Wednesday, 12 October 2016

Some things we can learn from the new Nobel winners


While not meaning to, the announcement that six Americans won science Nobels this year, all of them immigrants, should suggest something to all thinking people about the benefits from geniuses – and how it relates to thinking about people, especially immigrants, in clumps. (That is, it would suggest this to thinking people.)

J. Fraser Stoddart, born in Scotland, credited American openness with bringing top scientists to the country. He added, however, that the American scientific establishment will only remain strong "as long as we don’t enter an era where we turn our back on immigration."
    Stoddart said the United States should be "welcoming people from all over the world, including the Middle East.”

Nobel3The benefits from geniuses is just one part of the reason that economists value so highly the division of labour, a subset of what Austrian economists recognise as the Harmony of Interests when living in a free society.

The effect of a division-of-labour society is thus not only to increase the total of the knowledge that the same amount of brain power can store and  use, but also to bring that knowedge up to a standard set by the most intelligent members of the society.The average and below-average member of society is enabled to produce on the strength of the intelligence of the most intelligent…

Those same economists will naturally be looking to  what they can learn from the winners of the economics prize, Oliver Hart and Bengt Holmström, “two of the most eminent economists specialising in the analysis of contracting and organisational structure” – two more immigrants, it’s worth observing.

Hart, a British economist who teaches at Harvard, and Holmström, originally from Finland and now teaching at MIT, are leading practitioners of the formal, mathematical analysis of firms, contracts, and organizations. Hart is best known for his contributions to the “incomplete-contracting” or “property-rights” approach to the firm, while Holmström is considered the founder of modern principal-agent theory. Both have long been considered frontrunners for the prize (Paul Krugman tweeted that the two are so obviously deserving his first thought was, “didn’t they have it already?” — something said about Krugman’s own Nobel by No One Ever).

While not primarily theoreticians of the firm, the body of work by Hart and Holmström is worth careful study, says Paul Walker, making a “huge contribution to the theory of the firm, both separately and together.”

And while not Austrian economists themselves, says Peter Klein, “the body of work by Hart and Holmström is worth careful study and has interesting implications for Austrians— something I would definitely not say about all the recent Laureates.”

He explains:

As Nicolai Foss pointed out in an insightful 1994 article, and I have also discussed in my own work, the Austrian economists anticipated many of the points in the modern economics of contracting and organisation. Take principal-agent theory. While Mises’s 1920 article on socialist economic calculation offers the definitive statement on why a rational allocation of resources is impossible under common ownership of the means of production, it is sometimes forgotten that Mises 1922 book Socialism, which includes the calculation argument, also includes a lengthy discussion of incentives under socialism, and Hayek discusses the problem in detail in his contribution to Collectivist Economic Planning. Mises also addresses the separation of ownership and control in Human Action.

The Principal-agent Problem

Nobel2Holmström is best-known for a specific interpretation of the principal-agent problem (articulated in his most-cited article, “Moral Hazard in Teams”). Holmström examines a situation in which one party (the “principal”) has some task to be performed, but must hire another party (the “agent”) to perform the task. Performing the task is costly to the agent, so the principal must provide some incentives to get the agent to do what the principal wants. If the principal cannot observe or understand the agent’s actions directly — which is plausible, otherwise the principal could simply perform the task — then an incentive contract based on some observable, but noisy signal of output is problematic, because it exposes the agent to risks related to the noisiness of the signal. (For example, incentivizing salaried managers by giving them stock options helps to align their incentives with those of shareholders, but exposes them to the risk of market fluctuations that are caused by the Fed, by the actions of other firms, or other forces beyond their control.) Hence principals face a specific tradeoff between providing incentives for agents (by using performance-based pay) and insuring agents against risks beyond their control (by using fixed salaries). Exactly how this tradeoff should be managed depends on the particulars of the situation.

While the Austrians did not explore the specific aspects of the agency problem highlighted by Holmström — this tradeoff between incentives and insurance — they did recognize the importance of the agency problem, and Mises in particular offered a nuanced discussion of various means by which principals mitigate agency problems, anticipating a well-known argument of Henry Manne (see my discussion here). Austrian ideas about entrepreneurship, heterogeneous capital, and tacit knowledge can also improve our understanding of agency problems (Foss et al. 2007). (For further discussion of Austrian economics and agency problems see Padilla 2003 and Hülsmann 2008).

Property Rights and Ownership

While entrepreneurship does not get a mention in the Nobel citation, Hart’s insights on property rights and ownership have greatly influenced my own understanding of the entrepreneurial function. Following Frank Knight, I have argued that entrepreneurs establish firms because entrepreneurial judgment is non-contractible. In other words, an entrepreneur’s idiosyncratic understanding of the future — what Knight and Mises call judgement — can only be expressed through ownership of resources. Ownership provides the ultimate control of productive resources, meaning that owners get the final say in how resources will be used. A resource owner can contract for advice (e.g., by hiring a consultant), but only the owner can make the final decisions about deploying resources (the owner chooses whether or not to hire a consultant, which consultant to hire, and whether to act upon the consultant’s advice). Judgement is the act of exercising this form of control over resources. In other words, there are markets for assets, but not markets for judgement, because judgement implies the right to control an asset. To exercise judgement, the entrepreneur most own assets, i.e., must establish or maintain a firm. (This is a somewhat different perspective on entrepreneurship than Israel Kirzner’s well-known approach.)

Hart’s work with Sanford Grossman and with John Moore (hence, the “Grossman-Hart-Moore” theory of the firm) is based on a particular concept of asset ownership. Ownership, in this approach, is defined as residual rights of control — i.e., the right to decide how an asset will be used in situations not covered by prior agreement. In a world of perfect certainty (akin to Mises’s evenly-rotating economy), individuals could write very complex and detailed contracts about how various resources will be used under particular circumstances. With contracts like these, “ownership” is vague and indeterminate; it doesn’t matter who has formal title to an asset because the asset will be used in exactly the same way regardless.

In the real world of uncertainty, however, such contracts are impossible, because we cannot anticipate every potential future event and agree in advance on what we would do. In other words, all feasible contracts are “incomplete,” meaning that they contain some omissions or gaps. Property rights are thus necessary to fill in the gaps. If party A is the owner of the asset, then even though party B may have certain contractual rights to use the asset in particular ways, if an unforeseen contingency arises, the decision is made by party A. This is a useful and parsimonious way to think about ownership.

Nobel1In Hart’s work (his 1995 book is the most accessible treatment), these ownership incentives are important because they affect what kinds of investments parties are willing to make in creating and maintaining specialised investments. I find their theory of the firm insightful, though there are many potential problems with the details. More generally, though, their understanding of ownership helps clarify some ambiguities about property rights. For example, people often confuse residual control rights – the right to determine how a resource will be used when unanticipated circumstances arise – with residual income rights. But residual income rights can be partly delegated to non-owners; I can own a restaurant and collect a fixed fee, while letting the manager keep the net profit. That does not make the manager the owner of the firm, because he cannot change this arrangement, or sell the restaurant, or do a host of other things without my permission.

Mises works with a similar definition: “Ownership means full control of the services that can be derived from a good” (Human Action, p. 678). He goes on in that passage to distinguish this “catallactic” definition with the legal definition; i.e., ownership for economics means de facto control, not de jure control. (Under interventionism, as Mises points out, the control of legal owners is severely circumscribed by government policy.) Mises also contrasts the ultimate control afforded by ownership with the proximate, day-to-day control rights that can be delegated to non-owners, in the context of the principal-agent problem in corporations: “The general direction of a corporation's conduct of business is exercised by the stockholders and their elected mandataries, the directors. The directors appoint and discharge the managers. ... A successful corporation is ultimately never controlled by hired managers (Human Action, p. 304).” As I have emphasised in my own work, Mises always associated entrepreneurship exercised under uncertainty with resource ownership. Outside the imaginary construction of the evenly-rotating economy, “A capitalist is always also virtually an entrepreneur and speculator” (Human Action, p. 254).

Bottom Line

My overall reaction to this year’s Nobel is positive. As with Oliver Williamson’s work, there is much in the writings of Holmström and Hart for Austrian economists to admire. Unlike Williamson, they are less explicitly influenced by thinkers such as Hayek, and they write in the style of modern mathematical economists. But their work is worth careful study and has interesting implications for Austrians — something I would definitely not say about all the recent Laureates. 



  1. If all immigrants were all English speaking, university educated, atheists, from Western countries like Mr Stoddardt then your ideas on immigration wouldn't find any opposition.

    Furthermore, if you think an "all immigrant" line-up in an election year where immigration is a hot-button issue is a co-incidence, then I have a slightly used Nobel Peace Prize (2009 vintage) to sell you.

  2. John Lennox isn't an atheist and he'd fit so maybe we look at ability and world view. The latter would exclude a lot of Muslims because their world view is arranged around a political monstrosity based on a religious monstrosity.


  3. Peter , why are you not putting up my Posts? why are you censoring ?

    I wrote a thoughtful post .


    1. Hi Jane, I checked the spam folder to see if my moderator had inadvertently sent anything there under your name, but there is no sign. Sorry. What post was it on?

      And since you ask, I'm afraid moderation has become necessary (moderation, not censorship) because several trolls and several dozen spammers would be dining out here otherwise, meaning no comments at all would be read. So you really should *thank* my moderator. :)

  4. Thankyou for the reply Peter ,Ok I was wondering what was happening .
    I wanted to have a discussion on this as I am from Sweden, & we have having many serious problems with even legal refugees with murders, Rapes and unmentionable crimes, with but it is well down your blog list now , unfortunately

    From my perspectives here in Sweden, only liberals could confuse wanting to stop illegal immigration with encouraging brilliant scientist to come to America.It's propaganda for useful idiots who cannot reason, and they lap it up like the idiots they are.The propaganda has been coming for a long time, from Brookings, WaPo, CATO, NYT, Christian Science Monitor, The Guardian, . . .
    lot's of money at stake
    "Stoddart naturalized as a U.S. citizen in 2011."

    What part about the difference between legal immigration and illegal immigration don't these idiots get?
    The US Establishment/ Hillary campaign finds racism to be a great tool.

    There are too many unskilled uneducated "legal" immigrants too, even here in Sweden. Even if you look at legal immigration we are importing a growing and largely permanent underclass.

    Legal immigrants. They are legal migrants.
    Talk about spin and distortion.
    Trump parents were migrants, his 2nd & 3rd wife were migrants

    Trump has been a champion about legal skilled migration being high value to USA

    Trump has expressed widely held valid concerns about ILLEGAL migrants,low skill,non tax paying,criminals eroding USA

    And Muslim vetting as a necessary protection just like many other countries do (except my Country)

    Quite different

    This is Yet another puff piece example of media bias
    Yes, the article point stinks, because he only announced to go strong against low skilled and Muslim immigrants


  5. No,these immigrants are very atypical of most legal immigrants as well. The US does not select immigrants for skill or likely contribution to the commonwealth, but for family reunification which guarantees a steady stream of 3rd world denizens,poor and dependent on government. All the Somalis are here "legally" but the effects of them being here has not been that encouraging to say the least

    I will say it again, LEGAL!!!!! all LEGAL! good grief enough with the spin! and they also all contribute and don't take from the public dole!

    Are you concerned with the fact that Congress is stealing from the Social Security fund to fund false wars? Was the Social Security fund ever intended to fund the Pentagon's lavish spending, enrich the defense industry fat cats, and slaughter innocent civilians all over the world? I'll bet you're not because the talking heads on TV have never told you about the fact that Social Security is being plundered by government, and blowback is this engineered "refugee crisis"

    Government plunders everything

    A lot of people DON'T distinguish between the two,they are prejudiced against anyone not born here and with whitefish skin. A very prudent background check, so we KNOW that they are employed and in the US or Sweden legally is the Answer and a Wall, like most Country's. Even Israel has a Wall surrounding the entire Country

    If you'd listen you'd hear that all groups have members who are racist toward other groups. LEGAL !! LEGAL !, Middle Easterners and Hispanics are in the US because they want to get away from the people they left behind in their homelands. They don't want the dregs of their countrymen coming to US or Sweden either

    Illegal immigrants are invaders

    Hopefully this Came through , Peter , Excuse my English.


    Maybe I write too long of a post so I try splitting it up

    Thank you


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