power. But when bargaining powers are rather equal, like they are nowadays, long-term contracts become more interesting because no one has an incentive to veto a marriage due to unequal power.

The iPhone must have an exclusive carrier

Aren't you angry that the particular mobile phone you prefer has an exclusive contract with a carrier? This limitation of carrier choice seems anti-competitive, if not frustrating. US anti-trust authorities seem to be getting interested in these arrangements and may intervene. It turns out that maybe they should not.

Robert Hahn and Hal Singer say exclusivity contracts are in fact the best thing that could happen for consumer welfare. Indeed, they spur competition through innovation, and the fact that the smart phone industry is innovative is hardly an understatement. Indeed, the exclusive contracts allow manufacturers to share the risk with the carrier, they make sure that both want the success of the new phone, and thus insure better reception and coverage. All this taken together induces manufacturers to take more risk and go for even faster and bolder innovations, which ultimately benefits the consumer.

An economic model of God

To publish in Economics, marketing your paper is unfortunately very important. And it all starts with a catchy title. Some subjects can inspire you to absolutely great titles, like this one: "An Economist's Guide to Heaven." Dan Hamermesh could have penned that, but it is a paper by Nick Muller, Jo Anna Gray and Joe Stone.

The paper is not about how you can make sure the Pearly Gates are open to you, but rather it "offers an economic model of God and humanity as optimizing agents in the context of concrete belief archetypes (religious ‘contracts’) in Judeo-Christian theology." In plainer words, they study how belief about God influences the behavior of optimizing agents. In this paper, God optimizes, too, and believers know that. People care about private consumption, public goods and what God does to them, if they are believers. God benevolent, as He cares about public goods and likes to reward people instead of punishing them. Believers have a contract with God that entices them to provide public goods in exchange of godly rewards or punishments. Contracts can take four different forms, depending on the archetype within the Judeo-Christian belief system, which lead to different outcomes that can be tested using the General Social Science Survey.

Results are consistent with the model: strength of faith is irrelevant if there is no penalty in the contract, believers renege if there is no penalty, and contracts with penalty work, even if penalties are never exercised. What remains to be understood, though, is why there are believers in the first place.

Why boards keep bad CEOs

As described in a previous blog post, CEOs are not as expensive to a firm as commonly perceived, and they are are real bargain. Still, you have sometimes to wonder why some CEOs stay in charge despite lackluster performance. Is the board asleep at the wheel? The conventional wisdom is that it is all an inside job. As the CEO selects the board and the board selects the CEO, they all protect each other. And when a CEO really needs to be replaced, he is chosen among the members of the board.

Meg Sato advances that there could be another reason. It is all about rent seeking. The board may have interests that differ from shareholders, and thus wants to appoint or keep a CEO who performs in its eyes, but not in the eyes of shareholders. This happens because the CEO is kind to the board and will minimize the leakage of the surplus of the board.

The way this is analyzed is by model this as a Nash game, where CEO wage, costly CEO monitoring and CEO succession policy (internal vs. external) are determined. Because the board does not internalize the welfare of an outsider CEO candidate, it will tend to prefer an insider and monitor him little. Because CEO skills are perfectly observable ex-ante, such skills matter more in heterogeneous industries, and incumbents or insiders have acquired firm-specific knowledge, heterogeneous industries should have more insider CEOS and and longer CEO tenures. While this paper is purely theoretical, other empirical work confirms this conjecture.

Should we own our children?

We sink a lot of resources into our children, be it in time or money. while they are children, the return is largely non-material. Thereafter, there can be a material return, directly if children support their parents during old age (and often the support still goes the other way), or indirectly if there is a pay-as-you-go social security system. Given this lack if private return in children, and that it is lower than the social return, there is underinvestment in children, in quantity and quality. This can be corrected with subsidized schooling and fertility incentives.

Alice Schoonbroodt and Michèle Tertilt make the argument that all this could easily be resolved by giving parents the full rights on the income of their offspring. Then they would get the full return of their investment and have socially optimal fertility and investment. Of course, this is not possible, first because of human rights, and second because children cannot be committed to give up their income. But there was a time where parents could exert such control, and then fertility was also higher. In other word, altruism is not the only reason for fertility.

This brings another interesting aspect on the paper. Under normal circumstances, the Coase Theorem would apply, but here it cannot as parents cannot contract with unborn children, and the latter cannot make promises to their parents. This inefficiency can only be resolved with public intervention, either by by giving property rights to parents, or by giving parents appropriate incentives, financed by taxing children. The fact that fertility is endogenous, contrarily to what is typically assumed, has another consquence: the standard results that allocations are efficient if the interest rate is higher than the population growth rate is not necessarily valid, because of under-fertility in addition to the usual problem of over-saving. In other word, endogenous fertility is very important, and all these social security models that just assume fertility is reduced are missing something big.

On the advantage of marriage over cohabitation

Why marry when cohabitation can provide the same benefits of economies of scale and companionship? One may even think that cohabitation is superior because it allows a break up with less consequences. That is exactly wrong. The fact that divorce is costly makes that one is more careful in committing to marriage and, once married, one puts more effort into the marriage. The key here is that marriage is a commitment device that gives strong incentives to make a marriage work.

Murat Iyigun shows that this logic gives marriage a large surplus than cohabitation through spousal commitment, as long as men and women are available in roughly equal numbers and commitment costs are symmetric across genders. Otherwise, marriage surpluses collapse and cohabitation dominates.

The fact is that commitment costs are not equal, mostly because of children and traditional roles in the household and the labor market. In fact, the countries where women are the most equal to men (say, Scandinavia) are those where cohabitation is the most prevalent. That evidence goes exactly counter to the predictions of the Iyigun model. Unfortunately, the paper provides absolutely no empirical support for its results. In fact, it is not even motivated by any empirical fact that would need to be explained. What is it then good for?

How to best auction natural resources

It is now well known that many natural resources suffer from the tragedy of the commons: because they are not owned, they are overused and depleted. The solution is for the state to sell rights to them. Those rights were typically set administratively and often with political considerations, thinks of the ultra-low grazing rights on federal lands. But governments can obtain more for the natural resources, not only because it increases revenue, but also because it encourages an efficient use of scarce resources. After all, the market price is still a wonderful signal. Thus auctions come into play. But auctions can go horribly wrong as well, as documented by Paul Klemperer. Every auction is different, and details are important.

Peter Cramton offers a handy guide for the design of efficient natural resource auctions. It focuses on oil and mineral rights in developing economies, but there are lessons to be learned for other auctions as well. There is an incredible array of auction designs, which helps accommodate a multitude of market situations and government goals. So, the next time you have an oil field to sell, you know where to look!

What is a CEO worth?

Now that Congress seems due to pass this horrible bailout bill, let us reflect a little on one provision that seems to have sweetened the deal: limits to executive compensation. CEO pay has been controversial for a while now, so it is natural to ask whether they are worth it.

This is what Marko Terviö does using an assignment model and data from 1000 publicly traded US firms. First about the assignment model: its idea is to match firms and CEOs with different characteristics. Outcomes depend on the distribution of those characteristics, and as they are in fixed supply, the price of ability does not necessarily reflect marginal productivity.

The market value of a firm is pivotal here, as it is not only dependent on its current characteristics (and CEO), but future ones as well. Also, a firm contains capital that can be transferred to others. The current surplus of a firm is the product of CEO ability, firm size, a growth factor and capital. This may seem oversimplifying, but you needs to keep managerial ability observable by deduction.

Matching this model with Compustat data, the top 1000 CEOs appear to contribute between US$21 and 25 billion in 2004 (about 0.15% of market capitalization), and they have been paid $7.1 billion for it, including option packages. CEOs seem to be of little impact, but still a bargain. But what if all CEOs were replaced with the best one? The surplus gain would be $3.2-3.4 billion, rather modest. The reason is that the best are already matched with the largest firms.

On-the-job search and exploding wages

Real wages have been largely stagnant over the last decades for most workers, except for huge increases for some specialists, like CEOs, athletes and even some academics. Why so? Giuseppe Moscarini offers an explanation: it is all about the corporate culture and how employers chose to match outside offers for their employees or not.

Back in the 1970s, say, it was accepted by all human resource managers that outside offers should not be matched. Knowing this, employees had little incentive to pursue on-the-job searches. If they obtained an offer, the monetary, time and psychological cost of moving jobs (and potentially living quarters) made an outside offer little attractive. As a consequence, wages followed closely productivity.

Suppose now that the employer cannot commit to not match outside offers. Employees will then seek more outside offers, thus generating wage increases through matching. Knowing this, workers are willing to accept lower initial wages, expecting future increases. Wages now are disconnected from productivity.

Note that an employer who has matched an outside offer in the past cannot credibly commit not to match in the future, as its employees are actively seeking outside jobs. Thus matching once leads to an irreversible change in equilibrium.

It remains that for most professions, matching of outside offers in unheard of. But once it happens, expect a sudden boost in wages. Expect no increases thereafter, as firms have exhausted themselves trying to outbid each other.

On the pitfalls of institutional reform in developing economies

What is Africa's problem. Many argue it is an issue of governance. One needs proper ownership rights, in particular for land, for an economy to function efficiently and to encourage entrepreneurship. For this reason, international organization, foreign governments and some NGOs insist on a regular basis on governance reform. This is not necessarily a good idea.

William Easterly and Dani Rodrik have for quite a while highlighted that such western style reforms may be ill-suited for developing economies. The main point is that these reforms are not performed in a vacuum. For example, there is typically already a system of ownership in place. It may not use the same institutions as in a Western economy, but it somehow works. Or business contracts are honored through "informal ways", like reputation.

In the latter case, imposing a system with formal courts may backfire: as they enforcement capability may not be high, people may want to opt out of contracts they would have kept in a reputation system. In this sense, the existing system may be a second best institution that would have to be reformed from the bottom up.