Identity and organizations

Literature review of a seminal paper by George Akerlof and Rachel Kranton.
Inculcating in employees a sense of identity and attachment to the organization may do good to the well-functioning of the whole group. \

Monetary incentives remain a blunt instrument.
(1) Compensation schemes are based on observable variables. But these variables are at best a proxy of effort and ability of the employees. Information asymmetry still exists, incurring moral hazard and adverse selection.
(2) Monetary compensation may have negative effects. For example, employees may overperform on well rewarded tasks and underperform on poorly rewarded tasks. Workers may also backstab one another to be the best relative performer.

Vilfredo Pareto noticed that much of the utility depends not only on what economists usually think of as tastes, but also on norms as to how people think that they and others should behave. Another observation is how people should behave depends upon the particular situation.

The term identity is used to describe a person's social category---gender, race, group affiliation...It is also used to describe a person's self-image. IN a model of utility, a person's identity describes gains and losses in utility from behavior that conforms or departs from the norms for particular social categories in particular situations. In this model, individuals' utility function can change because people internalize norms at different time periods, triggered by different actions. 

We add a new variable, identity to basic principal-agent model.
In this new model, the worker's utility varies with his category as either an insider or an outsider, and his utility depends on his effort from the ideal for his respective social category, depending on his identity and situation.

Effect of adding this new variable:
When the agent sees himself as an insider, he max his identity utility by exerting the high effort, and thus he doesn't need a large difference in monetary rewards to induce him to work hard. If the agent sees himself as an outsider, then he requires a higher wage differential to compensate him for the utility he loses when he works in the interests of the firm.

The firm may have incentive to change the agent from an outsider to an insider.

perfect rationality....wait are you kidding me?

In game theory, a fundamental assumption is that people are rational in making decision each time they are called upon to move. Sometimes counter-intuitive equilibria occur in stylized game theory models and it makes people wonder: are people really that rational in making every decision in their daily life? One thing I feel certain about is that I'm not...

For decades a new sub-field of economics, behavioral economics, has been challenging the orthodox assumptions of neo-classical econ that people are predictably rational. Behavioralists have a point right: people can't be as rational as economists assumed in their models. Our brains are not powerful enough to make choices with no consideration of emotion, and most people won't make consistent strategies in subject to Bayes' rule of probability.

Behavioralists come up with a definition, bounded rationality, to state that people's rationality of decision making is impaired by mental constraints on information processing and probability calculation.

Yes I admit that people are not rational all the time, but the market still doesn't fail because it induces participants to be more rational than they otherwise would be in an environment with no price. Trials and errors entail progress and as participants get more experienced, they would know the tacit rules and have better outcomes. In game theory terminology, this is called the refined equilibrium. Mathematically most games have an odd number Nash Equilibira and some equilibria don't make much economic sense. I call them "irrationally rational equilibrium". To winnow out the bad equilibrium, game theorists come up with some refinement strategies like trembling hand equilibrium, consistent belief and reasonable beliefs. One thing surprising is that...after all these delicate and smart manipulations, the final results of games are often what we see in daily life! That is, perfect rationality can mimic the outcome of seemingly irrational behavior in market context.

One drawback of behavioral econ experiments is that they are mostly done in labs, which is a different environment from market, and thus the result may not be compatible with what people really would choose given that they are in a more dynamic and chaotic atmosphere. 

Unemployment insurance

The US unemployment insurance includes 53 separate jurisdictions, each with unique laws and operating procedures. The system is financed through a federal tax on payrolls, and the majority of the benefits paid by the system are collected by state-level taxes. During recessions, additional federal involvement kicks in.

Many unemployed workers are not covered either because they are recent entrants to the labor market or they quit jobs voluntarily. Some unemployed are not eligible for the insurance because they have not earned enough in their previous recent jobs or they have exhausted the insurance. Some unemployed don't get covered because they didn't file for the insurance in the first place.

Programs in different states vary due to difference in four general areas: rules of eligibility, what jobs are covered, variation in weekly benefit amounts, and variation in weeks for exhaustion.

Eligibility:
To be eligible, three conditions must be met:
(1) whether a worker has sufficient employment during some defined base period
(2) whether a worker has an acceptable reason for the job separation
(3) whether a worker continues to be unemployed, (in other words, determine if he actively searches new job while collecting the insurance)

The problem of condition (1): it may exclude low-wage, temporary workers and those who have a short labor history.

Condition(2): may be hard to differentiate voluntary quitting
Condition(3): information problem (Hayek's critique I guess...)

Unemployment insurance to some extent prevent major declines in consumption spending in response to layoffs, but we have to consider that variation across workers and those who don't collect insurance. 

Design of unemployment insurance:
1) most models find that optimal replacement ratios are less than 1 when unemployment benefits pose  significant disincentive to find work
2) models that allow for realistic levels of personal borrowing and saving lead to lower optimal replacement ratios than those that do not.
3) replacement rates that decline over the duration of the unemployment spell may be perferable to constant wage replacement rates
4) consider moral hazard when deciding the duration of insurance coverage.

Summary of Home ownership, job duration, and wages

In this paper, the authors first hypothesized that employed home owners, compared to renters, are less likely to be unemployed, have longer employment spell lengths, and earn higher wages. Then the authors tested the hypotheses empirically based on a rich Danish micro data set. The data set they used covered one percent of the Danish population from years 1993 to 2001 and contained detailed information of housing, labor market experiences and demographic characteristics.   The pattern of the data showed that on average homeowners have more favorable labor market outcomes than renters.

To investigate the impact of home ownership on job duration and wages, the authors specified a competing risks duration model for job spells, used a mixed proportional hazard model for the labor market transitions to capture unobservable work characteristics, and estimated a standard human capital wage equation.

To identify the causal linkage between homeownership and hypothesis, the authors modelled the selection process into homeownership and used two different identification strategies to check the robustness of their results. The first identification related to the fact that some people change their home ownership status during job spells. This identification required authors to observe job spells both when the individual is a home owner and when he is a renter. Conditional on heterogeneity, it helped authors to see the relation between employment outcomes and home ownership status. The second identification was about exclusion restrictions, which helped tease out variables that affect home ownership decision but have no direct impact on labor market outcomes. The authors considered regional home ownership rate, home owner status of the parents, and home ownership rate in the region of birth as variables that only affected home ownership status. The whole model endogenized home ownership status.

The results of the paper were conform to the hypotheses. Home owners are less likely to transit into new jobs, and they earn higher wages. The paper suggests that there are labor market gains for homeownership. The problem of the model is that to make it more tractable, the authors restricted the correlation structure.  

Summary of Tenure Choice and Labor Market Outcomes

This paper tested at the individual level the argument that regional homeownership rates are positively correlated with regional unemployment rates.

The null hypotheses were based on search theory which argued that renters have a higher matching rates to firms while home owners, due to fixed cost in property acquisition and immobility, suffer more from regional demand shocks. Specifically, the hypotheses contends that renters, compared to homeowners, have lower unemployment probabilities, shorter duration of unemployment and higher wages.

Some previous research papers showed that at aggregate level house ownership has a negative impact on labor market outcomes. However, these papers failed to present evidence at individual level. Besides, much of the current evidence is bivariate, which means there may be omitted variables involved. To test hypotheses at individual level, Coulson and Fisher used two data sets, namely the March 2000 wave of Current Population Survey (CPS) and 1993 wave of the Panel Survey of Income Dynamics (PSID), with a multivariate model.

The CPS data included information on 29753 individuals’ housing, labor market experiences and demographic characteristics. The sample reflected the relatively wealthier portion of the country. Coulson and Fisher first used probit model, in which the dependent variable is a dummy variable, to test the hypothesis that homeowners are more likely to be unemployed. The univariate test turned out to reject the hypothesis. To tease out the impact of omitted variables, Coulson and Fisher then added some other significant variables such as age, races, education levels, marital status, and locations, but refined regression still rejected the hypothesis.

Coulson and Fisher then used CPS data and OLS method to test the hypothesis that renters have more wages. Both the unconditional and conditional tests showed that home owners have more wages than renters, which rejected the hypothesis.  

Having rejected the first and third hypothesis using CPS data, Coulson and Fisher used PSID to test the three hypotheses, particularly the second that renters have shorter duration of unemployment. Compared to CPS, which only included a simple cross-section, PSID had longitudinal data, which could be better used to test spell length of the sample. The sample consisted of 5125 individuals, which had on average lower incomes, lower education levels and younger ages compared to those in the CPS data. The univariate and multivariate regression tests both showed that home ownership is a significant negative indicator for unemployment and home owners earn more than renters. Assuming that the length of spells satisfies Weibull distribution, Coulson and Fisher ran the regression and found that home ownership exerts a negative influence on the length of the unemployment. The second hypothesis was rejected.

Coulson and Fisher rejected the null hypotheses that homeowners have lower unemployment probabilities, longer unemployment spells and lower wages than renters. The possible reasons why the hypotheses didn’t hold may be that mobility of renters tend to equalize unemployment rates across areas regardless of the homeowners’ behavior, or firms don’t observe status of homeownership and tend to pool renters and owners into a single labor market.

However, this paper was criticized by Munch, Rosholm, and Svarer. They pointed out that Coulson and Fisher didn’t address the potential endogeneity of the home owner variable, which made it unclear if the positive labor market outcomes for home owners are causal or spurious.

The economics of the tenure system

The degree of job security for tenured faculty is higher relative to other kinds of jobs, but whether it is excessive is a different question.

The tenure system provides higher job security than a for-profit company would, but the monetary compensation is lower.

The correct view of the tenure contract is that universities get high-priced talent at a low monetary cost; they pay instead by providing job security.

While tenure provides job security, it doesn't guarantees a lifetime increase in salaries.

The disincentive of tenure system:
Untenured faculty view tenure as a incentive to work hard, but the desire to earn tenure also makes them cautious during the pre-tenured years. Many of them fear that unconventional teaching would impair their chance to get the tenure and thus they conform to conventional teaching and research topics that would pay off in a shorter time period. But when they take such mainstream teaching styles and research methods, the cost of innovative research and teaching at post-tenure career would be huge because they have locked in and failed to adopt more daring ways.

Dining and Housing

Student dining and housing are enterprise units in some schools, which means that they are expected to fully cover their operating and capital costs and receive no subsidies from the general operating budget of the university. But their operation still have impact on the rest of the university.

Higher dining rates increase the total costs of attending the university. It is the total cost of attending the school, not its tuition and fees, that influences accepted students' decisions to attend the school. It is also the total costs that determine the financial aid that is provided for students. Increased financial aid costs or reduced tuition revenues both mean that less money will be available to spend on the academic functions to the universities.

Intercollegiate athletics and gender equity

Even if the athletics department loses money on its operation, the claim is made that these sports are investments that generate considerable funding in the form of alumni contributions to the university as a whole.

A number of academic studies confirm that football bowl game appearances and basketball appearances in the NCAA men's basketball tournament have a positive effect both on the contributions that universities receive from alumni and on the quality of their entering students.

Intercollegiate athletics is more a participation activity than a spectator activity for students at Ivy League universities.

Public universities have long used success on the athletic field as a way of generating alumni and political support for their institution. To compete on the playing field with the public institutions in their conferences, Stanford, Duke, and Northwestern have all adopted the conference policy of awarding athletic scholarships.

Gender-equity efforts will have real financial cost if a university isn't able to bring itself to deeply cut male athletic programs. Sometimes gender-equity requirements add to the cost of existing women's sports.

State higher education cuts

Every state but Vermont is required by its constitution to balance its budget every year. In recessions when tax revenues fall and social welfare expenditure like Medicaid and TANF increases, either tax should be increased or some other public expenditure has too be cut.

But this can only explains the case of community colleges.

Baumol disease problem in higher education. It doesn't fully explain why college tuition is rising so much.

Now that there are many more PhDs, especially in the humanities, than tenure-track spots for them, the salaries of instructors are actually falling as universities turn to adjuncts. That directly contradicts the Baumol explanation.

 Robert Martin at Centre College did a research showing that between 1987 and 2008, full professor salaries increased by an average of 0.9 percent a year, and assistant professor salaries by a measly 0.7 percent a year. But support staff salaries grew at more than double that rate. If the core act of teaching is driving costs higher, that just shouldn't be happening.

A more plausible theory might be Bowen theory: universities will spend all the money they can possibly raise. If they raise more than they need for educational objectives, they will spend it on non-educational uses like climbing walls and nicer buildings.
Revenue theory of cost:
"

1. "The dominant goals of institutions are educational excellence, prestige, and influence."

2. "There is virtually no limit to the amount of money an institution could spend for seemingly fruitful educational ends."

3. "Each institution raises all the money it can."

4. "Each institution spends all it raises."

5. "The cumulative effect of the preceding four laws is toward ever increasing expenditure."

For details, read the paper by Ronald Martin and R. Carter Hill.

Three reasons tuition is rising

Research universities are spending too much. Even the record-high tuition cannot make up the volume of spending.

For many public universities, they rise tuition to shift cost because their support from state and local government has been shrinking. Community colleges have to keep cutting spending despite rise of tuition.

For non-research schools like liberal and arts colleges, their spending is increasing, yet their tuition is increasing more because they have to compensate for decline of donation and make up the new spending.

Source: Washington Post

Last banking class notes

Interstate banks provide convenience to customers. Lower cost due to economies of scales. More competition in banking sectors.
Drawbacks of branching of banks:
(1) we see a draining of deposit funds from local communities to other parts of the country.
(2) Banks become much larger and resemble "too big to fail".

Regulation in financial sectors may be the clearest test of how regulation works in a market. In other words, if regulation works anywhere, it must be the case that it works best in terms of financial market. Reason: Compared to other sectors, transparency in financial market is higher. Banks report vast quantities of data to regulators, and it is very easy for regulators to check those numbers.

Why is financial regulation doomed to fail?
(1) Ordinary people don't care about risks in their banks---- most people cite location as the most important reason for choosing a bank.
(2) Standardization: getting a mortgage or a loan is the same process no matter the banks are. Different banks evaluate them in the same way, following the guide lines of the Fed. The influence of the Fed goes beyond banks' balance sheets because banks follow the guidelines of the Fed.
(3) Less competition--regulation puts barrier in the way of starting a new bank.
(4) Less choice--can't share its own currency. (But most banks still provide checking account, which is private money, consisting a large chunk of the whole money supply in the economy.)

The creation of derivatives doesn't eliminate the risks. What we should care about is to when risks will explode and harm other people. It's not possible to prevent crisis from happening.

The point of regulation is to protect the sanctity of the payment system.
How to regulate
Bank of International Settlements:central bank to all the world's central banks
Issuance of guideline: Basel I, II and III. Suggested guidelines that are supposed to be adopted by central banks.

The most important thing that BIS does is to set up the capital adequacy requirement to prevent banks from recklessly investing with insufficient risk capital.

Basel I: any government issued securities are 100 percent risk-free. any country securities are safe.
A                                L
Greek bonds           deposits
100                          100
Capital requirement for the most risky lending: commercial loan 8% capital requirement (100% risk weight)
Mortgage loans are deemed to be safer: capital requirement is 4% (50% risk weight)
GSE securities: capital requirement 1.6% (20% risk weight)

For a bank, if it originates a mortgage, sells it to Fannie, (btw get a fee for selling the mortgage), and buys it back in a bundle of MBS, that very same mortgage would only require 1.6% of the capital requirement.

NOW the capital requirement for all mortgage is 1.6% requirement, including prime and subprime mortgages.
Commercial banks get money in 3 ways from this process: interest on mortgage, fee for selling mortgage to the Fannie in the first place, a lower capital requirement

SPV: off-balance sheet activities to avoid any capital requirement. (Bearstone)

Investment banks were not totally reckless:
(1)double A and triple A mortgages were demanded the same capital requirement, and double A mortgages had a higher yield, but most investment banks still chose triple A mortgages
(2) greed is about making money rather than losing money
(3) the problem may be overconfidence
(4) they bought CDSs for protection

In a free market, banks will use different algorithms to evaluate the mortgages, there may even be speicalization. Besides, with support of FDIC, banks will compete for deposits and tend to self regulate better. The bank runs are disciplining them.

Summary of The Problem of Transaction Costs

I.                    The problem to be examined

This paper is about negative externalities of one business firm upon others. The traditional economics analysis, developed by Pigou, contends that the firm is liable for the damage and that the firm should either pay tax of equivalent amount of the damage or close the factory in that area. But professor Coase argues in this article that such analysis is inappropriate and often leads to undesirable outcomes.

II.                 The reciprocal nature of the problem

The traditional approach focuses on how to restrain the negative externalities of the firm, but this analysis is wrong because the external cost is not simply a cost produced by the firm and born by the victim; instead, the problem is of reciprocal nature. The real question is to decide whether one group is allowed to harm the other or vice versa. The proper way of analysis is to determine in total and at margin whether the value of protection is worth the cost of restraining the firm.

III.               The pricing system with liability and damage

When the firm has to pay all damage it caused and the transaction cost is zero, there will be a desirable solution. If the firm that imposes negative externalities is liable for the damage, it will take into consideration the marginal social cost of its production, and based on cost-benefit analysis, it will either reduce production or pay to victim as compensation. On the other hand, the victim will reach a bargain with the firm based on his examination of negative externality cost and benefits. The both parties have to consider the opportunity cost, and if the cost is greater than the value they can get, then in a competitive market, they will reallocate the resources and reach a mutually beneficial outcome. The outcome of the bargain depends on preferences and negotiation skills of two parties, but the net social gain is the same.

IV.              The pricing system with no liability and damage

If the damaging business is not liable for the damage it has caused, but the transaction cost is zero, then the allocation of the resources will be the same as it was when the firm was liable for the damage. In this case, the victim will pay the amount no larger than externality cost to the firm for less damage, and the firm will accept it if the amount is larger than the value of its marginal product. If this transaction doesn’t happen, the victim will move out and no negative externalities would happen. As it is the case in III, the outcome depends on the value of firm’s marginal production and its cost on the victim.

It is necessary to know if the damaging business is liable for the damage since the establishment of the delimitation of right facilitates market transaction, but as long as the transaction cost is zero, people would bargain with one another to produce the most efficient distribution of resources, regardless of the initial legal position.

V.                 The problem illustrated anew

Problems of negative externalities can assume various forms in life. But the bottom line is that the problem is caused by both pollutant and the victim. The economic problem in all cases of harmful effects is how to maximize the value of production. The immediate question courts have to cope with is who has the legal rights to do what, but as long as the transaction cost is zero, the decisions of the courts concerning liability for the damage have no effect on the final allocation of resources. A legal rule that arbitrarily assigns blame to one of the parties gives the right result when that party happens to be the one that can avoid the problem at the lower cost.

VI.              The cost of market transaction taken into account

In real life, many welfare-maximizing reallocations are forsaken because of high transaction costs in the process of bargaining. In this situation, the initial delimitation of property rights will affect the efficiency with which the economic system functions.

A firm could reach the efficient outcome, but the administrative cost for firm to organize a transaction isn’t strictly less than that from the market. People will use firm to organize a transaction when its costs are less than the cost incurred through market.

When the transaction cost of the firm is very high, an alternative option is direct government regulation. The government, to some extent, is a super-firm because it can influence the use of factors of production by administrative decision and it can avoid the market competition. The government can use its power to get things done at a lower cost, but the administrative machine itself isn’t costless, and the regulation may not be efficient. All solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm. The law should produce an outcome similar to what would result if the transaction costs were eliminated. Hence courts should be guided by the most efficient solution.

VII.            The legal delimitation of rights and the economic problem

The courts should take into consideration the economic consequence of their decision. A comparison between the utility and harm produced is an element in deciding whether a harmful effect should be considered a nuisance.

The problem of negative externalities isn’t about restraining those who are responsible for them; instead, the problem is to decide that, given the negative externalities, whether the gain from preventing the harm is greater than the loss resulted from stopping the action that produces the harm. In a world with transaction costs, courts make decisions on economic problem and determine how resources are to be allocated. The courts are conscious of this and they make comparisons between what could be gained and what would be loss by preventing the actions. The delimitation is also the result of statutory enactment. Sometimes courts may protect the firm too far.

VIII.         Pigou’s treatment in “economics of welfare”

The existence of externalities does not necessarily lead to an inefficient result. Pigouvian taxes, even if they can be correctly calculated, do not in general lead to the efficient result.

IX.              The Pigovian tradition

For Coase, the idea that firm should be forced to compensate those suffer from negative externalities is the result of not comparing the total product attainable within various social arrangements. A tax system which is confined to a tax on the producer of the damage caused will lead to higher cost of solving the problem if the alternative solutions incur fewer costs. In addition, Pigouvan taxation begs the question of detailed information of personal preferences, which is hard to achieve in real market. What’s more, even if the problem of information is solved, tax will increase because more people will live in the vicinity, incurring reciprocal negative externalities on firms. If regulation is truly inevitable, the goal is to approach the optimum amount of negative externalities rather than just eliminate harm regardless of the cost.

X.                 A change of approach

Coase believes that analysis in terms of divergence between social and private cost of products pays close attention to particular deficiencies in market and tends to nourish the belief that any mechanism eliminating the deficiencies would be desirable, but such mechanism may induce unintended consequences.

Pigouvan analysis proceeds in terms of a comparison between a state of laissez-faire market and an ideal world. Coase suggests that a better approach should examine the transaction costs and delimitation of property rights, conduct cost-benefit analysis on various proposals and decide which institution to set up.

Coase thought that failure to cope with externalities correctly results from a wrong concept of a factor of production. Factors of productions are a right for a person to perform certain actions on his property.  The cost of exercising a right is the loss born somewhere else in consequence of exercising the right. In deciding social arrangements in which individual decisions are made, Coase believe that all solutions have costs and there is no reason to suppose that government regulation is called for simply because the problem is not well handled by the market or the firm. Economists should account for total effect of each proposed arrangement to make the best decision.

The ultimate thesis is that law and regulation are not as important or effective at helping people as lawyers and government planners believe. Coase and others like him wanted a change of approach, to put the burden of proof for positive effects on a government that was intervening in the market, by analyzing the costs of action.