Broken Symmetry

The Coase Theorem Does Not Apply to Multilateral Agreements

In The Problem of Social Cost (available here), Ronald Coase presented the case for what became his eponymous Theorem. In short, Coase argued that in the absence of transactions costs, parties would contract around default legal rules to achieve an economically efficient allocation of resources. As a result, in the absence of transactions costs, lawmakers should only need to ensure a clear definition of property rights and the enforcement of contracts, without worrying too much about who starts off with the property rights. The Coase Theorem has been on my mind a bit lately thanks, in part, to the Supreme Court grant of certiorari in the Stanford v. Roche case. If transactions costs could be ignored, then (according to Coase) none of the stakeholders in the tech transfer system should worry too much about a reallocation of ownership rights by the Supreme Court. An economically efficient bargain would always be reachable under a new allocation of rights -- assuming the transactions costs can be ignored.

But can they? Of course not. The uncertainty associated with tech transfer investments is often so great as to swamp the costs of negotiating these agreements. In this post, however, I want to abstract away from the specific economics of tech transfer, mortgage finance, corporate chartering, insurance, derivatives, or any other economically multilateral agreement in order to emphasize just how limited the Coase Theorem is in its general applicability to the analysis of large-scale social costs.

The Problem of Social Costs makes its case using a hypothetical example of a negotiation between a rancher and a farmer over who should have to pay for a fence and/or crop damage. That archetypical case comes in the first main section of the paper, titled "The Reciprocal Nature of the Problem." Coase's hypothetical is explicitly a bilateral agreement. Coase's emphasis of the "reciprocal" nature of the problem is implicitly bilateral in its symmetry.

So what? Consider the graph below, which compares how the transactions costs of bilateral contracts and the transactions costs of trilateral contracts add up as a population of parties increases. The calculation of both is based on the assumption that each party to an agreement (whether bilateral or trilateral) will pay the same fee for entering into an agreement. The calculation of both is made assuming every party in the population will enter into a single agreement with every unique combination of counter-parties. (In detail, these are total unique combinations of two and three picks from a population of n graphed as a function of n.) The graph shows how the relative difference in transactions costs diverges dramatically even for a population of 15 parties.

The difference is even more dramatic for a population of 100 parties.

What does this mean? At the very least it means that in policy debates about the allocation or reallocation of resources whose use involve three or more distinct economic interests (i.e., stakeholders), the Coase Theorem should not be invoked, or at the very least invoked only after everybody is satisfied that the transactions costs are completely overwhelmed by the economic benefits of a bargain.

But nearly every policy question involves more than two stakeholders. Even consumer transactions -- which seem like the quintessential bilateral agreement -- have indirect effects, compensated for through indemnifications and warranties. In other words, the Coase Theorem simply doesn't apply to any practical policy problem of interest.

At the same time, the Coase Theorem was very useful because it focusses our attention on transactions costs. In many cases, it may be easier to lower transactions costs than to decide how rights should be allocated. My point in this post is not to say that The Problem of Social Cost was fundamentally wrong, or even useless. Rather, I want to point out that we can usefully analyze transactions costs by breaking them out according to the number of parties necessary to an agreement.

This point gains strength as the number and variety of multilateral agreements increases. Nothing much at all seems to happen in our economy without getting buy-in from a host of stakeholders, either formally or informally. And the biggest economic issues of our day -- from Fed policy, to mortgage financing, to tech transfer models -- are all examples of vast, multilateral negotiations. Our world is no longer Coasean.

Positional goods present an especially interesting application of this analysis of transactions by number of parties. A positional good, by definition, is a good whose value depends both on the supply available and on the demand for the good by other consumers. Every transaction involving a positional good is at least a trilateral agreement, and arguably much more multilateral than that since the other consumer might not be based on the activity of a particular person, but rather on a general perception of the activity of an entire group of other consumers. The Coase Theorem simply doesn't apply to positional goods.

Van den Steen on Knightian Uncertainty and the Firm

From AER: (via MR)

According to Knight, then, people differ (with respect to uncertainty) in the confidence in their judgment and “the most fundamental change of all in the form of organization” is the “system under which the confident … ‘insure’ the doubtful … by guaranteeing to the latter a specified income in return for an assignment of the actual results” ( p. 269). While this is often interpreted as risk aversion, Knight’s “confidence” actually refers to the belief that your judgement is correct, i.e., ν. This description does fit the mechanism in this paper: the principal tells the agent what to do and gives the agent a fixed wage in exchange, i.e., he insures the agent against the principal’s mistakes; and it is the more confident player who becomes the boss.

From this interpretation of Knight, the essence of a firm is that it allows the confident entrepreneur to make all decisions under uncertainty and then bear all the financial consequences of these decisions, i.e., absorb the uncertainty. The driving force in the existence of a firm is, according to Knight, the difference in confidence, which was also one of the driving forces in this model. This is quite different from the Coasian view, where it is the cost of transactions, i.e., the cost of contracting on decisions, that drives firm boundaries...

Although I'm not convinced of the generality of Van den Steen's theory (which strikes me, because of his emphasis on differences in priors, as a better description of insolvent organizational dynamics than it does of technology startups, for example), I do find this interpretation of Knight pretty interesting.

Coming at this with my priors from having studied probability theory in the context of quantum mechanics, I tend to imagine Knightian subjective uncertainty as the Hilbert space for a particle, with objective uncertainty then being the expectation value for a particular observable. Then Van den Steen's theory suggests that the Knightian entrepreneur effects the collapse of a wave function into a particular state. But the actions of the Knightian entrepreneur may or may not be consistent with how a rational actor would behave in view of the expecation values! Rather, as Van den Steen suggests, it is the confidence of the entrepreneur (or at least the confidence projected), which results in a measurement and collapse into a particular state. That's very interesting because decisionmaking by an organization does seem to be driven at least partially by signals of confidence.

Incompatible observables permit another thought experiment. There are plenty of classical equivalents, and I see no reason why these should not constrain organizational economics as much as they do anything else. The most relevant pair of observables for financial statements are time and frequency. So one can imagine an entrepreneur who forces the system into a non-Gaussian state that maximizes or minimizes time-averaged measures of productivity, making it difficult, if not impossible for anybody who takes over to move the system back into a healtier state -- there simply isn't enough of what Van den Steen calls "confidence" available to make the measurement! But this too suggests that Van den Steen's might be a better theory of the insolvent firm than of a growing firm.

Do Good Fences Make Good Neighbors?

Why, yes, they do.

There's a debate among academics in patent law now over whether patents create an anticommons (or "gridlock") problem. The debate tends to assume without proving that there would not be a worse commons problem were patent rights peeled back to disable the system of exclusive rights to technology that developed in the 19th century in the United States.

But patent rights weren't the only property rights that were secured for the first time in the 19th century United States. In fact, the invention of barbed wire (itself patented) contributed to a dramatic decrease in the costs of securing real property in the 19th century. And to what effect? Richard Hornbeck reports:

This paper uses the introduction of barbed wire fencing to the American Plains in the late 19th century to estimate the effects of property rights on farmers' production decisions. Farmers were both formally and informally required to build fences to secure their land. From 1880 to 1900, the introduction and universal adoption of barbed wire reduced the cost of fencing, relative to wooden fences, most in counties with the least woodland. Over that period, counties with the least woodland experienced substantial relative increases in the improvement intensity of farmland, the value of farmland, and the productivity and production share of crops most in need of protection. This substantial increase in agricultural development appears to reject increased security of property rights due to barbed wire fencing. Some states' previous efforts to reduce the need for fencing are not found to have had similar effects, however, suggesting a difficulty protecting property rights in sparsely settled areas through legislation and the court system.

Why would state-enforced rules not work as well? See Robert C. Ellickson and Coase. (Still not transparent? See Calabresi and Melamed.) And note that patents are more like barbed wire than like state legislative efforts to shift the costs of fencing to herd owners (described in the paper).

If this seems like ancient history to you, then consider the fact that our government is going to have to learn how to be 100x more efficient with its tax revenues over the next few decades if we are to avoid insolvency.

Here's another interesting point: Ellickson found that even barbed wire was too expensive to be worthwhile in close-knit communities of ranchers and farmers like Shasta County, California.

What is the Systems Theory of Economics?

Systems theory is an attempt to put Hayek, Coase, Williamson, North, and Ellickson on more quantitatively rigorous foundations. Systems theory is an umbrella term for physics models of networks and dynamical systems that are used to understand how interconnected flows can end up in stable or unstable local equilibria, spontaneously synchronize, and generally evolve over time in feedback loops.

Here are some of the basic hypotheses about human behavior that might be associated with systems theory:

• Individuals have preferences for goods that can be measured in units of flow (quantity consumed/produced per unit time).
• Individuals seek to optimize the fit between their flow preferences and available flow using available information about past and present available flow.

These together suggest that individuals can be modeled as a nexus of flows of cash and other goods. In turn, the interconnected streams of these flows lead to additional hypotheses about the behavior of the integrated system of flows.

• Feedback loops in flow among individuals can result in more spatially and temporally stable preferences by synchronization of flow.
• A nexus of synchronized flows may be a firm or a market depending on the structure of interconnections. (I.e., the ability to synchronize flow over time determines what structures will persist.)
• Firms that synchronize with higher-bandwidth can operate at lower cost, sell at higher margin, or both.
• Firms with scale-free architecture are the most cost-efficient, but also the most susceptible to catastrophic failure.
• (Perhaps most surprisingly) Under certain circumstances, individual preferences will spontaneously synchronize through market price signals.

There is an evolutionary mechanism at work here in that the nexus of flows that constitutes a firm is in competition with other nexuses of flows for additional flow. Over time, some network structures will survive better. And the success or failure of a particular network will, of course, have an impact on how the preferences of individuals within it will evolve over time. There are deep connections between systems theory and the evolutionary theory of psychologists like Mihaly Csikszentmihalyi and sociologists like Donald T. Campbell. But the kind of data and scale of the models used by systems theory is more traditionally associated with economics.

Much of systems theory has been anticipated by New Institutional Economics, and in some cases sociology and psychology. The work from Haidt and Ehrenreich on hive psychology and collective joy, for example, is consistent within broad contours of the physics models of self-organized synchronization. Robert H. Frank's work on positional goods can be understood in terms of the sustainability of certain integrated flow structures over long times. In general, Thomas Schelling seems to have had these sorts of models in mind in his writing, although he tended to focus on the potentially destructive outcomes after long periods of repeated interactions.

I'm going to try to turn each of these bullet points into a separate post over the next few weeks or months.

Traffic Flow Revisited: Why are we letting the Ants win?

Last year I threw out an idea for how we could improve traffic flow with incentives: Install a device in everybody's car that permits the driver to offer a tip to a car nearby. My hypothesis is that nothing more articulate than that would be necessary for two drivers to cooperate in many situations that now lead to congestion. Think about the case of trying to pass somebody in the fast lane who doesn't see you or doesn't want to pull over. By implementing such a system, polite driving would be encourage and congestion diminished as those who really needed the road or were willing to pay for it would be able to spend money to get more of it.

I still think it's a good idea, and if there are any engineers out there who agree with me, I'd be interested in talking.

I was thinking about this again today as I sat in traffic on the freeway. It occurred to me after I realized that this traffic was just due to congestion, not an accident, that we sophisticated apes are being outdone by the ants that I observe from time to time in my California living room. These ants are very coordinated in their flow. No traffic jams. Why are we letting them show us up this way?

One commenter last year noted that such a system might lead to more accidents because of the distraction. That's a problem. But then why not make it even simpler. Why not setup something like bluetooth that connected by audio all drivers within a certain bubble around your car onto the same channel for communication? In other words, why not setup a public communications channel that was available at the push of a button so that people in cars nearby could start communicating with one another? Why are we letting the ants win?

Letter Comment to the FTC on the Evolving IP Marketplace

Here are a few excerpts:

According to systems theory, innovation emerges from iterated cycles in which data, theory, and the people who collect data and form theory constitute feedback loops, which evolve over time. Each cycle manifests as the gathering and exchange of information among a network of experts who act as gatekeepers to a set of symbolic rules and procedures. Following the terminology of Mihaly Csikszentmihalyi, I call the network of experts a “field,” and the set of symbolic rules and procedures a “domain.” To give examples, topology, physical chemistry, and constitutional law are domains. Each of these domains is associated, respectively, with the fields of mathematicians who specialize in topology; academic and practicing physical chemists; and academics, practicing lawyers, and judges who work on constitutional law.

From the point of view of an economist, the most important difference between systems theory and neoclassical theory may be that systems theory permits for economic actors (the field) to have preference functions (the domain) that evolve over time. As a result, although neoclassical theory is still a useful model of economic activity when changes in preferences are small within the window of time in which economic activity is observed, more generally no stable equilibrium may be reached because preferences may change during the period of observation. In addition, because systems theory need not assume that economic actors know how their preferences have or will change over time, an assumption that actors will try to match their allocation of resources to their preferences can be called “rational” only in a weak sense. Under systems theory, whether an economic actor will engage in an activity of consumption, production, or exchange is a function of: (1) their history of preferences; (2) their history of consumption, production, and exchanges with others; and (3) the frequency of their exchanges with others. Whereas within neoclassical theory institutions are designed to promote allocative efficiency, within systems theory institutions are designed to promote the discovery of information about preferences, and thereby the synchronization and frequency-matching of consumption and production activities through exchange and cooperation.

For example, the systems theory makes explicit the spatial and temporal dynamics underlying the knowledge problem described by F.A. Hayek in “The Use of Knowledge in Society.” With the systems theory in mind, we can identify the function of markets with their facilitation of the exchange of information and coordination of economic activity independent of central planning. This is in stark contrast with neoclassical theory, which often identifies the function of markets with the maximization of aggregate utility based on an assumption of stable preferences — a function that cannot be carried out by a central planner beyond a small scale. The systems theory therefore identifies markets as a mechanism for rewarding information exchange and cooperation, thereby facilitating economic growth.

Download Letter Comment to FTC on the Evolving IP Marketplace (Final)

Robert H. Frank's "Nonpositional Goods" are the Gauge Bosons of Local Symmetries in Economics

In "Positional Externalities Cause Large and Preventable Welfare Losses," Robert H. Frank notes how so-called "positional goods" may effect a redistribution of wealth in society by drawing resources into their creation that might be more efficiently allocated to other goods.

Earlier posts here and here considered the relevance of gauge theory to neoclassical economic models and concluded that invariances such as the Coase Theorem and the Miller-Modigliani theorem are conservation laws that are linked by Noether's Theorem to important symmetries in the neoclassical model.

I've been chewing this over for a while. An important question raised here is "What are transactions costs?" Somebody unfamiliar with the Coase Theorem or New Institutional Economics might naively believe the category limited to brokers' or attorneys' fees. They are not. Coase understood these costs to include, for example, the costs of searching for and identifying potential counterparties in addition to such fees. In fact, a major project for research within the field of New Institutional Economics seems to be getting precise in categorizing transactions costs.

On my view, the difficulty with categorizing transactions costs can be traced back to the fact that one person's "costs" are another person's revenue. In other words, transactions costs are deeply interwined with the symmetries or asymmetries in the bundle of goods and preferences held by potential counterparties.

Physicists have developed a very useful tool for categorizing particles based on the symmetries of the fields through which particles interact. This is gauge theory, of which Yang-Mills theory, which gives us the Standard Model, is the most well-established.

But before Yang-Mills theory there was Weyl's classical field theory. Classical field theory in physics actually bears much in common with neoclassical theory in economics. Both theories assume that symmetries in key variables are global. In neoclassical theory, if the value of some currency is inflated, then it may seem to each individual like they are richer, but because the currency value is inflated for everybody, buying power -- the value of the currency -- is the same.

By contrast, Yang-Mills (and in general any non-abelian gauge field) Theory permits for some symmetries to exist only locally. Many interesting consequences flow from the fact that global symmetries may be broken. One is path-dependence: The order in which interactions take place in Yang-Mills Theory matters to the ultimate configuration of the system. In fact, as Yang himself put it, when global symmetries are broken, "local symmetries dictate interactions".

Analogy to Yang-Mills Theory might bear fruit for economists. In particular, the methodology of categorizing interactions through local symmetry breaking could be very useful in formulating a more precise theory of transactions costs.

I will have more to say about this over time. For now, let me observe simply that most goods are produced and exchanged in discrete units. In physics terms, this means that the field of value in these goods is quantized. According to neoclassical economic theorists, this quantization shouldn't matter because goods can be exchanged indefinitely until the closest match to equilibrium is achieved.

That isn't what happens in practice, of course. To wit, what Robert H. Frank calls "nonpositional goods" are the analogs to gauge bosons of non-abelian gauge theory. Because the field of values for a good is quantized and because only local symmetries are conserved for the good, the lowest energy eqilibrium may never be reached.

But identifying "transactions costs" as the gauge bosons that result from local symmetry breaking is probably a useful insight in itself considering how difficult it has been to be precise about transactions costs in the past.

Gauge Theory in Economics

Here are few additional thoughts on the gauge invariance approach to neoclassical theory.

The Coase Theorem in neoclassical theory plays the role of a Noether's Theorem in classical mechanics. Miller-Modigliani is another Noether's Theorem that could be derived from a gauge invariance in neoclassical theory.

So here's the next question: Are there analogs to non-abelian gauge fields in neoclassical economic theory?

For that to be so, it seems that the order in which exchanges occur within an economy would have to matter to the equilibrium established. Already we are out of neoclassical theory then. But the path-dependence of economic growth is an accepted fact among some economists, so perhaps there are non-abelian gauge fields.

One mechanism whereby path-dependence might be introduced is through changes in cross-elasticity. An exchange of one good can effect the price of another, and cross-elasticity is the measure of such a change. There may be a non-abelian gauge field that dictates the cross-elasticities of demand.

Personally, I'd rather see a model of coupled parametric oscillations applied to understanding supply and demand than an agent-based model. But I don't have the time to really dig into this. And I'm not sure that adding formalism is important here. Douglass North and the other New Institutional Economics scholars seem to be pursuing a nonequilibrium theory of economics without one.

What would we call Goldstone Modes in an Economy?

Having gone over the paper by Per Bak, Simon Norrelykke, and Martin Shubbik, I am somewhat confused as to why footnote 9 in the Smolin paper identifies this mode with inflation. Unless I'm mistaken, anything that disrupts the scale invariance of prices could be the cause of the symmetry breaking.

If that's so, then inflation could be one cause of broken symmetry. But so too could anything that gives rise to wealth effects, including transactions costs when the assumption of scale invariance is approximate as it is for economics.

Economists have a name for the neoclassical theory that the initial allocation of resources has no effect on welfare: the Coase Theorem. It's actually pretty useful. Ronald Coase won a Nobel for it.

Making the identification between gauge invariance and the Coase Theorem should help the work of Smolin, Malaney, Weinstein in pushing us toward a nonequilibrium theory of economics.

The difference between debt and equity

The authors at the excellent AAO blog complain that the government's terms under the Troubled Asset Relief Program" (TARP) strike a bargain that is more like debt than equity as far as managers and investors in the companies that accept the terms are concerned:

Take a look at the term sheet for the injection. The government plans to buy preferred stock, now in vogue. It'll carry a 5% dividend, rising to 9% after five years; it can't be redeemed for at least 3 years; restricts dividends on junior preferred stock or common stock; has no voting rights; and restricts executive compensation to be in accordance with the Emergency Economic Stability Act's requirements. One other thing: it has a "perpetual life," apparently because the term sheet says so. Realistically, the Treasury is not going to be a longer-term player in these preferreds any longer than it has to be - and there are no restrictions on the transferability of its investment.

Is this complaint sound? Yes and no. At this point in time, there's no way to argue with the facts they cite in evidence for their reasoning. But it's important to remember how we got here. Fifty years ago, most public companies paid a substantial dividend to their shareholders, and holding preferred shares was a good way to invest in smaller or struggling companies whose common dividends were not secure. With the shift away from paying dividends toward reinvestment of free cash flow, the significance of the distinction between preferred and common has diminished. Thus the recent suggestion of some on FASB that only common shares should be considered equity.

Some readers may argue that tax efficiency is a justification for retaining earnings. Maybe. But on my view, if a company can't earn more than a dollar for each dollar it reinvests, then it should give me my cash and pay taxes rather than keeping some pet project on life support. I don't like taxes, but the government is setup to spend them -- and is subject to more checks, balances, and transparency into its spending.

Baird on Coase on Knudsen: Revisiting the History of Ford and Venice

A few years ago I listened into a podcast of Douglas Baird sharing his paper, In Coase's Footsteps, via the Chicago Law Faculty Blog.  I was particularly interested in his discussion of how it was human capital that had given Ford its comparative advantage.  Baird traces the Coase Theorem to research that Coase did while an undergraduate on the manufacturing processes at Ford and GM.  Baird pinpoints William Knudsen as the source of know-how at both GM and Ford:

Central to bringing this about was replacing the person in charge of production in the Chevrolet division with “the best production man in the United States,” a man named William Knudsen. Knudsen was empowered to make dramatic changes at Chevrolet, and he did exactly this. Knudsen divided the production of automobiles into two largely separate operations. First there was the manufacturing of the basic components, such as the engine, the transmission, the wheels, and so forth. Second, there was the question of assembling the component parts. Knudsen was convinced that efficient production required a dramatically different approach to each. (page 6)

This history is mostly consistent with the historical discussion in Waddell & Bodek's, Rebirth of American Industry, but it leaves out some facts that may be important.  At least as Waddell & Bodek tell it:

[Knudsen] played no part in the development of the Ford manufacturing process that was exploding at Highland Park while he was at remote plants.  That he was a sound manufacturing man was certain, and he had good business acumen, but he was not an expert in the Ford manufacturing system.  At best, he was an arm's length observer.

In 1920, Knudsen left Ford on friendly enough terms and went to work for Chevrolet.  He did a good job there and eventually rose to senior management at GM, but he in no way implemented the Ford system.  Assembly lines were not the Ford system, they merely looked like Ford.  In fact, just about everyone implemented assembly lines soon enough, and they did not need former Ford people to do it.  Knudsen, Chevrolet and everyone else failed to implement the management system that drove the creation of assembly lines; and that was the system that drove almost zero defects and an intense focus on cycle time.  Assembly lines without quality control and short cycle times were not the Ford system.

Waddell & Bodek don't in this passage give a complete account of how the difference in incentives caused by a focus on both cost and cycle time were key to Ford's success.  But that is the main message of their book.

Consistent with their observations, I thought it was interesting to see that the same independent tracking of time and cost was done in Venice in the 15th and 16th centuries

Commercial ventures entangled people in projects with different time returns, so that a kind of hook-and-eye weave of them all into a common undertaking was the result.  The republic governed all this activity with rules ensuring continuity and conformity of rules.  Weights and measures, value of goods, maintenance of quality, gave deals and products a sameness over the years.  Frederic Lane notes how the extensive use of double-entry bookkeeping made people think in terms of complex equations, holding together separate investments with overlapping periods of completion.  Investment partners of different ages and status made contracts binding them together, and any one merchant normally had a web of such engagements...

Time had a special significance for the city that traded so widely through different cultures and varying customs.  The merchant of Venice had his mind on climates far off, on products being matured in countries widely scattered, on the weather favorable for war on sea or land, on the times for sending precious cargoes upriver or down the Adriatic, on the holy seasons setting calendars elsewhere.  Time was fungible.  The constraint in  this wide spectrum of juggled schedules and calendars was the time of Venice itself, marked by recurring festivals, varying day lengths, unvarying liturgies.  Precisely because Venetian time formed a continuum, ways had to be found for measuring its different aspects.  In the tapestry of Venetian time, bells daily rang the hours for devotion and business, astrological phases marked the months, allegorical figures made vivid the four seasons of the year and the three ages of man, ecclesiastical ceremony haloed special times, and saints' feast jostled each other in the dense stream of passing days.  Edward Muir notes that time itself was elastic in Venice: "Through its power to arrange ritual life, the government attempted to impose its own political concerns on the cosmos by restructuring time, which was still in the Renaissance a comparatively flexible dimension defined by the saints' feast and the office hours of the Church rather than by the inexorable mechanisms of the modern age.  The length of an hour in Renaissance Venice, for example, varied according to the season; so time was truly relative."

From Venice: Lion City, by Garry Wills.

Time is now measured with subatomic granularity.  Should not our institutions be more accountable for how they use time than were the Venetians'?

How to Improve Traffic Flow

I was driving on Highway 17 on my way to Santa Cruz today, and I started reflecting on the question of how we could improve traffic flow using principles of synchronized flow.

Often on the highway, one will observe a slow driver in the fast lane, holding up a line of traffic.  This is particularly problematic on two-lane roads.  In physics terms, lane changes increase the viscosity of flow, which in turn slows the average rate of traffic, and increases the probability of accidents.

But because humans are driving, we have the possibility of coordinating behavior through incentives.  Ten years ago, this would have been impossible, because two drivers had no way to communicate efficiently (at least not safely) on the freeway.  Now we do.  Here's a very rough idea of how to solve the problem of highway traffic with incentives and technology:

1. Sell an RF device to drivers that can be installed within easy reach of the steering wheel, with an easily visible and readable display that registers a unique identification whenever another such device is nearby -- say within 100 meters -- for example, by displaying a picture of the make, model, and color of the car.  Make it easy to cycle through the nearby cars on the display.
2. Give each driver who installs the device the option of loading a certain amount of cash into memory, say $100, with a specified "tip unit," which could be decided by the user (say, $1).
3. Whenever a driver with the device installed comes up behind another car with the device installed, the device can prompt the driver behind: "Offer Tip?"
4. The driver may then press a button, which signals the device in the car in front that a tip of $1 is being offered from the car behind.
5. Now if the driver in front pulls over, the driver behind can press a button that says, "Give Tip."
6. The device in the car behind then executes an electronic transfer to the device in the car in front.   People who are not in a hurry can literally earn money for accommodating drivers who are.
7. By keeping each device synced with a mainframe by cell connection, the company selling the device can maintain a rating for each tipper (so that you can't game the system by promising a tip, but then not executing) and other anti-fraud measures.

Now obviously this is somewhat regressive as a "tax" on driving time because some people are going to be able to make much bigger tips than others, &c.  But I think it's still a net benefit to society because it would decrease accidents and road rage, and probably increase the average flow of traffic by a lot.  Right now, it's impossible for anybody to know whether the guy in the car behind them is just a jerk in a hurry or whether they're on their way to the hospital to save another person's life.  Besides, it's also a progressive "tax" in the sense that you don't have to pay anything if you take public transportation instead.

If anybody knows of any startups working on a similar idea, I'd like to know.  Because of the incentives of picking up free money and shorter commutes, I bet it wouldn't be hard to sell these devices.

Both an Agency Cost and an Externality

From VentureBeat, a quote from a Cisco VP on how and why virtualization doesn't always result in power savings for companies running large data centers:

"The reason a lot of virtualization practices never show up as savings is because the facilities department, which is not part of IT, will do what they think is right: Install processes on their cooling system that add an artificial load in direct proportion to the load you saved in the virtualization process. The device they install is called a hot-gas bypass. They take the output of the cooling system and pipe it into the input. So it keeps the chillers operational."

You couldn't make this stuff up.  It goes to show that you need good engineering in both your institutional design and your capital equipment if you're going to make cost improvements.  Focussing only on one or the other won't always help.

The Coase Theorem as the Harmonic Approximation for the Macroeconomy

In the last post, I showed how a market could be approximated as a simple harmonic oscillation in number of transactions per unit time (and price per unit time).

In the second to last post, I elaborated on how coupling between these markets could be analyzed with Feynman-style diagrams.

It's worth mentioning something else that just falls out of this analysis, which is very interesting.  Coupled simple harmonic oscillators are used by physicists to describe crystals in the so-called "harmonic approximation."  In this model, the lack of dissipative forces and the corresponding coupling dynamics lead to the result that energy, when added to any part of the system at a moment in time, will eventually be evenly distributed througout the system.

Not coincidentally, there is already a theorem in economics that describes the same effect in markets: the Coase Theorem.  If markets are modeled as simple harmonic oscillators with no dissipative forces of transactions costs interfering with their dynamics of oscillation or coupling, then regardless of where energy (see the last post for how "energy" shows up in markets) is added to the crystal, it will eventually be spread out evenly throughout the entire macroeconomy.

The Coase Theorem is the harmonic approximation applied to the dynamics of the crystal that is the macroeconomy.

The Most Important Role of Public and Private Regulators?

Libertarians struggle with the question of how and when any government or private regulation is proper.  In the wake of the subprime mortgage market collapse and in view of the existing problems with the patent system in the United States, I have come to a few more general conclusions.

The most useful role for regulators is to ensure that the consumers whose transactions constitute the smallest units of demand within a market are required to internalize at least part of both the positive and the negative externalities (i.e., social costs and benefits not otherwise priced into the bilateral transaction) of subsequent comparable transactions.  This will require at least the cooperation of the individual or firm that is counterparty to the smallest unit of demand.

In the housing market, a bubble developed because at each stage in the cycle from homebuyer to bank, to larger institutional investors, and back to buyer, no accounting was made for how an increase in home prices was going to increase the price and decrease the volume of transactions in other goods.  In other words, the opportunity costs of increasing prices in homes was not sufficiently internalized by homebuyers in the subprime mortgage market.  This problem could have been avoided by requiring homebuyers to buy insurance covering the risk of declines in home price due to off-site factors.  (Thanks, Lee Fennell.)

Taxes are probably the most impactful way that government regulators have ensured that the negative externalities of an individual engaging in particular activities are internalized by the same individuals in some measure.  (Thanks, Pigou.)  In the sense I'm thinking about them, taxes are like an insurance premium we pay to the government to ensure that somebody is worrying about (and will bail us out from) major catastrophes that are too large in scale or too long in time horizon for the market to accurately price into transactions with consumers.  Please note that this does not mean that I am in favor of raising taxes!  A corollary is that the role of government may be rationally more limited in places and times when private institutions are able to more accurately price low-probability and long-time horizon (i.e., major) catastrophes.  Requiring insurance and reinsurance against catastrophes is probably healthier for everyone than building labyrinthine bureaucracies (like FEMA) that aren't going to do much work on preventing disasters, and won't be much help when they inevitably occur.

Here's one piece of evidence to support this theory.  Warren Buffett and Charlie Munger have almost made a religion out of including negative feedback in every financial statement, probably even in every transaction.  The result?  Longer time horizons and more accurate pricing (through negative feedback) have permitted them to run what is perhaps the most efficient conglomerate in the history of humanity.

How is it organized? I don’t think in history of world has anything Berkshire’s size organized in so decentralized a fashion. Net amount of bureaucracy is tiny, costs are low, autonomy in subsidiaries is vast, no common culture shuffling people around. How far can this go? This system has gone farther than any other system. Low cost, not a lot of envy effects – where everyone compares everything. People in subsidiaries have a feeling – whereby there is less fealty to headquarters. If you want an imperial headquarters which exacts a big overhead charge on the provinces – they will resent it. Net number of intra-subsidiary transfers is tiny. It has worked well. It can go a lot farther. No one else has been here before.

Berkshire-Hathaway is one of the first private regulators to make negative feedback a priority, and look at what they have accomplished.  What would the world look like if we redesigned legal and social norms to encourage negative feedback (i.e., accountability).  And Berkshire-Hathaway did it without any government telling them that they had to.  They were seed crystals in this sense.

Update: The characteristic slope of the Taylor Rule for monetary policy (which requires that the magnitude of changes in target rates always exceed the magnitude of changes measured in inflation) could be viewed as an embodiment of the negative feedback principle.  A control theorist might say that the Taylor Rule leads to more stable economic cycles by requiring a decrease in money supply in response to increases in inflation.  Assuming the measurements were accurate, in the limit in which the lag in time between the decrease in money supply and the increase in inflation approches zero (i.e., assuming adjustments could be made instantaneously) the money supply rate and the rate of inflation should be equal.

Thus, the best known approach to matching the money supply rate to the real rate of inflation is not unlike the approach followed by Buffett and Munger in their attempts to match the price of Berkshire-Hathaway stock to their estimates of its intrinsic value: negative feedback works.

Lawyers as Choice Architects: Holmes, Posner, Hayek, and Sunstein

111 years ago, Oliver Wendell Holmes, Jr. wrote in The Path of the Law:

For the rational study of the law the blackletter man may be the man of the present, but the man of the future is the man of statistics and the master of economics.

Holmes's prophecy came true with the advent of law and economics, which is now the dominant theory of law for academics and practicing lawyers alike.  There isn't an area of law left untouched by the theory.  Judge Posner, perhaps its most prominent proponent, has himself put every major area of law on display through the lens of economics.  Economic analysis turns out to be ridiculously useful in achieving what Holmes identified as the object of the study of law: "the prediction of the incidence of the public force through the instrumentality of the courts."  Without economics, how else could lawyers predict the prospective behavior of large groups of people?

The answer is psychology.  And psychology, after taking a back seat for the past few decades, is making a comeback in law through the work of professors like Cass Sunstein, Richard Thaler, and Ian Ayres.  (I would add Charlie Munger, but he doesn't publish widely or often enough.)  What these professors share is an interest in the cases in which the behavior of people predictably deviates from the fundamental rational hypothesis of economics.  See the series of guest posts that Sunstein has done on "choice architecture" and "libertarian paternalism" on the Volokh Conspiracy for a sampler.

The power of "choice architecture" lies in its promise for weaker government interference with private choice.  In a world in which public and private rulemaking is uninformed by the quirks of human psychology (think of our herd instincts), government is more likely to ban entirely some activities that might be efficient at low intensity, or mandate some activities that might be done voluntarily, but not as consistently as necessary.

As "choice architects," lawyers seek to build legal systems with privately adaptable rules, which permit a decentralized, spontaneous order.  In this sense, libertarian paternalists build on the work of Hayek and Rothbard (although both would have disliked being associated with any form of "paternalism").

Would it be too bold to say: "For the rational study of law the master of economics may be the lawyer of the present, but the lawyer of the future is the student of irrational human nature and the master of psychology."

Patents as Intangible Asset Partitions

Before amending the patent law, Congress should consider the incredibly expensive alternative to our patent system: a world in which only trade secrets and contract rights can be used to define and enforce rights to intangible assets, such as R&D.

Some relatively recent academic work on the law of corporations has discovered a point that was probably obvious to many business people all along: that the corporate form is often more useful as a shield of the corporation's assets from shareholder creditors than it is as a shield of the shareholders from the corporation's creditors.  The terminology adopted to describe these different uses of corporate limited liability are "affirmative asset partitioning" and "defensive asset partitioning," respectively.

A key insight is that shielding a corporation's assets from each shareholder's creditors (including descendants and donees) permits a more stable pool of capital to be developed and deployed.  Without the corporate form, shareholders would have to place company assets beyond creditor reach by contracting with each creditor -- a project too expensive to be worthwhile, especially when the benefits of the contracts are shared with the other shareholders.  The corporation as an asset partition dramatically reduces the transaction costs of forming the pool of capital necessary for putting it into business.

What do asset partitions have to do with patent law?  In a very clever paper on the subject, Prof. Paul Heald argues that patents serve a similar transaction costs reducing function in pooling the human capital necessary to complete projects within a company.  To see how, consider that -- without patent rights -- companies would have to rely solely on contracts and trade secrets to protect their R&D.  Unfortunately, because employees can't willingly forget what they learned doing R&D at Company A, there is no practical way to enforce contract and trade secret rights without taking extraordinary (and expensive) measure to prevent employees from leaving, taking with them to Company B the family jewels.

Business history is replete with stories of raids of R&D employees.  For companies, and even whole economies, the essential ingredient of economic growth is human capital.  An underappreciated point about patent law is that it permits the more efficient development of human capital by a more free-market for R&D employees and less risky joint-venture among companies.

A corrollary is that if patent rights are weakened too much, companies will do redundant, wasteful R&D in producing the same level of innovation for consumers -- and if it's really valuable innovation (i.e., with highly inelastic demand), it's the consumers that bear the costs.

Congress and Courts should bear this in mind when trimming patent law back.

Coase, the Internet, and a Market for Ideas

The Internet is changing the economic costs and benefits of many activities in our society.  The economics of innovation are changing too.  The result could be the emergence, for the first time in history, of an efficient market for ideas.

Before the Internet, we lived in a world in which the transaction costs of reaching an agreement over who, how, and when an idea would be used for profit were usually expensive relative to the benefits of coordinating the commercialization of that idea.  Even after a system of property rights was established through patent law, many companies found the cost of obtaining and enforcing patents -- not to mention the cost of avoiding or paying for other companies' patent rights -- high relative to the benefit of exclusive rights to a market for a limited period of time.  Inventors have generally chosen to assign by contract the rights in their ideas to an employer in exchange for a paycheck.  Companies have often chosen to maintain their ideas a secret, opting out of the costs of procurement and assuming the risk of unmitigated competition.  Only companies from a select group of industries -- industries that can generally be characterized as extreme in both capital requirements and vigorous competition -- have chosen to obtain and enforce property rights in ideas.

The Internet is now causing a massive shift in the balance of the costs and benefits of our system of property rights in ideas.  Ronald Coase is famous for advancing the hypothesis that in a world in which there are no transaction costs, an efficient outcome will obtain regardless of the initial allocation of property rights.  Transaction costs, of course, are never zero in the real world.  But Coase's Theorem is useful because it tells us to expect markets to emerge as transaction costs become small relative to the gains from trade.

The transaction costs of our system of property rights in ideas has hardly vanished because of the Internet.  Yet the Internet is dramatically diminishing these transactions costs.  The costs of searching for prior art, freedom to operate, and ownership information may have dropped the most because of the public availability of search algorithms, and databases of patent disclosures and assignments.  But even the costs of communicating ideas has dropped as the Internet has enabled us to send a mindboggling array of media around the world in an instant.

Imagine how this shift in economics could aid our government in "promoting the progress of science and the useful arts" if, instead of narrowing the scope of property rights in ideas, we were to broaden and strengthen the system by tailoring these property rights to correspond to the economic value that inventors contribute to our economy.  The emergence of a market for ideas would level the playing field for independent inventors and startup companies in their attempt to compete with big business.  Whatever else we see emerge from patent reform, here's to the hope that our reforms will promote the emerging market for ideas.

UPDATE: click through to see the charts published in Bessen and Meurer's new book, Patent Failure.  The  fact that litigation costs increased for non-drug companies but not drug companies starting in the 1990s could be the result of increased demand for litigators because of the drop in transactions costs associated with patent procurement set in motion by new communication technologies, including the Internet.