Richard Holden

THE founder of modern economics, Adam Smith, pointed out that the “invisible hand” of competitive markets leads to an efficient allocation of resources. When markets are competitive government should just “get out of the way”.

Yet most markets are not perfectly competitive – the extreme case being where there is a single monopolist.

This opens the door to government interventions making markets work better. But which interventions are best? What tools should be used? Which markets should be targeted?

This year’s Nobel Prize in Economic Sciences was awarded to Jean Tirole for “his analysis of market power and regulation”. Tirole’s work provides answers to these vexing questions – it has deepened our understanding of how markets actually work, and provided policymakers with a playbook for how to make them work better.

As one example, imagine you are a government regulator of a monopolist, such as a power company. The large fixed costs involved might mean that having multiple competing firms is not sensible, but one large monopolist will charge high prices and hurt consumers. What do you do?

One answer is to control the prices they charge. But to do this effectively means knowing what their true costs are – something that is typically very difficult for a regulator. Worse still, you would like the firm to work hard at lowering their costs, but this won’t happen if they don’t capture some of the benefit of those lower costs.

In path-breaking work in 1986, Tirole and co-author Jean-Jacques Laffont (who might have shared the Nobel award had he not sadly died, too young, in 2004) showed how a regulator can best balance providing incentives to reduce costs with the use of public funds – perhaps raised through inefficient taxes, since incentives cost money.

Remarkably, Laffont and Tirole showed that offering the monopolist a menu of possible regulatory schemes does the trick. You, the power company, can have a cost-plus contract or a fixed-price contract, or something in between. You choose.

And just like a good magician’s carefully designed scheme, you will always choose the card he expects. This cunning trick makes it in the interest of the monopolist to implicitly reveal its costs through its choice of regulatory scheme.

Part of what makes Tirole’s work so remarkable is that he has been able to analyse complex markets such as credit cards, telecommunications and banking, yet use a general analytic approach from which broad lessons can be learned. It is social science at its absolute best: using mathematical rigour to illuminate real-world problems and provide effective policy prescriptions.

And it’s not just academics and students who might benefit.

As Australia embarks on its second great competition policy review, with Ian Harper due to report in March next year, Tirole’s Nobel provides a timely reminder of the importance and power of good competition policy. In many ways there are parallels between the evolution of the economics of regulation, and the competition policy reform process in Australia.

The year Tirole defended his doctoral dissertation at MIT was 1982, the same year that University of Chicago professor George Stigler won the Nobel prize.

Stigler – a towering figure both intellectually and physically – was a pioneer of the study of how firms interact, and how competition policy can achieve efficiencies by driving down prices. In many ways Tirole was his natural extension and intellectual heir – incorporating strategic decision-making and hidden information into the picture.

So, too, might it be with Harper and Fred Hilmer. The 1993 Hilmer report, and the reforms it heralded, was a watershed in Australia. It took a hard line against monopolies and anti-competitive practices, and the results have been hugely beneficial to Australian consumers.

Harper’s Tirole to Hilmer’s Stigler would be to bring Australian competition policy into the 21st century. To deal with complex markets with complex problems – such as firms that know a lot more than regulators do, markets that are hard to define, and markets involving complicated networks of players such as credit cards.

Tirole’s work provides a road map for Harper. But he could do well to use Tirole’s work as a touchstone, much the same way that Stigler influenced Hilmer.

Tirole is a scholar’s scholar – thoughtful, careful, creative and genuinely the smartest guy in the room. He has inspired a generation of young economists around the world. But his work has had impact far beyond the classroom, seminar room and academic journals. He has described how real, complicated markets work, and helped policymakers to make them work better.

Tirole is a kind of engineer for the social sciences. And in highlighting that, the Nobel committee has displayed impeccable taste.

Richard Holden is professor of economics at UNSW Business School. A version of this post appeared in The Australian.

Richard Holden

If there is one iron law of economics it is this: people respond to incentives. Offer an “all you can eat” buffet and people eat a lot. Double the demerit points for speeding on a holiday weekend and fewer people speed. And if you make school funding contingent on achieving threshold numeracy and literacy test scores then those thresholds will likely be met.

The trouble is that it might not be because of genuine improvements in skills.

The Business Council of Australia’s recent report on innovation suggested tying federal funding of education to the achievement of threshold NAPLAN literacy and numeracy standards. It argued that a well-educated workforce is crucial for innovation and economic growth.

I couldn’t agree more about the need for an educated workforce. And I’m not one of these metricphobes who thinks that measuring performance is inherently evil, or that all league tables are bad. Far from it. But I do worry a lot about how incentives for teachers and students in schools work. There’s a swath of evidence that incentives in education lead to unintended outcomes – or even outright fraud.

Put yourself in the position of the person who is the boss of all school principals in a state and who is faced with the Business Council’s scheme. Some portion of those principals run schools whose kids are presently below the literacy and numeracy thresholds. What do you do? Faced with the possibility of large losses of funding you probably put pressure on those principals to get better results.

What levers do they have available? They can’t change the selection of kids in their schools – and if they did it would just shift the problem elsewhere.

They can’t change the kids’ parents or their classmates and the important influences they have. They can’t easily change the teachers in their schools.What they can do is have teachers focus on testing outcomes rather than holistic ones. They can “teach to the test”.

Teaching to the test badly misallocates the most precious educational resource: teacher time. It focuses students on how to mechanically perform a small number of tasks.As one illustration of how details matter, consider giving students cash incentives to do more homework. Setting aside the cost, this seems like a no brainer – but in fact it can lead to negative outcomes.

Research I conducted with Roland Fryer of the Harvard University economics department was designed to document this difficulty. We provided incentives to 5th-grade schoolchildren in Houston, Texas, to do mathematics homework problems. They got $2 for each mathematics objective they mastered, using take-home worksheets and in-class computer software to assess performance.

Because we randomised which schools got the software and incentives, and which schools just got the software, we could determine the causal effect of the incentives. Just like a randomised, controlled pharmaceutical trial with a treatment and a control group.

The answer? Kids with incentives did way more maths homework. And they did significantly better on end-of-year standardised tests in mathematics.

Great news? Not so fast. These gains in mathematics were, alas, almost exactly offset by a decline in performance on standardised reading tests.

Interestingly, measures of intrinsic motivation did not drop – financial incentives did not destroy the “joy of learning”. Instead, it was what economists called “effort substitution” – incentives in mathematics shifted effort away from reading and to mathematics.

High-stakes testing for whole school districts or even whole states of Australia raises the disturbing possibility of outright test fraud.

Just last week the trial of 12 former educators accused of fraudulently inflating test scores began in Atlanta, Georgia. The group includes teachers, testing coordinators, principals and administrators.

At least one Atlanta school held pizza parties where they erased incorrect answers on tests and filled in the correct ones to boost kids’ scores. And not just a few. The prosecution claims that across the Atlanta public school system, in 2009 alone, 256,769,000 incorrect answers were “corrected”. Yep: one-quarter of a billion!

But surely that wouldn’t happen here in Australia? Perhaps not, although I’ll bet that’s what folks in the great state of Georgia thought until recently.

Steve Levitt (of Freakonomics fame) has also documented widespread teacher cheating in Chicago public schools: from changing answers, to getting tests ahead of time, to teaching answers to precise questions. Atlanta is not a one-off.Incentives are incredibly powerful – and in many settings carefully crafted explicit incentives can do a lot of good.

But education is a very complex environment, one in which explicit incentives have the potential to do more harm than good. If you pay for better NAPLAN scores then better NAPLAN scores you will get. But they won’t necessarily mean genuinely better literacy and numeracy. And you probably won’t like the side-effects.

Richard Holden is a professor of economics at UNSW Business School. A version of this post appeared on The Conversation.

James Morley

Six years after the dramatic collapse of Lehman Brothers, the US economy is finally showing signs of a stronger recovery from the global financial crisis. The Federal Reserve (Fed) is winding down its quantitative easing (QE) programs and all eyes are on it to see when there will be “lift-off” of the federal funds rate from the zero lower bound.

In its last policy statement, the Fed used the phrase “considerable time” in describing how long it will continue its zero interest rate policy. Indications are that most members of the policy committee believe the first rate hike should occur in 2015.

The amount of digital ink spilt over the phrase “considerable time” has been striking (many news articles have considered the subject, including Marketwatch, The Wall Street Journal and CNBC). And it begs the question, why does everyone care so much about what the Fed says in its statements?

If the Fed were entirely unpredictable, then we would expect anyone worried about future interest rates (such as financial institutions, homeowners or small businesses) to care a lot about any hint as to what the Fed might do. But the Fed is not unpredictable in this way.

The Fed and other central banks behave in a fairly systematic fashion – sometimes referred to as the Taylor rule. This can be characterised as a mathematical adjustment of the policy interest rate in response to changes in inflation and the unemployment rate (or an estimate of the output gap). If this mathematical formula implies a negative interest rate, then the Fed will be constrained by the Taylor rule in applying a zero lower bound rate.

But do we pay attention to the Fed’s policy statements just to discern when its policy committee thinks inflation and the unemployment rate will imply a positive rate based on the Taylor rule? And does the Fed have some special information about when this will happen?

The answer to these questions is “probably not”. Yes, the Fed has good forecasters. But the reason why analysts study its statements is that it also has the ability to keep the interest rate at zero, even when the Taylor rule implies the rate should be positive.

Why would the Fed want to keep rates at zero in the future? The short answer is that perceptions it will do so can stimulate the economy in the here and now. And forward guidance about future rates can be used as a policy tool even when current interest rates are constrained by the zero lower bound.

By signalling that interest rates will be lower for longer than under their “normal” policy, the Fed is hoping to convince households and firms to increase their debt-financed spending.

Specifically, lower future short-term rates should lead to lower current long-term rates, which stimulates current expenditure on durable goods and capital investment.

There has been a lot of academic analysis on the effectiveness of unconventional monetary policies. The evidence for QE is mixed. It does seem to influence the prices of targeted assets. But it is less clear if it does so without an offsetting effect on the prices of other assets.

QE has been most effective when the Fed’s announcements about it have changed expectations about future monetary policy. QE can be seen as a signal that the Fed will do whatever it takes to prevent deflation, including keeping interest rates lower than would be implied by their normal policy.

As for forward guidance itself, there are challenges in identifying its quantitative effects on the macroeconomy.

In recent research, Mariano Kulish, Tim Robinson and I studied expectations of the length of time interest rates would be kept at zero. We found these expectations increased when the Fed significantly changed its statements about future policy.

For example, in mid-2011 the Fed’s policy statement became explicit about the timing of the expected lift-off. It moved from outcome-based to calendar-based guidance. In response, estimates of the expected duration of zero interest rates increased significantly. Output growth and inflation also seemed to react to the guidance at this time.

This case study demonstrates how forward guidance can work when the Fed makes its intentions clear.

The success of the Fed’s forward guidance policy is also supported by the recent stronger growth for the US economy. And it explains why everyone watches the Fed so closely for any indication of when lift-off will actually occur.

James Morley is a professor of economics and associate dean (research) at UNSW Business School. A version of this post appeared on The Conversation.

Peter Swan

Almost everyone in a study soon to be published in Perspectives on Psychological Science thinks CEOs are paid significantly too much – almost everyone it suggests, except Australians.

The study, by Chulalongkorn University’s Sorapop Kiatpongsan and Harvard Business School’s Michael Norton uses survey evidence to discover “what size gaps people desire” when it comes to pay, comparing estimates of the wages of people in different occupations – CEOs, cabinet ministers and unskilled workers – with their ideals of what those wages should be.

They measure the gap by the ratio of CEO pay to average unskilled worker pay, finding quite a high degree of consistency across people from 40 different countries and from diverse backgrounds.

Nonetheless, there is a surprising outlier – Australia. Responding Australians would like to see a ratio of 8.3 times. The average across the countries is nearly half at 4.6 times. Australia’s ratio is the highest in the 16 countries for which the authors’ have actual pay data.

Perhaps not so surprisingly, it is more than 400% higher than the desired ratio in egalitarian Nordic countries such as Denmark.

One country in particular outside the group of 16 outdoes Australians in tolerating inequality — Taiwan — with a desired ratio of 20.

Apart from revealing a general desire for equality, the study also reveals how out of touch with reality most respondents are. For example, the mean estimate across 40 countries of the respondents’ estimate of the actual pay ratio was ten-fold, about twice the average desired ratio. By contrast, the actual ratio across the 16 investigated countries is 101, ten times higher.

For example, for the US respondents the estimated pay ratio was 30, compared with the actual ratio of 350, meaning they believe the worker at the ideal ratio would be earning US$1.8 million, when in reality the average CEO earns US$12.2 million while the average unskilled worker earns US$34,645.

In the face of such ignorance, these survey results make the case for abolishing the survey profession itself.

Australians (and South Koreans) by far topped the list in guessing average CEO pay with estimates of 41 times. This is almost half the actual ratio for Australia and thus closer than respondents in most other countries who typically had far higher error rates.

Perhaps we should be relieved that for most countries these pay ratio estimates are substantially lower than the amounts company leaders actually earn. Would the truth stimulate more French Revolutions and huge hikes in tax progressivity?

Sweden, for example, once had a magnificent marginal tax rate of more than 105% for high-income earners. This lasted until voters discovered that their most beloved best-selling author had lower take-home pay the more she earned.

Actually, ignorance is not a monopoly possession of the respondents. Some of the “credit” must be attributed to those who did the survey and published the results. For example, it is meaningless to talk about CEO pay ratios without considering the size of the company.

Typically, the larger the company, the higher the pay. Using raw pay numbers, each doubling of firm size increases pay by 30%. Since on average Australian companies are far smaller than in the US, our pay ratio falls way short of the US’s 350 times score.

This means we miss out on the “bargain” to shareholders constituted by the highest paid CEOs at the largest US companies. Since pay far from doubles with each doubling of firm size, large-firm CEOs cost shareholders very little relative to market capitalisation and earnings, in contrast to small-firm CEOs.

In fact, some prominent CEOs – such as the late Steve Jobs of Apple fame – choose to be paid a notional salary (US$1 in the case of Jobs) rather than the hundreds of millions they contribute to shareholder value.

Do they do this because of their love for shareholders and the average unskilled worker? No.

George W. Bush reduced the tax on dividends from the personal marginal rate to a maximum of 15%. But he still retained the double-taxation of company and personal income (unlike Australia). It then became more tax advantageous to receive dividends when one owned as much of the company as Jobs did.

Why does CEO pay go up with firm size at all? Actually, this relationship largely exists because size becomes a proxy for success and thus managerial talent. Such talent, the Steve Jobses of this world, is in limited supply. If one controls for talent then pay only increases by about 22% for each firm-size doubling.

My research with Jaeyoung Sung shows that firms compete for talent largely by raising pay for performance sensitivity, that is, by encouraging stock and option ownership. The reason for this is that typically only the manager is aware of his or her own talent. With more “skin in the game”, the highly talented manager’s effective take-home pay is much higher and can in some cases amount to billions of dollars.

Smaller firms in particular cannot afford to pay as much in direct cash pay. Hence, we see sensitivity falling rapidly with increases in firm size. Larger firms can afford to pay more. For them, talented CEOs are a bargain.

The real message of the survey study for Australians is that we are more tolerant of inequality, including pay outcomes, than are most other nations. This makes it easier for us to attract talented managers out of the limited global pool.

Importantly, it means that outcomes for most Australians will be better than is the case in the rest of the world. We can expect our economy to continue to outperform.

But this will be true only for as long as the Abbott government restrains its enthusiasm for raising marginal tax rates — much to the nation’s long-term detriment.

Peter Swan is a professor of finance at UNSW Business School. A version of this post appeared on The Conversation.