Tag Archives: Coase

Is There a Cybersecurity Market Failure?

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That is the title of my Mercatus working paper (PDF), released yesterday. Basically, it aims to be a short course in public economics for tech policy analysts. Almost all policy wonks have taken Econ 101, perhaps even a graduate version, in which they learn that externalities can cause markets to get prices wrong, and that this can result in market failure. What my paper stresses is that this link, from externality to market failure, is not automatic.

The paper is heavy on “what Coase really meant” (lots of smart people get this wrong), on non-property institutions and norms à la Ostrom, and on the often-ignored inframarginal externality as discussed by Buchanan and Stubblebine. By applying these ideas to cybersecurity policy, I try to show that it is not at all as obvious as many analysts think that there is significant scope for welfare-enhancing regulatory intervention. The point is not that there is literally zero market failure, but that proponents of cybersecurity regulation have not done the work they need to to show that market failure exists, if it exists. Indeed, many policy analysts may not even realize they are missing something. I hope that this paper will correct that and lead to a more humble and cautious approach to market failure among its readers.

I have plans for more work on tech policy in the future. Internet security and governance is a great research topic for young, tech-savvy economists interested in polycentric governance and institutions. If you’re interested in doing research in this area, let me know, I may be able to help.

What Does Steve Jobs Show Us About Central Planning, Democracy, and Occupy Wall Street?

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Karl Smith playfully suggests that it is ironic that Steve Jobs has so many fans among Austrian economists:

Apple was principally the complete opposite of the decentralized local-knowledge driven catallaxy that Austrian’s trumpet. It was a highly centralized, tightly controlled integrated company that managed every step of the process from design to retailing.

…Apple seemed to operate on the basis of “Five Year Plans” in which the Politburo decided what the future was going to look like and did what was necessary to bring it into being.

This is exactly what is supposed to not work, yet it worked spectacularly.

I am not an Austrian, but I do have a certain fondness for Hayek. I also believe that Steve Jobs is about as close to a Randian hero as can be expected outside of a novel. But contra Karl, I don’t think there is any tension here. In fact, I think a Hayekian (and Alchianian) view of competition can help us better understand why Steve Jobs was so great, and Steve Jobs can show us why in politics central planning, democracy, and voice-based political reforms are doomed to mediocrity or failure.

As a preliminary, let’s get out of the way the fact that it is well understood by Austrians and their fellow-travelers that central planning will always exist in a market economy. Coase’s The Nature of the Firm makes exactly this point. Firms are islands of command and control in a sea of free exchange. The exact boundaries of the firm in a market economy depend on transaction costs and the costs associated with central direction of resources. Hayek also articulates this in his most popular article, The Use of Knowledge in Society. The question is not whether planning will be done, but who is to do the planning?

Readers may be less familiar with what I will call the Hayek-Alchian view of competition. In “The Meaning of Competition,” an essay in Individualism and Economic Order, Hayek argues that “competition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis” (p. 94). Armen Alchian takes this further in his 1950 article, Uncertainty, Evolution, and Economic Theory. Alchian models the economy as an environment that selects practices for survival on the basis of positive or negative profits. It’s not firms’ motivation that matters; it is results. This evolution-based account is necessarily more dynamic than the profit-maximizing (motivation-driven) model that economists usually adopt.

Framed in this way, we can now ask the important question: Is Apple successful because it was big and centrally directed, or is it big and centrally directed because it was successful? From a Hayek-Alchian perspective, the answer is clearly the latter. Having a Randian hero centrally direct a lot of resources is not, in spite of Apple’s story, a recipe for success. Instead, following a recipe for success will result in a lot of resources to direct. Finding a recipe for success, not accumulating the resources to direct, is the hard part. That is why we need competition.

And that is why Steve Jobs was great. He had a recipe for success, a vision that worked, and he fought relentlessly for it. It could have been luck; an implication of Alchian’s view is that “[e]ven in a world of stupid men there would still be profits” (p. 213). But I don’t think it was pure luck. Here’s to the crazy ones.

The fact that Steve Jobs centrally directed billions of dollars of resources well does not mean that central planning has much hope in our political context. States do not face the market test, or if they do, it is on large time scales that make evolution toward relatively efficient forms of organization too slow to be useful.

However, if states did face the market test, I think I would be happy to live under the central planning of a Steve Jobs figure. Let a thousand nations bloom, let governance firms enter and exit, let customers migrate between jurisdictions easily. I think under these conditions, central planning would “work,” not in the sense that it would be 100 percent efficient, but that it would discover the recipes for the kinds of political products we all want to buy.

This is the biggest problem, in my view, with democratic political reform. Whether it’s the Tea Party or Occupy Wall Street, most reformers think things will get better if only their voices are heard more clearly. That is a pitiful, static, zero-sum conception of progress. What we really need are institutions that subject entire governments to Hayek-Alchian competition. When we have that, I think we’ll all be happy with centrally planned politics, but central planning won’t deserve the credit; the competitive process will.

How Twitter Could Solve Its Spam Problem, For Good

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Twitter spam is a frequent occurrence, and I typically ignore it, but not today. This morning I received this message from an account that has been spamming people for several days. I did my duty and reported the account for spam and…nothing.

I did a little research and discovered that the director of Twitter’s Trust and Safety team is @delbius (Del Harvey), so I asked her, “Can Twitter get more aggressive against spam? e.g., autosuspend reported accounts that frequently mention people they don’t follow?” She was kind enough to reply that they do, and that they’re working on improving the rate of detection.

I reloaded the offending account, and sure enough, Twitter said the account did not exist. I was satisfied. A few hours later, after spending some time thinking about Twitter’s spam problem, I noticed that it was back, perhaps unsuspended (or possibly there was some error when I reloaded it).

I can appreciate that the anti-spam people at Twitter have a difficult job (this report says they once accidentally blocked Biz Stone’s and Evan Williams’s accounts). They are trying to craft algorithms to deal with a constantly adapting and increasingly sophisticated enemy. Furthermore, Twitter has only around 500 employees; it can’t possibly have more than a couple of them working on anti-spam measures.

Machines are notoriously bad at pattern recognition. If only Twitter had millions of human-level intelligences who could ease the burden on the computer algorithms. But of course, they do! If Twitter’s users could somehow be persuaded to use the “report spam” function consistently, Twitter’s spam problem would be much reduced. And for all the ingenuity that the spammers have shown so far, it’s unlikely that they would ever be able to beat the human filter.

Reporting spam has, in addition to the private revenge component, a public goods component. There are positive externalities to being a good online citizen, and therefore good online citizenship is underprovided.

Fortunately, since Twitter owns Twitter, it can solve this externalities problem. Coase shows in his article The Lighthouse in Economics that lighthouses (the canonical public good) were provided by private actors because they were affiliated with harbors. Harbor owners undertook the building of lighthouses because well-lit harbors were more profitable. Public goods problems can be solved through the good incentives that ownership provides.

The solution to Twitter’s spam-reporting public goods problem, therefore, is entrepreneurial innovation on Twitter’s part. Twitter needs to incentivize its users to make use of the report spam button every time they receive a spammy @reply or are followed by a spammy account.

My incentivization suggestion is to increase, for users who report accounts that are ultimately verified or not contested to be spammy, the likelihood of showing up as a recommended user to follow. Publicize this change in the account suggestion algorithm and overnight, millions of Twitter users will report spam every chance they get. What is more, it will turn the spammers against each other. The spammiest users will make extensive use of Twitter Search to locate other spammers to report them, to increase the likelihood of being a suggested account.

If this suggestion were implemented, it’s hard to imagine how spam could continue to be a problem on Twitter. The ingenuity of the spammers will be matched by the ingenuity of people who are trying to game the Twitter account suggestion process. And if Twitter is going to recommend accounts, why not at the margin recommend those who are good online citizens?

If anyone at Twitter is reading this, I am happy for you to use this idea without further permission from me as it will solve an aggravating problem for me and other users. But only the first one is free. I have an economist’s perspective and a number of other ideas; if you want them, I’m going to need some stock options.

App Store Economics

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If you follow me on Twitter, you may have noticed last week that I have an app in the new Mac App Store. It’s called Gmail Dock, you can find more info about it here and here, and you can buy it here.

I am an economist, not a programmer, so what am I doing with an app in the App Store? This question got me thinking about the economics of the App Store, and I think I have a satisfactory answer.

As with most things, it begins with Ronald Coase (who turned 100 last month, huzzah!). What are stores? They are mechanisms for reducing transaction costs. Notice that I said “reducing.” Store owners are middlemen, and they take a cut of the proceeds for their trouble. Apple takes 30% of gross sales. Nevertheless, the value of their brokering services exceeds their cut of gross sales, so on net they reduce transaction costs.

When transaction costs are lower, we know from The Nature of the Firm that firms get smaller. They outsource more. More people start firms to which other firms outsource, so there are more entrepreneurs. Most importantly, patterns of specialization change. Instead of doing something for myself, I will be more likely to pay someone else to do it for me.

I wonder what The Nature of the Firm would have said if it had been written today, when so many businesses deal in products, such as software, that are characterized by high fixed costs and low marginal costs. The specialization story changes a little. My own adventures with the App Store are instructive.

I wrote Gmail Dock entirely for my own use almost a year ago. I was tired of desktop email clients like Mac OS X’s Mail that were slow, bloated, and not as useful as the web-based Gmail. So I wrote something that attempted to bridge the gap between desktop email and webmail. I found it useful. But I didn’t try to sell it online because of the difficulty of marketing, distributing, and collecting payment. Giving it away would have made me strictly worse off because of support requests.

The App Store came along, and all of a sudden it was cost-effective to sell my software. I went into business. But the thing that is different from the Coasian story is that my pattern of specialization hasn’t actually changed. I’m still producing the same things that I produced before the store came into the picture. Lower transaction costs plus low marginal costs mean that people’s hobbies, creative outlets, and tinkering will increasingly become profitable side businesses. Who knows, maybe some day I’ll get paid to blog.

Those of us who do not spend all day in front of a TV create real value in our spare time. Lower transaction costs enable us to capture some of that surplus. To me, that is one of the important stories of how the App Store, the Internet, and the world of low marginal cost is changing society.

Why Does Apple Offer Free Engraving?

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This Black Friday, I had the occasion to ponder why it is that Apple offers free engraving on iPods and iPads (hereafter, iP*ds). A small part of the reason is surely that it adds value for some of its customers. But assuming that the cost of engraving is not zero, this is not much of a reason to offer it for free. At best, it is a justification for offering the service at marginal cost. Indeed, Apple used to charge for iPod engraving.

If the kind of people who value engraving are also likely to place lower value on iP*ds, then it could be a method of statistical price discrimination. But this does not really seem plausible, does it?

The real reason Apple offers free engraving is to weaken the secondary market. iP*ds are durable goods. Apple has a monopoly on iP*ds, but it still has to compete with the products of its former self. If people get tired of their iP*ds or decide they want to upgrade to a newer model, they can sell their devices to other consumers, who in turn are not giving their money to Apple. By offering free engraving, Apple makes these used devices less valuable to other consumers. Who wants a weird engraving chosen by the previous owner on his iP*d? The more iP*ds are engraved, the smaller (or at least less valuable) the secondary market is, and the more profitable it is to be the durable-goods monopolist, Apple.

Jeremy Bulow wrote the classic article on how the secondary market affects durable goods monopolists, but as I recall he doesn’t consider personalization as a strategy. Instead, he focuses on how firms can rent instead of selling their products (effectively taking durability out of the equation), credibly promise not to lower prices in the future, or simply make their product less durable. Has anyone considered product personalization as a way to mitigate the durable goods problem? Are there other examples of firms doing this?

For those brand new to the durable goods problem, be sure to read Coase’s short 1972 paper before you tackle Bulow.

Update 11/29: I reply to a few objections here.

Do Elections Matter?

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I am told that there will be an election next week. Actually nobody told me; it’s what I gathered from the yard signs. Elections, for me, are a spectator sport. I will probably be up all night watching the Prop 19 returns come in, but I haven’t participated since Bryan Caplan showed me the mathematics of voter decisiveness.

While I agree with Caplan and others that voting doesn’t matter, my own research (very much in progress, caveat emptor) is making me wonder whether it’s possible, even in theory, for an election to matter. We all know that an individual vote doesn’t change the outcome of an election. But does the outcome of an election causally change policy, or does it just correlate with policy change?

Increasingly, I think the latter. Here’s one thought experiment: what would policy in the US look like if it were an autocracy instead of a democracy and nothing else were different? That is, let’s impose a strong ceteris paribus condition and change the form of government from democracy to autocracy.

My tentative reaction is that everything would be roughly the same as it is now. Think about it in Coasian terms. Government policies impose negative externalities on some people. Those people have an incentive to bargain with other people in order to get that policy changed. That can be as simple as bribing the autocrat to change the policy, or as radical as a coup in which defectors from the regime are promised larger returns than they are currently getting.

As in any Coasian theory, transaction costs matter, and insofar as transaction costs prevent exchange, it is possible for the nominal form of government to make a difference. This is why the nasty autocrats are so nasty; they have mechanisms, based on ethnicity, ideology, or external support, of preventing the exchanges that would remove them from power. But in the US, transaction costs seem reasonable even if they are not negligible. Furthermore, transaction costs must be evaluated relative to the externalities to be addressed. Modest transaction costs mean only modest externalities remain. As the externalities increase in magnitude, holding transaction costs constant, the greater is the likelihood that exchanges will resolve them.

If the US were a ceteris paribus autocracy, with the modest transaction costs and wide distribution of power that now exist, we’d get basically the same outcomes we have today. I’m not saying it would be exactly the same, but it would be close. And if that statement is true, then it must also be the case that elections mostly just correlate with policy change, they don’t cause it. Changes in electoral outcomes reveal changes in constraints faced by the government, they don’t themselves drive the change in policy.

This is not just a semantic difference. It means that your opinion gets counted about the same whether you show up to vote or not. In the long run, it doesn’t matter if voter turnout is 90 percent or 10 percent, or if voter turnout is ideologically lopsided. The real constraint that the government faces is still the same. Elections don’t matter.

This is where I resist the urge to water down my conclusions with statements about how tentatively I hold these views. I hold these views. Tell me, is this my most absurd belief?

A Difficulty in the Concept of Social Welfare

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Welcome to the third installment in our series of discussions of the Most Insightful Articles in economics. Today we are discussing Ken Arrows’s 1950 article A Difficulty in the Concept of Social Welfare.

If you’re interested in politics, you may have done the following thought experiment. Suppose there are three voters—1, 2, and 3—and three alternatives—A, B, and C. Voter 1 prefers A to B to C. Voter 2 prefers B to C to A. Voter 3 prefers C to A to B. By a vote of 2-1, “society” prefers A to B. It also prefers B to C. If a rational person prefers A to B and B to C, then that person prefers A to C. But in this example, “society” prefers C to A! Is society irrational? Is this just a problem with majority rule? To cut to the chase, in this paper Arrow shows that it is a general problem. Any method of aggregating individual preferences is either irrational or has some other properties that are arguably undesirable.

One can envision collective decision-making as selecting a social welfare function and then using it to compare states of the world. Arrow defines five conditions to which a social welfare function ought to hold:

  1. The function is universally defined. There are not certain preferences that people can have that cause the function to be indeterminate (though the function is allowed to express indifference).
  2. If someone decides that X is more desirable than he initially thought, and nothing else changes, the social welfare function cannot penalize X.
  3. The function should provide the same ranking for a subset of options as it would for that subset within a complete set of options. Adding or removing an option should not affect the ranking of other options.
  4. No preferences are taboo. Any social preference ordering is possible if people have the right individual preferences.
  5. The function must be collective in the sense that it does not simply mimic one person’s preferences.

Seems reasonable, no? Arrow’s proof proceeds by contradiction. He assumes that there are two individuals, three alternatives, and a social welfare function that satisfies the above conditions. These assumptions lead to three consequences:

  1. If both individuals prefer one outcome to another, then the social welfare function prefers it as well.
  2. “[I]f in a given choice, the will of individual 1 prevails against the will of individual 2, then individual 1′s views will certainly prevail if 2 is indifferent or if he agrees with 1.”
  3. If individual 1 prefers X to Y and individual 2 prefers Y to X, then the social welfare function must be indifferent between X and Y.

Now, suppose that individual 1 prefers X to Y to Z and individual 2 prefers Z to X to Y. By consequence 1, the social welfare function prefers X to Y. By consequence 3, the function is indifferent between Y and Z. Since the function prefers X to Y and is indifferent between Y and Z, the function must prefer X to Z. However, also by consequence 3, the function must be indifferent between X and Z. This is a contradiction, which means that one of our assumptions cannot hold. In Arrow’s words:

If we exclude the possibility of interpersonal comparisons of utility, then the only methods of passing from individual tastes to social preferences which will be satisfactory and which will be defined for a wide range of sets of individual orderings are either imposed or dictatorial.

What does this mean? There is no “will of the people,” at least not if that phrase is to encompass what we normally think of as rationality. Rousseau is incoherent. Democracy can be manipulated by agenda control, as Levine and Plott show in a hilarious article in Virginia Law Review.

How can we get around this conclusion? One way is if preferences are unidimensional and single-peaked. If all voters think in terms of a single liberal-to-conservative spectrum and prefer candidates that are closer to some optimum point, then you can no longer demonstrate the contradiction. Another way is if you allow some way of expressing intensity of values (interpersonal comparisons of utility), such as by bidding with dollars, though this may undermine some of Arrow’s conditions.

For discussion: Voter preferences are shockingly unidimensional, are they not? People who favor high taxes tend also to be pro-choice on abortion. What do these have to do with each other? Does this correspondence save democracy from the charge of irrationality? Or is it further evidence of it? Does Arrow’s result explain why everyone is so dissatisfied with the government basically all of the time? In light of Arrow’s result, are some voting systems better than others? Does the fact that collective choice is incoherent mean that collective morality is also incoherent?

Next time, we will discuss Ronald Coase’s 1960 paper The Problem of Social Cost. If Arrow had read Coase, he would not have made the errors that he made on p. 334. See you in the comments!