Category: Incentives

Labor Market Flexibility Increases Employment and Prosperity

“France is definitely behind,” says William Keylor, professor of International Relations and history at Boston University. “If France were to create a more-flexible labor market it would eventually increase productivity and prosperity, but the short-term transition would be difficult and people just aren’t thinking long term.”
There have been labor changes across continental Europe recently. Denmark’s measures to liberalize hiring and firing have helped the country cut its unemployment rate in half from about 10% in the early 1990s to under 5%. Spain, too, has introduced short-term employment contracts which have helped cut its unemployment rate by more than half from 20% a decade ago.
But elsewhere, attempts at change have met with staunch opposition, often resulting in watered-down measures. Italy passed changes to its labor laws in 2004, introducing an extension of temporary-work contracts that were introduced in 1997 and were credited with helping cut Italy’s overall unemployment rate to 7.1% from 12% when the contracts began. Yet many economists say Italy, which recorded zero growth last year, hasn’t gone far enough.
In Germany, where unemployment stands at 11%, a coalition government headed by conservative leader Angela Merkel has promised to reduce unemployment by introducing similar measures to those hotly debated in France. The government had to settle on compromise measures that can extend a current probation period for workers to 24 months, from the current six. But companies don’t have the right to terminate contracts within those two years without giving just cause. Other, more difficult, provisions, are still on hold.
The new measures that will be introduced in Parliament as early as today are targeted at “disadvantaged” youths, which refer to people between 18 and 25 who have left school without any qualifications and who are unemployed. The provisions include increasing financial incentives to employers to hire people under 26 who face the most difficulties.
It would apply to some 160,000 young people currently hired under government-subsidized job contracts, according to an interview with Employment Minister Jean-Louis Borloo in an interview with Le Monde newspaper. The cost to the government would be around €150 million ($180 million) in the second half of 2006, Mr. Borloo was quoted as saying.
But economists said the change of tack was a bad signal. “The real problem is that the results obtained by opponents of the new law…show that it is very difficult to introduce reforms in France,” Dominique Barbet, economist at BNP Paribas, wrote in a research note. “This will give opponents of reform confidence for future actions.”

For the full story, see:
ALESSANDRA GALLONI. “Bowing to Protesters, Chirac Abandons Youth-Labor Law; Reversal Highlights Europe’s Difficulties With Painful Reforms.” The Wall Street Journal (Tues., April 11, 2006): A3 & A10.
(Note: the title and version of the article quoted here are from the online version. The title and content of the version in the printed paper was a little different in a couple of places.)

Solution to Problems in Health Care and Higher Education: Change the Incentive Structures


Vernon Smith, one of the 2002 recipients of the Nobel Prize in economics, advocates fundamental institutional reform:

Physicians and medical organizations face escalating administrative costs of complying with ever more detailed regulations. The system is overwhelmed by the administrative cost of attempting to control the cost of medical service delivery. In education, university budget requests are denied by the states who also limit the freedom of universities to raise tuition.
If there is a solution to this problem, it will take the form of changing the incentive structure: empowering the consumer by channeling third-party payment allowances through the patients or students who are choosing and consuming the service. Each pays the difference between the price of the service and the insurance or subsidy allowance. Since he who pays the physician or college calls the tune, we have a better chance of disciplining cost and tailoring services to the customer’s willingness to pay.
Many will say that neither the patients nor the students are competent to make choices. If that is true today, it is mostly due to the fact that they cannot choose and have no reason to become competent! Service providers are oriented to whoever pays: physicians to the insurance companies and the government; universities to their legislatures. Both should pay more heed to their customers — which they will if that is where they collect their fees.



For the full commentary, see:
VERNON L. SMITH. “Trust the Customer!” The Wall Street Journal (Weds., March 8, 2006): A20.

Contrasting Planners with Searchers in Economic Development



Source of book image: http://www.amazon.com/gp/product/1594200378/sr=8-1/qid=1143511279/ref=pd_bbs_1/102-0403843-7507349?%5Fencoding=UTF8

A professor at New York University and a senior fellow at the Center for Global Development, Easterly spent most of his career as an economist at the World Bank. He had to leave that job after publishing his iconoclastic 2001 book, “The Elusive Quest for Growth,” which skillfully combined a history of economists’ growth theories with a devastating empirical analysis of the failure of international efforts to spur third world development. The book’s theme was “incentives matter.”
In “The White Man’s Burden,” Easterly turns from incentives to the subtler problems of knowledge. If we truly want to help the poor, rather than just congratulate ourselves for generosity, he argues, we rich Westerners have to give up our grand ambitions. Piecemeal problem-solving has the best chance of success.
He contrasts the traditional “Planner” approach of most aid projects with the “Searcher” approach that works so well in the markets and democracies of the West. Searchers treat problem-solving as an incremental discovery process, relying on competition and feedback to figure out what works.
. . .
“The White Man’s Burden” does not match “The Elusive Quest for Growth” as a tour de force. Easterly is doing something harder here: not merely cataloging past failures but trying to suggest a more promising approach. Unfortunately, his alternative is still underdeveloped, devolving at times into slogans.
After all, Searchers plan, too. The question is not whether to plan, but who makes the plans, how they are changed and where feedback comes from. “The White Man’s Burden” underplays the essential role of competition, not only in markets but between political jurisdictions.

For the full review, see:
VIRGINIA POSTREL. “The Poverty Puzzle.” The New York Times, Section 7 (Sun., March 19, 2006): 12.
For Easterly’s latest book, see:
Easterly, William. The White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good. The Penguin Press, 2006. 436 pp. $27.95.

“Unlike Pilots, Doctors Don’t Go Down with Their Planes”


(p. C1) With all the tools available to modern medicine — the blood tests and M.R.I.’s and endoscopes — you might think that misdiagnosis has become a rare thing. But you would be wrong. Studies of autopsies have shown that doctors seriously misdiagnose fatal illnesses about 20 percent of the time. So millions of patients are being treated for the wrong disease.
As shocking as that is, the more astonishing fact may be that the rate has not really changed since the 1930’s. “No improvement!” was how an article in the normally exclamation-free Journal of the American Medical Association summarized the situation.
. . .
But we still could be doing a lot better. Under the current medical system, doctors, nurses, lab technicians and hospital executives are not actually paid to come up with the right diagnosis. They are paid to perform tests and to do surgery and to dispense drugs.
There is no bonus for curing someone and no penalty for failing, except when the mistakes rise to the level of malpractice. So even though doctors can have the best intentions, they have little economic incentive to spend time double-checking their instincts, and hospitals have little incentive to give them the tools to do so.
. . .
(p. C4) Joseph Britto, a former intensive-care doctor, likes to compare medicine’s attitude toward mistakes with the airline industry’s. At the insistence of pilots, who have the ultimate incentive not to mess up, airlines have studied their errors and nearly eliminated crashes.
“Unlike pilots,” Dr. Britto said, “doctors don’t go down with their planes.”

For the full story, see:
DAVID LEONHARDT. “Why Doctors So Often Get It Wrong.” The New York Times (Weds., February 22, 2006): C1 & C4.

Lazear, New Chair of Council of Economic Advisors, Emphasizes Labor Market Flexibility


Ed Lazear was a labor economist at the University of Chicago during the time that I was a graduate student there, circa 1975-81. Sometimes in collaboration with the late Sherwin Rosen, he created models of the labor market that suggest ways of understanding otherwise puzzling labor market phenomena, for example in suggesting that CEOs might be highly paid to provide an incentive for all those who participate in the ‘rank-order tournament’ that results in the choice of CEO (see the Lazear-Rosen paper cited below).
Here is a brief excerpt from remarks by Ed Lazear following his being sworn in as Chair of the President’s Council of Economic Advisors on 3/6/06:

Healthy productivity growth over the past few years has been followed by impressive job creation and reductions in unemployment rates to levels that are low by historical standards. And we continue to improve. Much of the strength of the U.S. economy results from flexibility in labor and capital markets, and from keeping tax rates low.



For the full remarks, see: http://www.whitehouse.gov/news/releases/2006/03/20060306.html (Thanks to Gary Blank for providing me this link.)
One of Lazear’s most interesting papers:
Lazear, Edward, and Sherwin Rosen. “Rank-Order Tournaments as Optimum Labor Contracts.” Journal of Political Economy 89, no. 5 (1981): 841-864.

Solzhenitsyn Endures: The Return of “The First Circle”

    Source of book image:   Amazon.com.

I remember Ben Rogge recommending The First Circle, decades ago when it first appeared in English. It is a powerful, courageous, wise work, bearing many lessons. As you read the book, you keep hoping you can find someone to blame for the evil that is happening. But as Solzhenitsyn works his way up the bureaucracy, each bureaucrat has a plausible motive for his part in evil; one motive, for example, is the protection of the bureaucrat’s family. Only when you reach Stalin, do you find someone who you can really despise. But he seems borderline crazy, so even he is not a totally satisfying villian.

The book can be seen as illustrating a point that Rogge often made: socialism is not bad because it is run by bad people; it is bad because it provides ordinary people incentives to do bad things. (These are not his words, but I believe they capture his point.)


Alexandr Solzhenitsyn. Source of image: online version of the NYT article quoted and cited below.

(p. A1) MOSCOW, Feb. 8 — A grandfatherly figure, his bearded face wrinkled into a smile, peers down from billboards around town.

It is surprise enough that the man is Aleksandr I. Solzhenitsyn, the once-exiled writer, Nobel Prize winner and, of late, octogenarian scold. It is even more so that the billboards advertise his adaptation — broadcast on state television, no less — of one of his fiercely anti-Soviet novels, “The First Circle.”

Solzhenitsyn has been called the conscience of the nation, but his reputation has risen and fallen as tumultuously as Russia itself since the collapse of the Soviet Union. “First Circle” has once again placed him on the national stage, reaching an audience that would have been inconceivable to him four decades ago, when he smuggled the book out of the Soviet Union.

For the full article, see:

STEVEN LEE MYERS “Toast of the TV in Russian Eyes: It’s Solzhenitsyn.” The New York Times (Thurs., February 9, 2006): A1 & A3.


A scene from the Russian mini-series version of The First Circle. Source of image: online version of the NYT article quoted and cited above.

“Sachs Aid Model Has Financed Tyranny”: More on Why Aftrica is Poor


Famine in Niger is no surprise — desert wastes, locusts and decades of Marxist rule keep it second-to-last on the world poverty list. Famine in the fertile climes of southern and eastern Africa, however, seems more shocking. But there’s a common thread: centralized state rule — incompetent at best — marked by corruption and sustained by aid. These are the shackles that keep Africans poor: It would be nice if EU and U.S. trade barriers were removed at trade talks in Hong Kong this week, but exports are a distant notion to the 75% of Africans who live off the land.
Niger is little-blessed by nature, but it has also spent its postcolonial era trying various forms of failed government, with Marxism reigning longest. A quarter of the population — 2.5 million people — faces starvation. Yet more temperate southern and eastern African countries are on the edge of famine, too, with 10 million affected in southern Africa alone. Again, we find the same economic profile: Zimbabwe, Malawi, Zambia, Mozambique, Swaziland and Lesotho all lack economic freedom and property rights; all have economies mismanaged by the state; all depend on aid. All these countries have a history of utopian schemes that failed to produce everlasting manna. State farms, marketing boards, land redistribution, price controls and huge regional tariffs left few incentives or opportunities for subsistence farmers to expand. Despite torrents of aid, these cruel social experiments could not turn sands verdant or prevent the granaries of southern and eastern Africa from rotting.
Ethiopia’s Prime Minister Meles Zenawi believes that allowing Ethiopians to own their land would make them sell out to multinationals. He seems to have overlooked a basic market principle: It demands a willing seller and a willing buyer at an agreed price. If that price is worth selling for, the farmer might have some money to reinvest elsewhere; if that price is worth buying for, the purchaser must have plans to make the land profitable. If there is no sale, owners might have an incentive to invest in their own land and future, having, at last, the collateral of the land on which to get a loan. After decades of socialism, Ethiopia’s agricultural sector — the mainstay of the economy — is less productive per capita than 20 years ago when Band Aid tried to defeat famine. Although 60% of the country is arable, only 10% has been cultivated. Ethiopia is entirely dependent on donations; but instead of grasping reality, Mr. Zenawi, a member of Tony Blair’s “Commission for Africa,” is forcing resettlement on 2.2 million people.
In Zimbabwe, the murderous kleptocrats of Robert Mugabe’s regime deny that land seizure has pushed their rich and fertile country into famine: Some three million people face starvation today.
. . .
African leaders must be pushed to reduce economic intervention, free financial markets, remove bureaucratic obstacles to setting up businesses, establish property rights and enforce contract law. These are the forces that release entrepreneurial energy. But the ruling cliques will do none of these unless forced to do so as a condition of aid. The Sachs aid model has financed tyranny and corruption for 40 years, leaving Africans destitute. The world trade meeting in Hong Kong will hear cries for “Trade Justice” for Africa, representing more protectionism and more state-run, aid-fueled schemes. What we really need is economic freedom and the rule of law at home: We are perfectly capable of improving our own lot if only allowed to do so.

For the full commentary, see:
FRANKLIN CUDJOE. “The Terms of Trade: Africa Needs Freer Markets — and Fewer Tyrants.” The Wall Street Journal (Weds., December 14, 2005): A20.
(Note: ellipses added.)
(Note: The WSJ identifies Mr. Cudjoe as “director of Imani, a policy think tank in Ghana.”)

Good Rules Encourage Entrepreneurship, Resulting in Vibrant Economy

Some useful observations from the 2004 co-winner of the Nobel Prize in Economics, Edward Prescott:

Good tax rates, . . . , need be high enough to generate sufficient revenues, but not so high that they choke off growth and, perversely, decrease tax revenues.  This, of course, is the tricky part, and brings us to the task at hand:  Should Congress extend the 15% rate on capital gains and dividends?  Wrong question.  Should Congress make the 15% rate permanent?  Yes.  (This assumes that a lower rate is politically impossible.)
These taxes are particularly cumbersome because they hit a market economy right in its collective heart, which is its entrepreneurial and risk-taking spirit.  What makes this country’s economy so vibrant is its participants’ willingness to take chances, innovate, acquire financing, hire new people and break old molds.  Every increase in capital gains taxes and dividends is a direct tax on this vitality.
Americans aren’t risk-takers by nature any more than Germans are intrinsically less willing to work than Americans.  The reason the U.S. economy is so much more vibrant than Germany’s is that people in each country are playing by different rules.  But we shouldn’t take our vibrancy for granted.  Tax rates matter.  A shift back to higher rates will have negative consequences.
And this isn’t about giving tax breaks to the rich.  The Wall Street Journal recently published a piece by former Secretary of Commerce Don Evans, who noted that “nearly 60% of those paying capital gains taxes earn less than $50,000 a year, and 85% of capital gains taxpayers earn less than $100,000.”  In addition, he wrote that lower tax rates on savings and investment benefited 24 million families to the tune of about $950 on their 2004 taxes.
Do wealthier citizens realize greater savings?  Of course — this is true by definition.  But that doesn’t make it wrong.  Let’s look at two examples:    First, there are those entrepreneurs who have been working their tails off for years with little or no compensation and who, if they are lucky, finally realize a relatively big gain.  What kind of Scrooge would snatch away this entrepreneurial carrot?  As mentioned earlier, under a good system you have to provide for these rewards or you will discourage the risk taking that is the lifeblood of our economy.  Additionally, those entrepreneurs create huge social surpluses in the form of new jobs and spin-off businesses.   Entrepreneurs capture a small portion of the social surpluses that they create, but a small percentage of something big is, well, big.
Congratulations, I say.  Another group of wealthier individuals includes those who, for a variety of reasons, earn more money than the rest of us.  Again, I tip my hat.  Does it make sense to try to capture more of those folks’ money by raising rates on everyone?  To persecute the few, should we punish the many?  We need to remember that many so-called wealthy families are those with two wage-earners who are doing nothing more than trying to raise their children and pursue their careers.  Research has shown that much of America’s economic growth in recent decades is owing to this phenomenon — we should encourage this dynamic, not squelch it.

For the full commentary, see:
EDWARD C. PRESCOTT. “‘Stop Messing With Federal Tax Rates’.” The Wall Street Journal (Tues., December 20, 2005): A14.

Some Evidence Patents Matter

Apparently the evidence is mixed on the importance of patents as an incentive to innovation, though it always seemed intuitive to me that patents should matter. Petra Moser has just published research from his dissertation, that seems to add evidence on the side of patents mattering:

How Do Patent Laws Influence Innovation? Evidence from Nineteenth-Century World’s Fairs

Petra Moser

Abstract: Studies of innovation have focused on the effects of patent laws on the number of innovations, but have ignored effects on the direction of technological change. This paper introduces a new dataset of close to fifteen thousand innovations at the Crystal Palace World’s Fair in 1851 and at the Centennial Exhibition in 1876 to examine the effects of patent laws on the direction of innovation. The paper tests the following argument: if innovative activity is motivated by expected profits, and if the effectiveness of patent protection varies across industries, then innovation in countries without patent laws should focus on industries where alternative mechanisms to protect intellectual property are effective. Analyses of exhibition data for 12 countries in 1851 and 10 countries in 1876 indicate that inventors in countries without patent laws focused on a small set of industries where patents were less important, while innovation in countries with patent laws appears to be much more diversified. These findings suggest that patents help to determine the direction of technical change and that the adoption of patent laws in countries without such laws may alter existing patterns of comparative advantage across countries. (JEL D2, K11, L51, N0, O14)

Source:
Moser, Petra. “How Do Patent Laws Influence Innovation? Evidence from Nineteenth-Century World Fairs.” The American Economic Review 95, no. 4 (2005): 1214-1236.

Incentives Matter

    Traffic congestion on 7th Avenue near Times Square. Source of photo: online version of the NYT article quoted and cited below, downloaded at: http://www.nytimes.com/2005/11/11/nyregion/11traffic.html

(p. A23) It is an idea that has been successful in London, and is now being whispered in the ears of City Hall officials after months of behind-the-scenes work by the Partnership for New York City, the city’s major business association: congestion pricing.

The idea is to charge drivers for entering the most heavily trafficked parts of Manhattan at the busiest times of the day. By creating a financial incentive to carpool or use mass transit, congestion pricing could smooth the flow of traffic, reduce delays, improve air quality and raise the speed of crawling buses.

Source:

SEWELL CHAN. “Driving Around in Busy Manhattan? You Pay, Under Idea to Relieve Car Congestion.” The New York Times (Friday, November 11, 2005): A23.

British Inventions Taken Up and Exploited in the United States

They_Made_AmericaBK.jpg   Source of book image: http://www.mikemilken.com/fincareer.taf?page=they_made_america

Was it a difference in “innovative energies” that mattered, or was it a difference in institutions and incentives?

(p. 11) This crucial difference between invention and innovation was borne in on me on my return to England in 1957. As a young science reporter, I visited the government-funded National Physical Laboratory at Teddington, and they showed where their senior researcher Robert Watson Watt had in 1935 invented the radar system that was to help the Royal Air Force win the battle of Britain. His former colleagues remarked with chagrin on how swiftly this British invention had been taken up and exploited in the United States after 1939, laying the foundation for the great electronics industry. It was the same story with antibiotics, following Alexander Fleming’s 1928 discovery of penicillin; with Maurice Wilkes’s pioneering efforts in developing the first commercial application of the computer at the offices of J. Lyons and Company in 1951 and with the jet engine. All of these British inventions were superseded by the innovative energies of America.

Source:

Evans, Harold. They Made America: Two Centuries of Innovators from the Steam Engine to the Search Engine. New York: Little, Brown and Co., 2004.