New on EconTalk: Market Failure and Government Failure

I've been a subscriber of the EconTalk series of podcasts maintained by George Mason University's Russ Roberts. EconTalk has been a source of interesting and intellectual discussions about relevant economic issues for me, so it's about time I help promote this website.

In particular, the latest podcast is Brookings Institution's Clifford Winston on "Market Failure and Government Failure." The standard case has always been that markets sometimes fail, and because of this, there is a need for government to step in and correct the failures. But then again, governments also fail and are most of the time imperfect. Therefore, it is always the case that when you talk about market imperfections, government failures are also part of the discussion. I think this is the reason why the economics field of public choice theory exists starting with the "father of public choice theory" and continuing with great economists James M. Buchanan and Gordon Tullock. Buchanan also won a Nobel Prize in economics for his work in public choice theory.

New interesting papers # 001

In the spirit of the excellent work done by the CSSRR website, I'd like to start a series of what I think are interesting new papers from the different top Economics department websites. This is the first:

University of Cambridge (Cambridge Working Papers in Economics)
#0946: Growth, Development and Natural Resources: New Evidence Using a Heterogeneous Panel Analysis
by T.V.V. Cavalcanti, K. Mohaddes, and M. Raissi
(November 2009)
"This paper explores whether natural resource abundance is a curse or a blessing. In order to do so, we firstly develop a theory consistent econometric model, in which we show that there is a long run relationship between real income, the investment rate, and the real value of oil production. Secondly, we investigate the long-run (level) effects of natural resource abundance on domestic output as well as the short-run (growth) effects. Thirdly, we make use of a non-stationary panel approach which explicitly es- timates the long-run relationships from annual data as opposed to the dynamic and static panel approaches which might in fact estimate the high-frequency relationships. Fourthly, we account for cross-country dependencies that arise potentially from oil price shocks and other unobserved common factors, and allow countries to respond differently to these shocks. Finally, we explicitly recognize that there is a substantial heterogeneity in our sample, consisting of 53 oil exporting and importing countries with annual data between 1980-2006, and adopt the methodology developed by Pesaran (2006) for estimation. This approach considers different dynamics for each country and is consistent under both cross-sectional dependence and cross-country heterogeneity. We also check the robustness of these results by using the fully modified OLS method of Pedroni (2000). Our non-stationary approach also allows for country-specific unobserved factors, such as social and human capital, to be captured in the fixed effects and the heterogeneous trends together with any omitted factors. Our estimation results, using the real value of oil production, rent or reserves as a proxy for resource endowment, indicate that oil abundance is in fact a blessing and not a curse, exhibited through both the long-run and the short-run effects."

University of Glasgow (Department of Economics Discussion Papers)
#2009-33: Colonialism, European descendants and democracy
by Luis Angeles
(November 2009)
"This paper advances that the share of European descendants in the population is a major determinant of democracy in former colonial countries. We test this hypothesis using cross-section and panel regressions with 60 developing and developed countries that were once colonies. We …nd that the share of European descendants can explain more than half of the di¤erence in measures of democracy between the least and the most democratic countries in our sample. We control for other potential determinants of democracy and test for endogeneity bias using instrumental variables."

University of Oxford (Department of Economics Discussion Paper Series)
#466: Two and a Half Theories of Trade
by J. Peter Nerey
(December 2009)
This paper discusses the place of oligopoly in international trade theory, and argues that it is unsatisfactory to ignore firms altogether, as in perfectly competitive models, or to view large firms as more productive clones of small ones, as in monopolistically competitive models. Doing either fails to account for the “granularity” in the size distribution of firms and for the dominance of large firms in exporting. The paper outlines three ways of developing more convincing models of oligopoly, which allow for free entry but do not lose sight of the grains in “granularity”: heterogeneous industries, natural oligopoly, and superstar firms.
#467: Directed technical change, the elasticity of substitution and wage inequality in developing countries
by Alberto Behar
(December 2009)
We develop a model of endogenous skill-biased technical change in developing countries. The model reconciles wildly dispersed existing estimates of the elasticity of substitution between more and less educated workers. It also produces an estimating equation for the elasticity, which allow us to produce overdue estimates for developing countries. With four types of data, elasticity estimates for developing countries are consistently about 2. In a skill-biased technical change framework, this estimate makes sense of what appears to be little or no correlation between relative skill supply and wage inequality.

Toulouse School of Economics (Working Paper Series)
#588: How Should the Distant Future be Discounted When Discount Rates are Uncertain?
by Christian Gollier and Martin L. Weitzman
(November 2009)
"It is not immediately clear how to discount distant-future events, like climate change, when the distant-future discount rate itself is uncertain. The so-called “Weitzman-Gollier puzzle” is the fact that two seemingly symmetric and equally plausible ways of dealing with uncertain future discount rates appear to give diametrically opposed results with the opposite policy implications. We explain how the “Weitzman-Gollier puzzle” is resolved. When agents optimize their consumption plans and probabilities are adjusted for risk, the two approaches are identical. What we would wish a reader to take away from this paper is the bottom-line message that the appropriate long run discount rate declines over time toward its lowest possible value."

University of Warwick (Economics Department Working Papers)
#922: A Nonparametric Analysis of the Cournot Model
by Andres Carvajal and John K.H. Quah
(November 2009)
"An observer makes a number of observations of an industry producing a homogeneous good. Each observation consists of the market price, the output of individual firms and perhaps information on each firm's production cost. We provide various tests (typically, linear programs) with which the observer can determine if the data set is consistent with the hypothesis that rms in this industry are playing a Cournot game at each observation. When cost information is wholly or partially unavailable, these tests could potentially be used to derive cost information on the firms. This paper is a contribution to the literature that aims to characterize (in various contexts) the restrictions that a data set must satisfy for it to be consistent with Nash outcomes in a game. It is also inspired by the seminal result of Afriat (and the subsequent literature) which addresses similar issues in the context of consumer demand, though one important technical difference from most of these results is that the objective functions of rms in a Cournot game are not necessarily quasiconcave."

Yale University (Department of Economics Working Papers)
#74: Does Land Abundance Explain African Institutions?
by James Fenske
(November 2009)
"I show how abundant land and scarce labor shaped African institutions before colonial rule. I present a model in which exogenous suitability of the land for agriculture and endogenously evolving population determine the existence of land rights, slavery, and polygyny. I then use crosssectional data on pre-colonial African societies to demonstrate that, consistent with the model, the existence of land rights, slavery, and polygyny occurred in those parts of Africa that were the most suitable for agriculture, and in which population density was greatest. Next, I use the model to explain institutions among the Egba of southwestern Nigeria from 1830 to 1914. While many Egba institutions were typical of a land-abundant environment, they sold land and had disputes over it. These exceptions were the result of a period of land scarcity when the Egba first arrived at Abeokuta and of heterogeneity in the quality of land."

New MU Economics Papers: December 2009

I thought I'd start a new series on promoting new working papers of the Department of Economics at the University of Missouri. Think of it as one of my initial contributions to the department. First up, for the month of December:

A Non-Experimental Evaluation of Curricular Effectiveness in Math (WP 09-13)
by Cory Koedel and Rachana Bhatt
(December 2009)
"This paper uses non-experimental data to evaluate curricular effectiveness. We show that non-experimental methods can be used to obtain causal estimates of curricular effects at just a fraction of what it would cost to produce analogous experimental estimates. Furthermore, external validity concerns that are particularly cogent in the context of curricular evaluations suggest that a non-experimental approach may be preferred. Our results provide important insights for educational administrators and policymakers. In the short term, we find large differences in effectiveness across some math curricula. However, like many educational inputs, the effects of math curricula do not persist over time, a result that would be quite costly to attain using experimental data. Across curricula adoption cycles, publishers that produce less effective curricula in one cycle do not lose market share in the next cycle. One explanation for this result is the dearth of information available to administrators about curricular effectiveness."

Paul Samuelson (May 15, 1915-December 13, 2009)

One of the greatest economic thinkers of all time has already left us. He will definitely be missed, students and fellow economists alike. I'm sure you've already seen the many online news articles that celebrate his accomplishments in life. He was the first John Bates Clark winner, and the first American Nobel Laureate in Economics. For me, I think his greatest contribution is helping create the "Neoclassical synthesis," the current mainstream field of economics that incorporates both neoclassical principles with Keynsian ones.

NFL and domestic violence?

In their latest NBER paper, David Card and Gordon Dahl tried to explore one of the most perplexing forms of violent behavior--violence by men against their partners and children. Two common interpretations are put forth by economists: family violence may be interpreted as instrumental behavior; family violence may on the other hand arise simply because men like to commit violence and women tolerate it in return for higher transfers. Ouch. Well, Card and Dahl offers an alternative: family violence simply "represents expressive behavior that is triggered when conflictual interactions escalate out of control." Their key hypothesis is:

"[T]he risk of violence is affected by the gain-loss utility associated with salient emotional cues. Specifically, [they] assume that negative cues--based on realizations relative to expected outcomes--increase the risk of violence."

So how did Card and Dahl test their hypothesis? They look at the effects of National Football League (NFL) game outcomes. They analyzed data from states that are home to six different NFL teams, focusing on the effect of wins and losses of the home team on police-reported family violence incidents. But why focus on NFL? Two things:

"On the one hand, many fans feel a strong emptional attachment to local teams. Home games on Sunday afternoons typically attract a quarter of the television audience in markets with a local NFL team. Team affinity is reinforced by extensive pre- and post-game coverage by local news and entertainment media. On the other hand, the existence of a well-organized betting market allow us to infer the expected outcome of each game. Assuming that a game outcome is random, conditional on the pre-game [Las Vegas] point spread, we can interpret any difference between the rate of family violence following a win or loss as a causal effect of the outcome of the game. Moreover, we can easily define the strength of the emotional cue associated with a win or a loss in a given game."

Four interesting findings are found:

1. An "upset loss" by the home team (a loss when the team was predicted to win by more than 3 points) leads to an 8% increase in the number of police reports of at-home male-on-female intimate partner violence (this is after controlling for location fixed effects, the pre-game point spread, sesonality and weather factors, and the size of the local viewing audience).

2. An "upset win" (a win when the team was expected to lose by more than 3 points) have at most a small effect in reducing family violence.

3. Upset losses in more salient games (those involving a traditional rival, or occurring when the home team is still in playoff contention) have a larger effect on the rate of intimate partner violence, as do unexpected losses after games involving an unusual number of sacks, turnovers, or penalties.

4. NFL game outcomes have little or no effect on police reports of female-on-male intimate partner violence.

All in all, Card and Dahl are finding that:

"[T]he strong impact of random external factors on the rate of family violence provides compelling evidence that at least some portion of family violence arises through a breakdown of control, rather than as instrumental behavior driven by purely rational choice."

I know it seems that this new research somewhat points to a [small] negative impact of the the greatest sport in America. But look on the bright side--coaches can use this study in their pre-game motivational speech to their team: "Listen guys!!! We're expected to win this one. If you don't want to be responsible for thousands of domestic violence out there, you better shape up and deliver!!!"

Go figure.

By the way, which NFL teams are in the study? Carolina Panthers, Denver Broncos, Detroit Lions, Kansas City Chiefs, New England Patriots, and Tennessee Titans. Well, at least we won't be seeing spikes in domestic violence after Lions or Chiefs games.

Predatory pricing

Greg Mankiw's blog directs us to one interesting article by the New York Times about how the American Booksellers Association is accusing Amazon, Wal-Mart. and Target of predatory pricing:

"In [a] letter [to the Justice Department] dated Thursday, the association argues that steep discounting on 10 hardcover titles by authors including John Grisham, Stephen King and Barbara Kingsolver “is damaging to the book industry and harmful to consumers."

Initially you would think that price competition is good for consumers--it brings down the price and so increases the welfare of the society as a whole. Not good for the losing companies though. If a firm can't take the heat, then that means they're not as efficient as the winning firms, and so society is better off that they're out of the market. In the end, everyone's happy--the remaining firms are efficient in producing goods, the consumers are satisfied with the low prices.

But then again, the problem comes in when winning firms are charging prices that would make them lose profits. Doing so, anyone can think that these firms are just charging this low just to push smaller competitors out of the market. When the dust is settled, and the firm with the lowest price is the one remaining, he can practice monopoly power and then charge higher prices. How can the consumers complain--only one firm is remaining and the firm can charge whatever it wants. And this is what you call predatory pricing.

This is what they meant when you start to question: "Hey prices are going lower and lower, and low prices are what consumers want. So how can they say this behavior is harmful to consumers?" The answer is, it may be good in the short term, but it's not in the longer term. And when that time comes when there's only a monopoly remaining, it may be hard for new entrants to come in because the monopoly might again revert back to its practice of predatory pricing to drive out the new player. So, better avoid that situation and let the government make a stand that such behavior will not be tolerated.

So in sum, it may be good for consumers to have a price war, but it is only up to the point where one firm or three will start doing some predatory pricing. And it can be easy to determine if indeed some firms are practicing predatory pricing--the burden is with the other firms to prove that the prices charged by winning firms are below profit levels. And I think the American Booksellers have established that already. It's exciting to look forward now to what will happen to Amazon, Wal-Mart, and Target in this case.

Honoring John R. Meyer

John Robert Meyer of Harvard University, who is considered to be the father of transportation economics, died on October 20, 2009. His life's research included transportation issues, studies of market evaluations of corporate equities and their relationship to debt structures, capital write-offs, takeover defenses, cash flow, and information asymmetries.

Here is an excellent tribute by Economix's Edward L. Glaeser.

Holiday cheers... or not

Well, since that part of the year when most holidays are occuring are near, I thought I'd share this enlightening article from the Economist:

"Employees in European countries tend to have a better deal than most, enjoying more days off work than their counterparts in Asia or America. Workers in Finland, France and Brazil have the most generous statutory allowance, getting 30 days of holiday every year. Americans work longer hours: theirs is the only rich country that does not give any statutory paid holiday. (In practice, most workers get around 15 days off.) This work ethic may in turn help to explain Americans' material wealth. Even adjusting for purchasing-power parity, America generates more wealth per person than all but a handful of mainly oil-rich economies such as Norway."

Basically, what the article is saying is that it seems the less holidays a country has, the richer the country is (the Economist webpage has an excellent graph). I mean, when I noticed that there's not much holidays here in the U.S. and there's a ton in the Philippines (the Philippine president can declare a holiday--even only a week in advance), I suspect that's there's a correlation somewhere.

It could be more intuitive than you would initially thought. I mean, there is really a trade-off--a day of holiday is a day without production. Thus decreasing the overall GDP for the year. Go figure.

Altruism in Game Theory

Most if not all microeconomic models assume that individuals only care about what increases their utility. In fact, this notion goes back to Adam Smith, who believes that it is individuals' self-interests that keep the economy going. Even the most recent evidence on altruism, an exception to the notion of the self-interested homo economicus, show that altruistic people are not really motivated by generosity per se. According to a paper by Matthew Rabin of University of California-Berkeley, people who seemed to be altruistic are so only to altruistic people; they are similarly motivated to hurt people who hurt them. This concept of "fairness equilibrium" is the revolutionary concept that is introduced by Rabin into game theory:

"People like to help those who are helping them, and to hurt those who are hurting them. Outcomes reflecting such motivations are called fairness equilibria. Outcomes are mutual-max when each person maximizes the other's material payoffs, and mutual-min when each person minimizes the other's payoffs. It is shown that every mutual-max or mutual-min Nash equilibrium is a fariness equilibrium."

In other words, for Rabin:

"If somebody is being nice to you, fairness dictates that you be nice to him. If somebody is being mean to you, fairness allows--and vindictiveness dictates--that you be mean to him."

Rabin's revolutionary idea comes into play when he contends that people are willing to sacrifice their own material well-being to either help those who are kind or hurt those who are unkind, and that these two stylized facts have greater effect on individual's behavior because as it will turn out, the material cost of such sacrifices becomes smaller.

The implications of Rabin's study are similarly interesting. His ideas create issues that do not arise in the simple two-person, normal-form, complete-information games. The implications are more complex if an individual is given the choice of helping everybody or hurting everybody. A classic example that Rabin discussed is how much an individual will contribute to a public good--should she contribute to reward those who have contributed, or should she not contribute to punish those who have not contributed? Another interesting implication is if we extend the idea to sequential games. In particular, fairness equilibrium may change the motivations of players at a certain stage of the game: a first-mover may choose some action that will compel another player to regard him positively (or negatively).

Rabin's idea could help explain why if you and your wife are facing a prisoners' dillema and you're willing to sacrifice yourself by not squealing. It's the same reason why your wife will not squeal also. Therefore, we find another Nash equilibrium different from the standard Nash equilibrium solution to the prisoners' dilemma game: both prisoners are better off squealing.

Reference:
Matthew Rabin. 1993. "Incorporating fairness into game theory and economics." American Economic Review 63(5):1281-302.

Truman and the Economists

I just want to share a little anecdote here. Late President Harry S. Truman (1884-1972) is not only considered one of the greatest U.S. presidents, but he is also one of the most well-celebrated natives of Missouri. The Univeristy of Missouri mascot is even named after him--Truman the Tiger. Us economists, on the other hand, are famous for making different assumptions before arriving at a conclusion. Economists are famous for popularizing the terms "ceteris paribus," and it's no surprise that the different schools of thought that plague economics since Adam Smith arise because each school is based on differing assumptions.

So what does President Truman and economists have in common? Well, none actually. In fact, President Truman's not too excited about economists, as the following quotation that he immortalized shows:

"Give me a one-handed economist! All my economists say, 'on the one hand...on the other'."

Well, what can economists say? For economists, economic outcomes is predictable only if you make certain assumptions. But of course, you can't help but emphatize with him. Can't wait for that day when there's only one school of economics and that we don't need to give different outcomes based on different assumptions in answering every economic questions.

Managing Transactions

Just to give you a background on economic governance, which is the body of work for which Professors Ostrom and Williamson are awarded the Nobel prize of economics, the following are taken from the fast readdocument that can be accessed from the Nobelprize.org website, written by its Editor-in-Chief, Adam Smith (cool name):

"The 2009 Sveriges Riksbank Prize for Economic Sciences is concerned with the basic question of where best to conduct transactions; in the open market, within firms, or among self-regulating groups of individuals."

For Professor Ostrom, it is self-regulating groups of individuals on the subject of the infamous common good:

"Elinor Ostrom has made extensive studies of the management of common property by groups of common owners, contrasting that with management by state or private institutions. Perhaps surprisingly, she has found that those with a vested interest in the resources they manage are frequently better at regulating those resources than publicly-appointed management bodies would be. Her research reveals that in many, but not all, cases, allowing users to develop their own rules to regulate the use of common property results in the most efficient solution for managing those resources... In short, self-governance can be successful."

User participation in governing public projects is not a new thing. Lately, it has been one of the blueprints of developing agencies when they lend money to governments to fund public projects (I should know--I came from the Asian Development Bank). And this is because they want end-users to get a great sense of ownership on these projects. But what sets Professor Ostrom's work apart is that for her, there is more participation for the end-users:

"[Ostrom's] principles are in stark contrast to the common view that monitoring and sanctioning are the responsibility of the state and should be conducted by public employees."

It is quite unusual that Prof. Ostrom won the Nobel Prize in Economics, and it is not just because she's the first woman to be awarded the prize. It is also because she's really not an economist; she's a political scientist. And that could probably be the reason why her huge contribution is really not theoretic, but empirical:

"Her work incorporates both case studies of numerous real-life examples and laboratory experiments testing the ways people interact. The experiments reveal that people seem more willing to regulate others' behaviour than predicted, and also that the development of efficient rules for regulation depends critically on good communication between the people involved."

If you want the theory, we now turn to the other winner, Professor Williamson. For him, some transactions are better conducted within firms:

"Oliver Williamson's work deals with understanding the limits of the firm. He has extended the theories of why certain transactions can be accomplished more efficiently within firms than they would by competition between firms or individuals."

The first way to understand Williamson's contribution is to think that transactions may not be efficient in the market:

"[N]egotiations have to continue until both parties agree, haggling costs can be substantial, and there is no guarantee that the final agreement will be either immediate or efficient."

Williamson argued that firms can be s oltion as they provide a cheaper way to resolve conflicts:

"[H]is theories predict that hierarchical organizations are better places to conduct transactions, such as the sale of coal for power plants, wherever there is either significant complexity or mutual interdependence underlying the transaction. The results of his analysis have significant implications for public policy, including the regulation of competition, since what at first sight might seem an apparently imperfect market may in fact be the most efficient way of regulating a particular set of transactions."

But this does not also suggest that all transactions should be done within a firm; they're also not perfect: executive authority of firms can also be abused. Also, some recent trends point out that transactions are better handled outside the firm: outsourcing is one perfect example:

"Williamson's theories extend previous work on the limits of the firm's efficiency, by Ronald Coase among others, to a level at which empirical testing of predictions becomes possible."

Nevertheless, Williamson categorized when are firms appropriate--it is when transactions are complex or non-standard, parties are mutually dependent, and assets are relationship-specific. But Williamson warns that if government tries to come in and regulate in this case, policies should be careful not to limit the size of corporations.

In conclusion, Williamson's message is simple and clear:

"Large private corporations exist primarily because they are efficient. They are established because they make owners, workers, suppliers, and customers better off than they would be under alternatie institutional arrangements. When corporations fail to deliver efficiency gains, their existence will be called in question."

2009 Nobel Prize for Economics

Copyright Indiana University and UC-Berkeley

Wow, history is made today when the Nobel Prize for Economics for this year was awarded to a woman, the first one in the Prize's 40-year history. Professor Elinor Ostrom, a professor of political science at Indiana University was awarded the prize "for her analysis of economic governance, expecially the commons." She shares the prize with another American economist, Professor Oliver Williamson. Williamson is awarded the prize "for his analysis of economic governance, expecially the boundaries of the firm." And about time too. Williamson is a great influence of mine, particularly on his work on institutional economics. He has contributed much on the economics of transactions cost, and so this prize is well-deserved.

According the Nobel website:

"Elinor Ostrom has demonstrated how common property can be successfully managed by user associations. Oliver Williamson has developed a theory where business firms serve as structures for conflict resolution. Over the last three decades these seminal contributions have advanced economic governance research from the fringe to the forefront of scientific attention."

For more information on their work, check out the Nobel website.

Congratulations, Professor Ostrom and Professor Williamson!

Their Nobel lectures will be held on December 18 at Stockholm University.

Another reason to rein in population

Forget about the age-old debate on Malthus' dismal claim regarding over-population. He says that if population grows at an exponential rate, there wouldn't be enough resources left to satiate the consumption of everyone. Modern growth economists would say "That's what technology is there for, Malthus old boy. So don't worry about it." Malthus' primary message is just simply for nations to control population growth, but people nowadays are simply not too concerned about it. Fortunately for Malthus, there's a new research that analyzed a new reason for people to take the old boy seriously.

From the Economist, according to Thomas Wire, a postgraduate student at the London School of Economics, controlling the surge in population may benefit more than making sure everybody has still something to eat years from now--it will benefit the environment:

"Mr Wire totted up the cost of supplying contraception to women who wished either to delay their childbearing years or to end them artificially but who were not using contraception. He examined projections of population growth and of carbon-dioxide emissions made by the United Nations and concluded that reducing carbon emissions by one tonne would cost just $7 spent on family planning, as opposed to at least $32 spent on green technologies.

Mr Wire points out that if all women who wanted contraception were provided with it, it would prevent the release of 34 billion tonnes of carbon dioxide between 2010 and 2050."

Talk about hitting two birds with one stone (climate change and population growth). If you really think about it, it's really a no-brainer: population growth can influence the environment--and it's not just on the issue of contraception. Take for example the most common case of garbage control. The more people there is, the more trash is thrown to the garbage. But of course, that's just one of those that you can observe on the surface. Definitely the relationship between population and environmental degradation is more intricate to the point that you may arrive concluding that we should all then be self-sufficient enough so that there wouldn't be any industrial waste from companies that are selling us things that we need. But we don't need to get into that.

What Mr. Wire did is a good thing because he puts some hard facts on at least one aspect of the issue. Now what we need is more of these kinds of discoveries and laying-down-of-facts to finally put the age-long debate to rest.

Missouri Bushwackers?

Well, not really economics related, but I'd like to share something about the University of Missouri.

Some of the college athletic teams these days have names that are connected to people in their history. The Kansas Jayhawks have their name based on a group of people during the Civil War:

"The Jayhawk is a mythical cross between two common birds -- the noisy blue jay and the quiet sparrow hawk. The word came to prominence just before the Civil War, in Bleeding Kansas, where it was adopted by militant abolitionist groups known as Jayhawkers. With the admission of Kansas as a free state in 1861, Jayhawker became synonymous with the people of Kansas. The Jayhawk appears in several Kansas cheers, most notably, the "Rock Chalk, Jayhawk" chant in unison before and during games."

We also have the Sooners of Oklahoma:

"The University of Oklahoma features 17 varsity sports teams. Both men's and women's teams are called the Sooners, a nickname given to the early participants in the land rushes which initially opened the Oklahoma Indian Territory to non-native settlement."

And then we have some other collegiate teams whose names are based on Indian tribes or chiefs.

Now as for the Missouri Tigers:

"In 1864, while in the midst of the American Civil War, the board of curators suspended operations of the University. It was during this time that the residents of Columbia formed a "home guard" unit that became notoriously known as the "Fighting Tigers of Columbia". This name was given because of the group's steadfast readiness to fight against Confederate bushwhackers, hoping to plunder the city and university, under the command of "Bloody Bill" Anderson. Later, in 1890, an alumnus suggested the University's newly-formed football team be called the "Tigers" out of respect for those who fought to defend Columbia."

But, it turns out that the term bushwacker is more synonimously associated with Missourians fighters during the Civil War:

"The term was widely used during the conflict, though it came to be particularly associated with the guerrillas of Missouri, where such warfare was most intense. Guerrilla warfare also wracked Kentucky, Tennessee, Arkansas, and northern Virginia, among other locations. One of the most vicious actions during the Civil War by the bushwhackers was the Lawrence Massacre.

Pro-Union guerrilla fighters in Kansas were called "jayhawkers". They used tactics similar to the bushwhackers. A typical jayhawker action was a cross border raid into Missouri."

So, what I'm trying to point out is that there is definitely a good argument for using "Bushwacker" as the name of Mizzou's athletic teams instead of "Tigers." This is specially the case when we consider the "Border War" rivalry games between the University of Kansas (Jayhawks) and the University of Missouri (Tigers), which are based on a historical period of time shared between the two states during the Civil War:

"The intense rivalry between the two universities can be traced to the open violence involving anti-slavery and pro-slavery elements that took place in the Kansas Territory and the western frontier towns of Missouri throughout the 1850s."

And those involved are no less than jayhawkers from the Kansas side of the border and bushwackers from the Missouri side of the border. So it seems more appropriate to have the Missouri Bushwackers fight the Kansas Jayhawks during these Border War games.

But then again, there is also a strongly negative association with the bushwackers (unless you're a Clint Eastwood fan). They're not really the sort of peple you'd like to get involved with back then ("Bloddy Bill" Anderson and Jesse James are among them). And there's the massacres and such. So I guess "Tigers" was the best decision.

And the fact that I'm starting to like Truman the Tiger doesn't hurt as well.

GDP as the not-so-right measure of well-being

Well, the debate on whether gross domestic product (GDP) per capita is the measure of economic well-being is not new. This has been going on for some time, and some institutions, like the Centre for Bhutan Studies, came up with other alternative measures of well-being, like the happiness index.

Now, even France is getting in on the forefront. From the Economist website:

"Among those convinced that official statisticians should join in is Nicolas Sarkozy, the French president. On September 14th a commission he appointed last year, comprising 25 prominent social scientists, five with Nobel prices in economics, presented its findings. Joseph Stiglitz, the group's chairman and one of the laureates, said the 292-page report was a call to abadon 'GDP fetishism'."

I think the effort is noble. I support looking for other measurements of well-being. But to abandon one of the pillars of Keynesian economics because of the notion that "Americans may be well fed yet are fed up" or that "an Indian may be desperately poor and yet say he is happy" may miss the whole point. The Indian is happy because he is satisfied with what little he has left. But in the first place, he has little because he can't afford anything else. And he can't afford is because he may not have a job, or at least he has a job that earns him only a little. This last fact can be captured by GDP per capita. If the Indian has as much access to many things as the average American does, it's not impossible to see that the Indian can also be well fed but is fed up.

GDP is not just about production. One of the basic things being taught in macroeconomics is that it's a circular flow. Whatever is produced is what is earned. It may sound simplistic, but indeed if less is produced, then less is expected of what is earned. As a result, it is least likely that an average person from a low GDP country (a.k.a., the Indian) can purchase the things that the average person from a high GDP country (a.k.a., the American) can buy.

So it seems like these new measures are trying to compare apples and oranges. You just can't compare the two, unless you take into account the differences in the environment facing the two. The funny thing is we accept the fact that we are now living in a world where everything is becoming more globalized, so how is it that we forget that we should not try to isolate the things that can only be bought in America from the things that can only be bought in India and try to say that the Indian is more happy compared to the American.

So before they replace GDP with these new measures of economic well-being, maybe finding measurements based on subjective interpretations may not be the right way to go. They may be good complimentary measures, but definitely not substitutes.

NFL coaches are not irrational; just eccentric

I'd like to go back to my previous post about punters in danger of losing their jobs. I'd like to focus this time on one of the papers mentioned by the source. David Romer analyzed why the behavior of National Football league (NFL) teams on fourth down situations depart from the behavior that would maximie their chances of winning in a way that is highly systematic, clear-cut, and statistically significant.

Let me restate his findings clearly and in detail:

1. What is the situation?

The choice on fourth down between kicking (either for a punt or field goal) or going for it and trying for a first down (or better yet, a touchdown).

2. So what would teams do to maximize their chances of winning?

Like any rational agents in an economic system, NFL teams maximize their objective function, which is simply to win the game. Now going for it on fourth down or simply kick the ball would depend on the attractiveness of the distributions of ball possession and field position, but Romer came up with what could be considered objective-maximiing decisions using dynamic programming analysis:

"On the team's own half of the field, going for it is better on average if there is less than 4 yards to go. After midfield, the gain from kicking falls, and so the critical value rises [the critical value is the yardage-treshold where a value lesser than this treshold means that the team should go for it]. It is 6.5 yards at the opponent's 45 and peaks at 9.8 on the opponent's 33. As the team gets into field goal range, the critical value falls rapidly; its lowest point is 4 yards on the 21. Thereafter, the value of kicking changes little while the value of going for it rises. As a result, the critical value rises again. The analysis implies that once a team reaches its opponent's 5, it is always better off on average going for it."

3. So now that we have some scientific metersticks on how "rational" teams would maximize their objectives during fourth downs, what did Romer's empirical findings show on how NFL teams actually decided on these situations:

"Team's actual choices are dramatically more conservative than those recommended by the dunamic-programming analysis. On the 1,604 fourth downs in the sample for which the analysis implies that teams are on average better off kicking, they went for it only 9 times. But on the 1,068 fourth downs for which the analysis implies that teams are on average better off going for it, they kicked 959 times... Over most of the field, teams usually kick even with only 1 yard to go. Teams are slightly more aggressive in the [red] one, but are still far less aggressive than the dynamic programming analysis suggests."

Romer attributes these not-so rational behaviors to two some-what "eccentric" qualities: NFL teams could have more complicated objective functions as merely just winning the game, like through "subtle" channels--their risk aversions could come from the fans, it could come from owners, even coaches or players. The other attricbute of this "irrational" behavior is that these NFL teams are just simply imperfect maximizers. Rather than use mathematical and statistical tools, decision makers rely mostly on experience and intiotion than formal analysis in their quest to maximize the team's chances of winning.

It's a good thing the Missouri Tigers turn out to be less "eccentric" and more "rational" in last night's game against the Bowling Green Falcons. In the fourth quarter, the Tigers were down 20-13 and they find themselves in a situation where the had the ball and they're facing fourth down at the opponent's 39 yard line. Did they go for it? You bet they did, and they converted it successfully. They eventually scored during that drive that tied the game. They scored another one on a run after the Mizzou defense stepped up and stopped the Falcon's next offensive drive.

They maximied their objective.

And they won the game.

I have to thank a good friend of mine, Dottie Heibel, for bringing me to that game--the first live football match of my life (also enjoyed my first tailgate party! Thanks to Dottie's sister Nancy and his husband Ed). And what a game it was. Spirits were way down at half-time with the Tigers trailing behind the Falcons with 13-6 at the score board. But I guess the Tigers were just experiencing the jitters of having to play on home turf for the first time this season. Coach Gary Pinkel might have one hell of a motivational talk with the team as quarterback-sensation Blaine Gabbert and his crew got back in high spirits from the locker room and managed a comeback win. What a game.

Romer's original intention for his study may have been to analyze an eccentric behavior among firms by using NFL teams as an illustration. But I think he showed us that he can become a very good NFL coach. And I wouldn't be surprised if Coach Pinkel managed to read Romer's paper before the game.

Reference:

David Romer (2006) "Do firms maximize? Evidence from professional football." Journal of Political Economy 114(21): 340-365.

Asian Enterprises Amidst the Global Crisis

Before I left Asian Development Bank to pursue Ph.D. education in the great state of Missouri, I was involved with a team in chanrge of analyzing the impact of the recent global economic crisis on enterprsiees in Asia. Led by my great mentor and colleague, Rana Hasan, the resulting paper would be included as the special chapter for the volume, Key Indicators 2009, one of the flagship publications of the Asian Development Bank.

I'm happy to know that the launching of the publication was good, and that the special chapter itself is even better. Among the highlight of the study, I'd like to share three excellent points:

1. There's no question about it: Asian enterprises has been hit hard, and this is evidenced by scaling back of operations, cutting of production, and laying-off of workers in many of the region's most dynamic and export-oriented enterprises. Most hit hard is the manufcturing sector--among the eight Asian countries we studied, seven reported declines in manufacturing employment by about 2 percent to 7 percent between the first quarters of 2008 and 2009.

2. Since one of the consequences of the global crisis is weaker export demand, we saw large enterprises hit by the crisis. But the smaller enterprises (the SMEs) are victims as well. This is because another consequence of the global crisis is reduced aggregate demand in Asian countries. Since SMEs tend to be more domestically-oriented, we also saw SMES hit by the crisis as well. As for the large firms, it will be a slow recovery because it is expected that demand for exports to likely only recover gradually. And this is an important point because looking back to the 1997 Asian Financial Crisis, the Asian economies were quick to get back on track primarily because strong export demand is there. That is clearly not the case this time.

3. Seeing that export would not help much, it is recommended that some economies rebalance their economic growth toward domestic sources. A potential source is the rapidly growing urban middle class, which will be key to increasing domestic demand. Now, because most Asian workers depend on SMEs for their livelihood, the expansion of the middle class hinge on the dynamism of SMEs (or Asian enterprises in general). Given this, constraints to entry and growth of SMEs (a.k.a. nonproductive-related transactions costs) should be eliminated. Governments should promote adoption of productivity-enhancing modern technologies that will not only provide well-paying jobs, but increase the supply of goods and services required by the domestic market as well.

The key here is to increase domestic demand in each of the Asian economies.

Punters beware: Your days are numbered

Your a coach of a high school football team. It's fourth quarter, and your trailing behind your opponent in score. You have the ball at your opponents 40, but it's fourth down and long. Should you punt or go for it? Well, some statistics would encourage you to go for it.

James Kwak of the Baseline Scenario blog shares with us these two links (including one which David Romer of UC-Berkeley wrote) that discuss some statistics and the game theory behind the scenario above. The bottomline is: never punt the ball. Well, at least for the most part. It's funny because in playing Madden in Playstation, I never like to punt. Most of the time, I go for it at fourth down. I don't know if it's just my preference or some kind of intuition, but lo and behold, there's some statistical facts that would back up such strategy.

Very interesting. Not so for punters.

On a slightly unrelated note, for what would be the last Arch Rivalry game in the near future, Mizzou beat Illinois 37-9 last Saturday, September 5. Mizzou won the last Arch Rivalry game. With star players such as Chase Daniel and Jeremy Maclin already in NFL, Illinois is expected to have a chance at winning the series after they lost to Mizzou in the last four games. Unfortunately for them, new quarterback Blaine Gabbert was excellent and helped the Mizzou team notch a fifth win. Well, they didn't employ the no-punt strategy, but then again, I don't think they need it either.

Return of Keynesian Macroeconomics (a.k.a., The Great Divide... Again)

In one of his newest and provocative but excellent articles, Paul Krugman asks of the recent financial bubble of 2008, "How did economists get it so wrong?" For him, "the economics profession" went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth." And what was this beauty he's referring to? Neoclassical economics.

"Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn't sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals intereact in perfect markets, this time gussied up with fancy equations."

Here afterwards, Krugman points at the downside of the neoclassical thought:

"They turn a blind eye to the limitations of human rationality that often leads to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets... that can cause the economy's operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don't believe in regulation."

And so, among Krugman's recommendations for economists is:

"... [T]hey have to admit... that Keynesian economics remains the best framework we have for making sense of recessions and depressions."

Krugman has many excellent points in his article, particularly ont he part where all these neoclassical theories and finance theories have not been successful in explaining what happened during the recent crisis--or more importantly, predict it. I agree with his assessment that economists must take into consideration that the market is not all perfect and frictionless, and that economists may not even need to start from scratch when they begin to. As Krugman correctly refers to, behavioral economics, particularly behavioral finance, has already covered much on how human cognition can bias the decisions of what economists initially assume to be rational individuals.

But then again, maybe part of the solution would need not be the complete dismissal of neoclassical economics. If we follow Krugman word per word that the Keynsian doctrine is best in handling recessions and depressions, what about periods outside of these incidents? Maybe the solution is to find a way to reconcile both schools of thought--and this is what I consider perhaps the Holy Grail of economics (a very difficult one to accomplish, otherwise someone would have done it by now). Let's take Krugman's point exactly: individuals are rational, but certain cognitive biasses would make it appear they are irrational. And I think this kind of analysis that is within the heart of behavioral economics can still be analyzed within the framework of neoclassical economics.

Krugman would categorize me as a "freshwater" economist (and this is not simply because I'm associated with the University of Missouri), and that he expected me to always have a "reason to cling to neoclassicism." But I'm not among the "purists," and I can see the advantages of Keynesian theory. I just hope he also sees some advantages of neoclassical theory.

Current Social Science Research Reports

The Current Social Science Research Reports (CSSRR-DISC), which I am currently subscribed to, has a new weblog:

http://www.disc.wisc.edu/info/

The Reports contain the latest publications in the field of economics and has helped keep me updated about the latest economics research. It is provided by Jack Solock of the Data & Information Services Center of the Center for Demography of Health and Agin of the University of Wisconsin System.

All the Reports can be accessed through the weblog. Better subscribe to the Reports too.

Employment effects of the global economic slowdown

The impact of an economic crisis on labor markets can be transmitted through the decline in GDP (Betcherman and Islam, 2001). It may be the same case for this recent global economic slowdown. One way of measuring this impact is through the use of elasticity of employment with respect to output, or as Kapsos (2006) labels it, the "employment intensity to growth." It is simply a measure of how employment varies with economic output—how much employment growth is associated with each percentage point of economic growth. The measure is normally used to analyze how the growths in economic output and in employment move together through time. In our present case, we can use the employment elasticities to calculate how much employment will change for each country in the next two years given projections in national output.

We can complement this analysis by also making use of an alternative employment elasticity—this time, with respect to exports. Asian Development Bank (2009) reports that the global recession has been transmitted to Asia primarily through the trade channel. The drop in G3 income has led to a reduction in G3 import demand. This resulted in a sharp contraction in developing Asia's exports. Now, the contraction in the demand for Asian exports has caused numerous factory closures, and layoffs have been reported across the region, particularly in electronics and in the most labor-intensive industries such as toys. Thus the economic slowdown has also affected employment through exports. It may then also be useful to calculate the "employment intensity to exports"—how much employment growth is associated for each percentage point of export growth—to find out the magnitude of the impact of exports' decline on employment.

Methodology and data used

Following Kapsos (2006), the empirical relationship between employment and GDP was estimated using a multivariate log-linear regression model:

lnEi = a + b1*lnYi + b2*(lnYi*Di) + b3*Di + ui

where Ei is total employment in country i, Yi is GDP, and Di are the country dummy variables. From the equation, the elasticity of employment with respect to GDP in country i is given as b1 + b2. The elasticity represents the change in employment associated with a differential change in output. b2 varies for each country.

Employment elasticities to exports were also calculated using the same specification:

lnEi = s + b1*lnXi + b2*(lnXi*Di) + b3*Di + ui

Ei again represents employment in country i and Xi represents total merchandise exports. Thus, two types of elasticities are calculated: the elasticity of employment with respect to total output, and secondly, with respect to exports.

The regression is estimated for the most recent years (2003 to 2007) using data from 8 countries from East Asia (China, Hong Kong, and Korea) and Southeast Asia (Indonesia, Malaysia, Philippines, Singapore, Thailand).

Data on employment, GDP and exports were taken from World Bank's World Development Indicators Online (WDI). Total employment per se is not available in WDI, but was instead derived using data on total labor force and total unemployment rate:

Employment = labor force * (1 – unemployment rate)

GDP values are measured in constant 2000 US dollars, but exports are in current US dollars. Official foreign exchange rates were also downloaded from the WDI to convert exports to constant 2000 US dollars.

Once elasticities were calculated for each country, they were then used to estimate the changes in total employment in 2008, 2009, and 2010 based on projected GDP changes and export changes. The calculation for each country is simply:

% change in Ei = % change in Yi * (b1 + b2)

GDP and export growth projections are provided in the statistical index of Asian Development Bank (2009).

Employment estimates

East Asian countries were found to have the lowest employment elasticities with respect to GDP, whereas countries in South Asia have the highest. In terms of elasticities with respect to exports, Philippines has the highest employment elasticity at 0.84. Other countries have elasticities between 0.20 and 0.30, except for China, Hong Kong, and Thailand, which have elasticities less than 0.10.

With respect to GDP all countries will experience lower employment growth in 2008. The change is lower still in 2009 compared to 2008, with the more industrialized countries experiencing negative employment growth. The growth will rebound in 2010 for all countries, with few countries back at their respective 2008 levels.

With respect to exports, some countries are expected to have lower employment growths in 2008, with Sri Lanka and Philippines already in negative values. The negative growth of these two countries will continue in 2009, together with the rest of the countries (except for India, which has no available export projections). The countries are expected go back to positive employment growth in 2010, with only Hong Kong back at its 2008 levels.

Concluding remarks

The use of elasticities is a simple yet economically intuitive way of estimating the impact of the recent global economic slowdown on employment levels. Provided that the elasticities are stable over time, we can use the elasticities calculated from previous years' data to determine how much growth in employment is expected in the future given a projection of growth in GDP. Kapsos (2006), however, pointed out one shortcoming on the use of employment elasticities. The methodology utilized here only takes into account information on employment, output, and exports. It is likely that the estimated employment elasticities will suffer from omitted variable bias. Other variables may influence either employment performance, economic performance, or exports, but they are not controlled for in the model. Nevertheless, the elasticities presented here provide an estimate of the relationship between employment and output (or exports). These estimates may likely as well provide an indication of what will happen to employment in the next two years.

References

Asian Development Bank. 2009. Asian Development Outlook 2009. Manila.
Betcherman, G and R. Islam. 2001. "East Asian labor markets and the economic crisis: An overview." in G. Betcherman and R. Islam (eds.) East Asian Labor Markets and the Economic Crisis: Impacts, Responses, and Lessons. Washington, D.C.: The World Bank and The International Labour Office.
Kapsos, S. 2006. "The employment intensity of growth: Trends and macroeconomic determinants." in J. Felipe and R. Hasan (eds.) Labor Markets in Asia: Issues and Perspectives. New York: Palgrave Macmillan for Asian Development Bank.
World Bank. World Development Indicators Online. Downloaded 20 May 2009.

Institutions matter part 2

I'd like to go back to that article in the Economist I mentioned a few posts back. The article makes a good point which is of a different sort of perspective. Political constraints that interfere with economically efficient solutions is indeed another form of institutional constraints that interfere with efficient economic choices. The most common analyses of how institutions matter for economic growth is in cases where it limits the growth of certain economies: trade policies that inhibit the free flow of goods to and fro a country, labor market policies that constrain the growth of establishments, even the lack of reinforcing property rights. But the article points to one other aspect--that of preventing an economy from rebounding (efficiently) from an economic slowdown, or in this case, an economic crisis.

The same way that institutions should foster the economic growth of a country (breaking down trade barriers, a strong reinforcement of rule of law, etc.), institutions should also take the role of ensuring a country gets back to its growth track after experiencing a devastating crisis. One way is safety nets should have already been in place to mitigate the adverse effects on the already vulnerable members of the population (the poor and the marginalized), as we have espoused in our recent paper. Another one, which seems to be a revolutionary idea, is suggested by Raghuram Rajan, former IMF chief economist, in another Economist article: a cycle-proof regulation--a regulatory system that is immune to boom and bust. And like Dr. Rajan mentioned in his article, there should also be a balance so as not to over-regulate, but enough so that the policies in place would last for many years.

Online resource for economists

I've added two excellent online resources for economists on the nav bar on the left: the aptly named Resource for Economists maintained by the American Economics Association, and the list of Economic Journals on the Web maintained by the Department of Economics at State University of New York in Oswego.

Very, very useful sites.

All these financial talk... what about the poor?

The recent global economic is probably the worst that has happened in the Asian region since the 1997 financial crisis. The dust hasn't settle though: academic discussions are still abound--what went wrong, what will be the impact on other non-financial sectors, and what could be done to prevent the same crisis happening again. You can check the latest issue of the Economist to see that it's still a long way to go before that third type of discussion is going to be resolved. While it still remains to be seen what will happen to the other non-financial sectors, we economists can have an idea on what will happen based on certain assumptions. Of course, making assumptions is an essential part of an economist. But that's not the main point really.

For Asian countries, one of the important aspects is the poverty dimension. Much has already been done among Asian countries in reducing poverty. Since poverty reduction is essentially difficult to achieve without economic growth, this ongoing gloabl economic slowdown already being experienced by these Asian nations is going to be a cause for great concern. Needless to say, we can expect a slowdown or a complete stop in the reduction of poverty. Worst, the global economic slowdown may lead to more poverty. So how will the picture of Asian poverty take shape in the coming months or years?

Of course, we can come up with sophisticated models that would predict what would happen to poverty. These models may utilize the state of the art econometric methods or involve a gazillion dependent variables to consider--because the more variables you include, the more close it is to reality. But forget that for the moment. Just simply consider the relationship between the two variables, poverty and GDP per capita. Let's just consider one of the most basic analyis--how much change in the level of poverty will happen now that we expect GDP per capita to change? In other words, let's consider the impact of the global economic slowdown on poverty by making use of the elasticity of poverty due to a change in GDP per capita. This is exactly what Rana Hasan, Maria Rhoda Magsombol, and me did in the latest working paper from the Asian Development Bank.

We try to predict how the economic slowdown will affect the incidence of poverty in developing Asia over the next 2 years. We provide numbers on the basis of various scenarios for economic growth using the empirical relationship observed between poverty and incomes between 1990 and 2005. We used different scenarios because there is still considerable uncertainty regarding how much countries will grow in 2009 and 2010.

As mentioned in the previous paragraph, our starting point for projecting poverty incidence in 2009 and 2010 is the empirical relationship between economic growth and poverty reduction observed between 1990 and 2005. We estimate this relationshop using a simple linear regression model whereby the log of the poverty rate is regressed on GDP per capita. The resulting coefficient would then be our estimate of the growth elasticity of poverty. The regression is estimated separately for each Asian subregion in order to account for the fact that the relationship between economic growth and poverty reduction is likely to vary within a region as large and diverse as developing Asia.

Indeed, we do find that growth elasticities vary considerably across subregions. The growth elasticity in Central and West Asia is considerably higher than in other subregions, including Southeast Asia. Much lower growth elasticities are found in the Pacific and South Asia. Furthermore, the growth elasticity is smaller in absolute value for higher poverty lines, confirming previous research. But enough of that--what we want to know more is what will happen in the next two years.

So assuming that each subregional growth elasticity applies to every country within a subregion, we can estimate what poverty would be like in each country based on different scenarios for the growth of country-specific GDP per capita. Our estimates indicate that a reductionin growth of GDP per capita of between 1 to 3 percentage points over growth registered in 2007 would result in 21 to 61 million additional $1.25/day poor in 2009 and 34 to 98 million additional poor in 2010 as compared to a baseline scenario of no economic slowdown. Correspondingly, in terms of $2.00/day poverty, the picture is worst.

One cannot know now which is the most accurate scenario, but that may eventually be besides the point. It will be worst than the case where this whole global economic slowdown didn't happen at all. Needless to say, it will become crucial to get affected economies of the region back to paths of economic high growth and for them to provide mechanisms for protecting the welfare of the poor and vulnerable. Countries will need to consider how to alleviate adverse conditions for their populations, especially those subgroups that are already poor and whose plight is likely to worsen, and those liable to fall in poverty.

Specialization versus Diversification

I was discussing the other day with another fellow young economist, Mitch Abdon, about this concept of product space. She is part of the team here in the Asian Development Bank that applies Ricardo Hausmann's product space theory and methodology for the country of Pakistan (project headed by Dr. Jesus Felipe). She brought up an interesting point. If at first it may seem that the product space theory compliments one of the basic tenets of international economics (specially from Adam Smith) which is that specialization is the key to economic growth--you are wrong. On the contrary, the product space theory espouses more and more diversification of products--not specialization in any one or two--because this is the only way that you can get to more sophisticated products. And as indicated in my previous posts, the level of sophistication of products is one characteristic of developed nations.

My only reservation with this new insight is that, diversification is not the only route to more sophisticated products. The fact is, specialization on one type of product can also lead to more sophisticated products. I think the iPhone is a perfect example. It is today's most sophisticated cellular phone--but it is not far away different from the old and less-sophisticated analog celphones that we had before. But frequent research and specialization on cellular phone technology has led to improvements and developments, and the latest one is the iPhone. I wouldn't be surprised if in two year's time, more developments on the technology (a.k.a. specialization) might give us the next generation of cellular phones that would make the iPhone significantly obsolete.

Diversification does lead to more sophisticated products. But so does specialization.

Why are some poor countries still poor? A technological reason...

I was mistaken in my blog entry yesterday. Professor Ricardo Hausmann did not gave a talk in the afternoon on his discovery theory, but something else that is also very related: product space. In addition to what has been shared in my previous post, the products space is one way of explaining why poor contries continue to be poor and failt to converge to the income levels of rich countries. It is based on a standard notion that what a country produces matter for subsequent economic performance because industrialization creates spillover benefits that fuel subsequent growth.

In the history of mankind, new products are created out of raw materials, and then newer, more sophisticated products are likewise created from these previously created products. This and other possible factors cause one product to be related to another. Obviously, only rich countries specialize on these more sophisticated products, whereas poor countries can only produce less-sophisticated ones. And so, this is where Professor Hausmann, Cesar Hidalgo, Bailey Klinger, and Albert Lazlo-Barabasi point out the answer to the question posed by the title. The network of relatedness between products (the product space) show that more-sophisticated products are located in a densely connected core whereas less sophisticated products occupy a less-connected periphery. Poorer countries tend to be located in the periphery, where moving toward new and more sophisticated products is harder to achieve.

Much entertained and enlightened by Professor Hausmann's talk, he ended his discussion of product space by pointing to the consequences for economic policy. As the product space can show, as well as several case studies, it is difficult for production to shift to products far away from the periphery, where poor countries find themselves. The challenge really is to identify correct government policies that would help the country make large jumps toward that space where more sophisticated products lie. As mentioned in my previous post, this may involve encouraging entrepreneurship and investment in new activities, as well as push out unproductive firms. For Professor Hausmann and his colleagues, it is precisely these long jumps that generate subsequent structural transformation, convergence, and growth.

Professor Hausmann's work makes a huge economic sense. My only reservation is that it seems this whole product space concept centers on tradeable goods. What about the sophistication level of non-tradeable goods? What about much of the service sector? Human capital? Although we can easily argue how tradeable goods are likewise related to non-tradeable goods (sophisticated computers breeds smart computer geeks), it would give a more complete picture if they show how services come into play. As the case of the Philippines would show, for example, one particular good has helped push the country's growth rate upwards and it's not "tradeable"--overseas workers.

If you need more technical details about what product space is and how it's done, check Cesar Hidalgo's excellent website.

A talk with Ricardo Hausmann

Ricardo Hausmann, Director of the Center for International Development in Harvard University, visited the Asian Development Bank (ADB) to present his latest research on development as a process of learning to produce and export sophisticated products. He first met with the economists before lunch time, and I indulged myself in listening to the excellent development economist.

I have not particularly seen the actual paper or presentation itself, but I recon that it is related to Professor Hausmann's 2005 paper with Jason Hwang and Dani Rodrik ("What you export matters," CID Working Paper no. 123, December 2005, Harvard University Center for International Development), which is driven by his earlier work with Professor Rodrik in 2003 ("Economic development as self-discovery," Journal of Development Economics 72: 603-33; an earlier NBER version can be downloaded here). Basically, it's not enough that countries should promote policies that would increase access to foreign trade and investment and imported capital equipment and intermeiate goods (access to state-of-the-art technologies) as well as secure property rights (good governance). Learning what one is good at in terms of which products to produce is an equally important determinant of structural change. Some traded goods are associated with higher productivity levels than others and that countries that latch on to higher productivity goods will perform better. This process of product specialization involves entrepreneurs exploring and discovering the underlying cost structure of the economy.

The problem is is that this discovery process is unlikely to be adequately provided under laissez-faire. As Professor Hausmann's 2003 paper notes:

"... [L]aissez-faire leads to underprovision of innovation. Governments need to play a dual role in fostering industrial growth and transformation. They need to encourage entrepreneurship and investment in new activities ex ante, but push out unproductive firms and sectors ex post."

Professor Hausmann didn't actually discussed much about his presentation, but opened the forum for questions regarding any of his latest research. Among which is his work on growth diagnostics. His most significant insight was how it relates to the Washington Consensus. Coined by John Williamson in his 1990 work, "Latin American Adjustment: How Much Has Happened?" (Washington: Institute for International Economics), the Washington Consensus is a list of ten policy reforms he suggested as needed for Latin American countries hit by the debt crisis of the 1980s:

1. Fiscal discipline
2. Reordering public expenditure priorities
3. Tax reform
4. Liberalizing interest rates
5. A competitive exchange rate
6. Trade liberalization
7. Liberalization of inward foreign direct investment
8. Privatization
9. Deregulation
10. Property rights

So, Professor Hausmann mentioned that each of these are well and good, and may actually result to positive outcomes to countries. His whole point, however, is obvious in the title. Williamson meant for these reforms to be applied to Latin America only. So Professore Hausmann, like other economists, was surprised that multilateral agencies such as the World Bank and the International Monetary Fund adopted the Washington Consensus as the generic solution to all economic problems faced by developing nations. Professor Hausmann stressed that these policy recommendations have to be taken into context. What is really needed is to sit down, ask specific questions to a development country, and get down to the details on what is actually going wrong. And so the growth diagnostic literature is born.

For a retrospective view of the Washington Consensus, here's what John Williamson himself has to say.

Introducing the product space

Ever heard of product space? It's one of the new frontiers in the field of international trade and economics spearheaded by Ricardo Hausmann, Cesar Hidalgo, Bailey Klinger, and Albert Laszlo-Barabasi. It basically tries to map a country's endowments and technology, and shows where the country's comparative advantage lie (in terms of products) and where the country is currently situated in vis-a-vis its comparative advantage. One very interesting finding is that based on this new form of analysis, they find that the way countries develop comparative advantage is far from random, and that there might exist a lack of convergence in international income levels given the structure of the product space. Still developing countries might find themselves in the outer periphery of the product space with few opportunities for diversification, whereas other better-off countries find themselves near the central core of the product space and have developed capabilities easily deployable in a wide range of products, creating a path to convergence.

Wikipedia's entry on Ricardo Hausmann provides a simple analogy that would give you a picture of what product space is:

"Think of a product as a tree and the set of all products as a forest. A country is composed of a collection of firms, i.e., of monkeys that live on different trees and exploit those products. The process of growth impliesmoving froma poorer part of the forest, where trees have little fruit, to better parts of the forest. This implies that monkeys would have to jump distances, that is, redeploy (human, physical, and institutional) capital toward goods that are different from those currently under production. Traditional growth theory assumes there is always a tree within reach; hence, the structure of this forest is unimportant. However, if this forest is heterogeneous, with some dense areas and other more-deserted ones, and if monkeys can jump only limited distances, then monkeys may be unable to move through the forest. If this is the case, the structure of this space and a country’s orientation within it become of great importance to the development of countries."

It's actually a very exciting and interesting new field, and it surprisingly has economic sense. Too bad though, as Niny Khor of the Asian Development Bank mentioned, much still needs to be done in terms of its theoretical foundation. But the fact that it is built upon the basic models of international trade, it won't be long before a firm and strong theory will come out and support the product space field.

In the meantime, you can check Cesar Hidalgo's excellent website for a snapshot of what a country's product space would look like...as well as his other materials on this subject.