What I’m Reading

I have always had a taste for intellectual history, or history of thought, and it's one reason I initiated this reading group. My friends and I all have an undergraduate education in economics, that is, a relatively high definition but low-level present day cross-section of economic theory and empirical methods. That cross-section gets one thinking like an economist, but leaves them somewhat unaware of why such ways of thinking came to dominate, for good or for bad, and which 'defunct economists' are to blame for our thinking.

There are many books in the history of economic thought, but most could be more aptly referred to as histories of political economy. That is, they present a history of the early economists, and their quarrels to erect the field. What is fewer and far between in the market are texts which provide insight on why we've come to favor particular models of endogenous technological growth, or even insight into early debates in economic theory at the turn of the 20th century. I wanted a book which included such topics, one that would help me understand why we use Cobb-Douglass, and what other paths the field could have taken had other ideas won out.

A deeper understanding of this history is intrinsically interesting, but it will also help me better my own thinking, as I learn more about how others in the past saw old problems in a new light and set down different ideas which reoriented the field. There is much to be gained, for the pursuit of the next revolution, in studying the numerous of the past.

The first 7 pages of this book merely provide some motivation, an outline of the structure of the book, and some tips for how it should be read. I am excited to continue it with my friends.

I am embarrassed to admit I am just now reading this classic essay for the first time. Hayek begins with a simple question: "What is the problem we wish to solve when we try to construct a rational economic order?". A first answer might be 'the efficient allocation of scarce resources' and as Hayek mentions, the theoretical solution to this problem follows quite naturally once we've formalized things: the marginal rates of substitution for any two goods are to be equal in all their uses. As one example, each firm choosing between iron and steel should value the tradeoff between the two the same at their current margin. If it were the case that a particular firm valued steel (in terms of units of iron) more on the margin than any others, they are leaving money on the table by not trading with the other firms until this condition is reached.

The equilibrium condition is elegant, but it assumes each firm knows how the numerous others value the two inputs. Perhaps they do, once an economic order is constructed, but this puts aside the real substance of how that must be done.¹ So the real question, put quite crudely, is how the values of an innumerable number of firms and individuals can be given to the individuals making the decisions—and depending on this answer of how we might purvey such information—for whom is it feasible to make the decisions?

There are a number of possible answers to this final question, but they can be vaguely summarized as lying on a continuum between decentralization and centralization, with the former being that individuals are to allocate their own resources free from direction, and the latter being that some central authority lays out directives for individuals and firms. Clearly the former could not work. What would compel the masses with their own narrow impulses to cooperate with one another in any way commensurate with broader interests? It must be that the economy without a plan, that of individuals making their own free choices, is doomed to shortage and starvation. Conversely an economy that is designed by the brightest and most benevolent, with the modern tools of science, must be the one that is able to fulfill the needs of its citizens.

These two alternatives must be judged with at least a glance away from pure formalism and toward the real world. The real world is characterized by the vast singularities of time and place, by the ever changing wants and needs of the others, and by a great number of things that are known only to one. So there must be some system for aggregating this information, or succinctly communicating it to the relevant parties. If some resource suddenly becomes scarce (or merely more desirable), those who presently hold it ought to know so they can redirect it to its more socially desirable end. Such individuals need not know why such a resource is suddenly worth more, or even whether this phenomena is supply or demand driven (the latter corresponding to the previous parenthetical).

There is to date no better, perhaps no other, method of feasibly aggregating such local information and purveying it to interested agents than ours. That method is as simple and mundane as the price system. It is costs, high or low, in terms of whatever else can be gained for the commensurate costs, that coordinates individuals to supply their labor, to divert resources from old needs to new ones, to invest in more socially useful skills, to spend their time in accordance with their own values but also those of their fellow citizens. It is the changes in relative prices which push individuals to change their course of action, one that is decidedly more commensurate with others' values, but also their personal optimum given market prices. This does not merely apply to household consumption decisions or small scale ventures. Even long run speculative bets like aggregate R&D spending, of which the benefits are still mostly social (meaning that the inventors do not reap even half the benefits of the drugs they create), are highly responsive to changes in expected pharmaceutical profits! Relative prices not only wrap up infinite bits of inaccessible local information, through the undirected individual actions of many, but they guide the individuals to contend with the needs of the whole in their own free decision making.

This point may be mundane to us, but we should not let it be. Had it been designed, as Hayek says, it may be regarded as the greatest innovation, probably the most consequential, in history. This aside, we are also indescribably better off for it. Nobody should pass through modern life without exercising a moment of ecstatic wonder (and gratitude) at the very luxuries that are afforded to us, the foods that are shipped from afar, the goods that come to us only through the actions of an innumerable many who have never met each other, and are motivated primarily by their mere duty to themselves and their family. Do not live your life without at least once noticing the awe of the mere pencil.

Alchian and Demsetz build on Coase's answer (as well as Knight's subsequent work) to a classic question that many would never think to ask: Why do firms exist? They begin with a radical claim that firms have no fiat power or disciplinary authority beyond that of regular market participants. Any view to the contrary is a "delusion", because firms do not own the human capital they employ. Thus, just as your grocer is bound by your preferences and your ability to seek competing options, firms are constrained by their employees' preferences and their perpetual ability to seek competing options. This is completely orthogonal to the length of employment.

So Alchian and Demsetz' first point is that the essence/nature of the firm is not about command, nor control of subjugated parties, at least in a sufficiently competitive setting. The absence of explicit prices within the firm does not preclude a price mechanism from directing inputs to their productive uses. For workers, many of these (relative) prices are simply changes in wages associated with higher productivity, or conversely, slacking ('shirking')—as well as the benefits and costs of terminating the contract. The former mechanism, that of rewarding employees for higher productivity, and the challenges posed by this problem, are central to the nature of the firm according to A & D.

Imagine that there are returns to team production, such that the marginal product of two workers working together is greater than the sum of their products when working individually. If there are any productivity gains to be had from collaboration, then teams will form. But teams introduce another problem, a free riding problem that they refer to as the metering problem. There are costs associated with measuring, or observing, each individuals' productivity contributions. And so, and this is a greater problem as teams grow, there is a private incentive for each worker to slack off a little and free ride off the others' productivity. This is the case so long as there are any monitoring costs. All individuals navigate the labor leisure tradeoff such that the marginal rate of substitution is equal to the slope of the budget constraint, the negative of the wage rate. But the existence of metering/monitoring costs drive a wedge between the true price of leisure (the full social cost, including the impact on the teammates) and the private cost to that individual. When your team cannot readily measure your productivity, leisure is cheaper, because there are smaller personal losses associated with decreasing your productivity. The cost of an hour of leisure is now less than w. Thus, your peer slacks on the group project, but still receives an A.

So formal institutions, firms, arise to solve this metering problem. A & D briefly mention another possible solution, that external entrants may bid to replace shirking team members. But potential entrants still face the metering problem, having to identify who the slackers are, and they face the same set of incentives once they join the team. A compelling solution is hiring a monitoring specialist: a manager. The manager must be able to contract individually with each of the workers, and hold the power to terminate contracts, give raises, etc. It is the manager, and their ability to efficiently monitor, that privatizes the costs of slacking, and reduces (or eliminates) the incentive to slack. Only then can the full productivity gains of the team be reaped in the market. It is chiefly to better facilitate cooperation, and internally align productivity incentives, that organizational institutions emerge.

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