Convergences

Marginal Cost & the Content Industries

[The following was posted on the AEI's Enterprise Blog yesterday.]

Margin of Error: Against a Persistent and Pernicious Fallacy

By James DeLong

January 29, 2010, 5:24 pm

In a pair of recent posts (here and here), Matt Yglesias embraces one of the most pernicious and destructive fallacies of economic thought: the proposition that prices “should” equal marginal cost. As my colleague Solveig Singleton explained in “Is Cheaper Always Better? Misusing the Concept of Marginal Cost in Policy Discussions,” the idea that “efficiency” is reached by the P = MC equation is true only in an abstract world of unrealistic and static assumptions, but the persistence of the myth continues to cause great damage.

Does the concept of static efficiency or marginal cost have *any* appropriate uses? Rarely. . . .

Models of perfect competition and the concept of marginal cost have some power to explain some of the forces at work in real markets, but they are not a sound normative measure of what the real world ought to look like.

For more discussion, see “Marginalized,” and for a real coup de grace see the eminent economist William Baumol’s 2006 monograph for AEI, How Regulators Can Be Misled By Simplistic Theory, which warns:

Only this year I heard a conference presentation dealing with the economic and legal principles of copyright suggest that the innovating Schumpeterian entrepreneurs are automatically to be deemed proper subjects for antitrust attentions because in the period before imitators enter the market, they can charge prices that exceed the marginal-cost levels of perfect competition. Never mind that this is a prescription for undermining intertemporal efficiency. Never mind that marginal-cost pricing would generally preclude recoupment of the research and development (R&D) costs of the innovations at issue, costs that will have to be incurred many times again if innovation is to continue.

Baumol is too kind in limiting his indictment to “some economists” who are “not as careful as they should be,” because the fallacy and its consequences are woven into a great deal of professional analysis and policy recommendations, not to mention most of antitrust.

Six years ago, the Competitive Enterprise Institute (CEI) did an excellent workshop on Declining Marginal Cost Industries, featuring talks by giants Ronald Coase and Lester Telser. (Disclosure: I helped Fred Smith put it together.) The descriptive blurb notes:

The declining marginal cost problem remains the key challenge to a range of industries. As Ronald Coase long ago noted, a declining cost industry must find some way to finance itself: either via creative multipart pricing (facilitated by bundling or contracts) or via some form of government subsidy. The markets solution has traditionally relied on distinct marketing strategies in different geographic regions and to different segments of the markets, with market segmentation facilitated by the high costs to consumers of transport and/or the difficulty of acquiring information about the prices paid by others. The government subsidy approach inevitably entails government regulatory and /or price controls (there are no “free” subsidies). Clearly, we prefer the market solution.

Homeland Insecurity

[The following was posted on the AEI's Enterprise Blog today. An additional source should also be added -- Stewart Baker has a book on security issues coming out soon. See Skating on Stilts.]

The Monsters Coming Out of Your Computer

By James DeLong

January 29, 2010, 5:44 am

The Center for Strategic and International Studies (CSIS) and McAfee security company put on a panel this week to release their report “In the Crossfire: Critical Infrastructure in the Age of Cyber War.” A simultaneous release occurred in Davos.

The approach was a survey:

Six hundred IT and security executives from critical infrastructure enterprises across seven sectors in 14 countries all over the world anonymously answered an extensive series of detailed questions about their practices, attitudes and policies on security-the impact of regulation, their relationship with government, specific security measures employed on their networks, and the kinds of attacks they face.

If you weren’t nervous when you walked into the event, you should have been when you came out. The attacks are unrelenting, and, as one of the panelists pointed out, the bad guys are not faced with intractable problems of coordinating across large and sclerotic public and private bureaucracies and political jurisdictions, and they don’t spend all their time in meetings. In particular, governments are making inadequate use of the information and expertise that exists in the private sector.

It was a good, tough discussion, with lots of solid nuggets from people who know their business. (The audio is here.) There are some unexpected twists. Not surprisingly, the oil and gas industry is a prime target because its information is valuable. But the oil and gas industry can harden up; who hardens the water & sewer system, where the information is not valuable but the potential for disruption is very high? How do we reconcile an open and public Internet with increasing security concerns?

The report’s lead author was Stewart Baker, former assistant secretary of Homeland Security and former general counsel of the National Security Agency. After the session, he recommended a couple of other useful reports: SecDev’s “Tracking GhostNet: Investigating a Cyber Espionage Network” (2009), and “Capability of the People’s Republic of China to Conduct Cyber Warfare and Computer Network Exploitation,” prepared by Northrop Grumman for the U.S-China Economic & Security Review Commission.

Prepare to sleep with light on. The monsters may not be in the closet, but they are coming out of your computer.

Biotech, IP, & Regime Uncertainty

The din over health care legislation obscures the subsidiary fights occurring at odd corners of the battlefield. One of these concerns data exclusivity for biotch research results, an important topic of passionate interest to the industries involved that gets no attention whatsoever from anyone else. (For a description of the issue, go here.)

The industry wants an exclusivity period of 12 years (well, it wants more, but will settle for 12), and it appears to have locked this into the existing legislation in both the House and Senate, over the opposition of House health baron Henry Waxman and the Administration, who think 7 years is enough. 

But nothing is over until its over, and Waxman and the Administration, and the generic manufacturers, have not quit trying to squeeze the period down, according to the AP. It could just be bargaining, notes the article. In the sink of corruption called DC, there is no particular reason to think the advocates of a shorter period believe actually this is pro bono publico:

The drug industry . . . is already under pressure to boost the $80 billion, 10-year contribution it agreed to make to the overhaul last year.

The effort to reduce biotech drug protections could be a way for the administration to pressure the industry to increase its contributions, or to make it easier for Obama to show the $80 billion deal with drugmakers will benefit consumers.

I favor more IP protection rather than less, for reasons explained in Bleeding Biotech.  However, whatever the outcome, it would be nice to have the decision made as a result of an assessment of the needs of the innovation system rather than on the basis of an auction of political support.

Fierce Biotech is afraid that all the work (if one can apply this name to massively expensive influence peddling) already done may be for nought. If health care does not pass, then this issue, like many other sub-problems, will be back to square one, and the incentives for innovation will continue to suffer from regime uncertainty. 

This is unfortunate, because the only realistic road to increasing the efficiency of the system goes through fostering innovation, not discouraging it.

A Rumble of Tumbrils

By all accounts, DC lobbyists have never had a better year, as companies (and unions, and non-profits, and public employees) jostle for places at the government trough, and this spectacle has been a prime fuse for the Tea Party movement. In the Daily Beast, Tunk Varadarajan pegs the real reason for the nastiness of the soi-disant "educated classes", who are major players in the scam: the people have caught on:

Yes, the populists fear and hate the big businesses and Wall Street; but—and this is the heartening thing—they have not let this turn them against capitalism and the free market. They seem truly to have taken in the point, long emphasized by libertarians and others, that big business is not the same thing as capitalism or the free market, that it is in fact often their enemy. Perhaps the Obama administration has finally driven this point home, as it has been an object lesson in how the party of big government is really in bed with big business, giving it all the bailouts and favors. So by this reckoning, the Tea Parties would be a very serious development in which anti-big business forces would finally join with anti-big government forces to create a genuine free-market party that would maximize the opportunities of the little guy—like this small-business owner from California. (Note, this YouTube clip has nearly 250,000 hits and 6,000 comments.)

This video makes me emotional, because this woman represents an America that Tocqueville would have lauded. I will take her any day over the “educated class,” the bureaucratic mollusks and the defeatist sad sacks in Washington. I do think the Tea Partiers are political amateurs, but the content of their politics is deadly serious. The professional politicians will dismiss them at their peril.

Gresham's Law of Politics

Gresham's Law is that "bad money drives good money out of circulation." In fact, though, this is true only if government insists that citizens treat the bad and the good as equivalent legal tender. If people are free to choose, the good money will become the dominant medium of exhange.

So it is in politics. If the government rewards the base metal of favor-seeking, subsidies, and crony capitalism, then these will drive out the gold of actions that make the economy, the market, and the political system actually work better.

And we are there. Politico says, in "New Groups join climate lobby fray", that 1,160 businesses and groups and 2,780 individual lobbyists are working on climate change, including such newcomers as Campbell Soup, plus 170 alternative energy reps.

And every one of these is trying to twist any legislation to corporate advantage, without looking at the issue whether the whole enterprise is a bubble that is on the verge of bursting.

My bet is that it is a bubble -- as the government has become more active, it has become much better at creating bubbles, as in the housing market via Fannie and Freddie and in the financial markets with a host of misguided requirements. The climate change bubble will make it a hat trick.

An Education on Climate Change

Climate Skeptic has a great 90-slide presentation on Catastrophe Denied: A Critique of Catastrophic Man-Made Global Warming Theory. (Also available as a PowerPoint.) It delves into the theories and arguments of both sides, and is readily accessible for us scientific semi-literates.

One of his key points concerns feedback effects. Without positive feedback, fear of warming becomes untenable. CS examines the evidence, but also explains why any claim of runaway positive feedbacks must be viewed warily:

When a natural scientist looks at a natural process that is new to her, she is going to assume that process is driven by negative feedback, especially if that process has been stable for hundreds of millions, even billions of years. Take climate - it has been fairly stable within certain bounds for millions of years. . . .

But this hypothesis of incredible stability is hard to square with the positive feedback hypothesis we discussed before, that the climate is a car perched on the top of the hill, needing only a small nudge for it to roll out of control. This strong positive feedback case, and in particular the tipping point phenomenon that alarmists are always talking about in the news, make no sense -- they defy any intuition a natural scientist might bring to a complex process. Long-term stable processes are not balanced on the top of a mountain where they could be tipped over the edge, or else they would've already been tipped over the edge long ago. Something would have sent that car down the mountain millions of years ago if it was really so precarious. The same is true with climate.

Another Year Older, And Deeper in Debt

The collapse of the special interest state comes nearer. Coyote Blog points out that states are disabled from dealing with their budget problems by a combination of federal strings and judicial imperialism that prevent adjustments. He notes: "Just about everyone except for taxpayers have a set of lawyers in courts full time preventing budget changes that affect their special interests."

The end state is ineluctable: "The only way through this is going to be a massive string of state and local government bankruptcies."

A commenter finds a half-full glass in this:

At every level from state pensions to federal gov’t Treasury bonds, liabilities have been accumulated that cannot possibly be paid. It’s mathematically impossible.

The sooner they begin defaulting in earn[est], the sooner we can get through this Depression and the sooner we can begin rebuilding on a more stable basis.

Sure, the Depression will be painful. But the longer we postpone it, the more debt we rack up, the worse the pain will be when we are eventually forced to deal with it.