Inequality Through the Ages

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Economists are often interested in inequality as a modern phenomenon. They collect evidence on the distribution of wealth between the rich and the poor, both in the present and over the past two or three centuries (largely since the advent of industrial capitalism). This is important for evaluating and monitoring present-day levels of inequality, for learning about the historical causes and consequences of inequality, and for examining the effects of inequality on economic performance, for example in the form of gross domestic product (GDP) growth.

In a seminar at Pompeu Fabra University (UPF) on 24 May, Prof. Peter Turchin (University of Connecticut, Complexity Science Hub Vienna) invited his audience to consider a broader view.  He began by arguing that, since approximately 10 million years ago, human structural equality has followed a zig-zag pattern. In the first stage, the strong hierarchical nature of the groups formed by our ancestral primates is likely to have led to high degrees of structural inequality, which remained the case until more recognisable forms of human society emerged.

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Source: Presentation by Prof. Peter Turchin, 24 May 2017

Approximately 200,000 to 100,000 years ago (depending on one’s definition of “human”), a large part of humanity was organised into foraging bands, and by 10,000 years ago, into small farming communities. These societies would have been more egalitarian than the social groups of their ancestral primates, due to their increased requirement for cooperation and relatively flat social structure. However, such egalitarian groups rarely grew beyond a typical size of several hundred or at most a few thousand individuals. One explanation for this is that humans can only maintain face-to-face cooperation with around 100 to 200 individuals, and therefore effective cooperation broke down once egalitarian groups grew too large.

To overcome this threshold, human societies required hierarchy. Specifically, adopting a hierarchical structure means that each individual needs to maintain face-to-face links with only his superior and his subordinates, creating a societal unit that can be scaled up indefinitely. Such hierarchical structures, combined with surplus resources generated by advances in agriculture and private property rights, allowed humans to form chiefdoms and archaic states numbering millions of individuals in the past 10,000 years. Due to their hierarchical nature, these societies were also characterised by higher levels of structural inequality, which is evident from a historical record of slavery, human sacrifice, unequal rights for commoners and elites, deification of rulers, and large wealth disparities.

When we look at modern societies, two important differences with these archaic states stand out. First, in many instances modern nation states are even larger than the societies described above, with tens or even hundreds of millions of members. Second, although present societies do exhibit varying levels of economic inequality, the severe forms of structural inequality described above have largely disappeared. Moreover, the explicit aim of many modern government structures is to benefit the public at large, for example by codifying human rights and democratic ideals. This raises an important question: how do such pro-social norms become dominant in human societies?

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Source: Presentation by Prof. Peter Turchin, 24 May 2017

Prof. Turchin emphasises that the ultrasocial behaviour required to sustain societies of many millions comes at a significant evolutionary cost to the individual members of those societies. For example, volunteering for military service involves a large sacrifice of one individual’s chances of survival for the benefit of genetically unrelated individuals. In view of this, he proposes that the rise of ultrasocial norms can only be explained by an evolutionary mechanism operating between societies.

According to Prof. Turchin, the turning point came with the advent of the Axial age approximately 3,000 years ago. In part due to advances in technology — including the use of horses to travel longer distances, and the increased use of composite bows and iron — military competition between societies intensified. In this environment, the largest and most cohesive societies are likely to prevail, for example because mustering a large army is a collective action problem that requires a very high degree of intrasocietal cooperation.

This meant that evolutionary pressures favoured the selection of societies with prosocial cultures, including those with norms and institutions that constrained rulers in order to promote the public good. This period also saw the gradual disappearance of many structural forms of inequality as societies grew, including human sacrifice, the deification of human rulers, and eventually slavery. At the same time, new world religions, whose central messages often emphasised prosocial norms, started to spread.

Two opposing forces were therefore at play. On the one hand, a society expanding in size needs to increase the depth of its hierarchy to accommodate more individuals, which tends to increase structural inequality. On the other hand, competition between societies favours more cohesive and cooperative societies with lower levels of inequality. With the advent of the Axial age, military pressures meant that the latter force began to dominate the former, ultimately yielding the (relatively) prosocial societies much of the world lives in today.

This hypothesis generates predictions that can be tested against alternative theories. For example, opposing theories could hold that inequality only started to decline in the modern age instead of following a zig-zag pattern over millions of years, that mass religion generates inequality through oppression instead of being prosocial, or that military conflict destroys cooperation and decreases social scale instead of promoting ultrasocial norms. With a view to distinguishing between such rival hypotheses, Prof. Turchin is involved in building a global historical database of cultural evolution, Seshat, with the aim of collating data from diverse sources on the sociopolitical organisation of human societies from the earliest times up to the present.

Ultimately, research undertaken in this field is likely to provide important insights for the inequality debate in economics, as well as other economic issues. For example, if they are correct, the arguments summarised above have implications for development theory and the mechanics of how individual nation states become more successful, prosocial societies. They also have implications for the cooperation required between nation states to address global issues such as climate change.


References

Turchin, P.  (2015) Ultrasociety: How 10,000 Years of War Made Humans the Greatest Cooperators on Earth. Beresta Books.

10 Years, 5 Leading Economists: The BGSE Anniversary Roundtable (Part 2)

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Students with Professors Alvin Roth and Christopher Sims

This is the second of two posts reporting on the roundtable discussion that took place on Friday, 31 March as part of the BGSE’s 10th Anniversary Celebrations. The first post focused on the contributions of the first three speakers,  Prof. Richard Blundell, Prof. Matthew Jackson and Prof. Anne Krueger. This post discusses the contributions of the last two speakers, Prof. Alvin Roth (Nobel Laureate 2012) and Prof. Christopher A. Sims (Nobel Laureate 2011) on  “The Practical Influence of Economic Research”.

Prof. Alvin Roth, Stanford University

Parothrof. Roth began by talking about the practical influence of his own research on matching markets. As Prof. Roth explained, these are markets where prices do not succeed in bringing the demand side and supply side of the market together. For example, while in a commodity market the price determines who will produce the good (those firms that can make profits at the given price) and to whom they will sell it (those with a willingness to pay greater than the price), the same cannot be said for the placement of students in public schools or the placement of new doctors in their first hospital.

Prof. Roth set out how economists’ research in matching markets played a crucial role in the design of more efficient school assignment systems. One problem in assigning learners to public schools, for example, is that parents may be incentivised not to list their first choice of school at the top of the list they submit to the relevant education authority, because they believe that their children’s chances of being assigned to the first choice is slim, and so they list their second or third choice at the top. However, in order to assign children to schools efficiently, the authority needs to know what parents’ true preferences are, and in this case economists can help to design the market such that parents have an incentive to reveal their true preferences.

Similarly, the college admissions process typically involves some congestion, since prospective students typically apply to many colleges,  but only accept a place in one college. This means colleges are faced with repeated rounds of admission decisions once they are informed that students who were accepted will not take up their places. A more efficient system would have prospective students submit their preferences over all colleges in advance, and are then placed in a single round using a central assignment mechanism.

Aside from designing more efficient matching markets, Prof. Roth also believes that economists can play an important role in gathering or producing evidence for the policy changes they advocate. As an example, Prof. Roth mentioned economic experiments undertaken in the United States (US), which convinced US policymakers to adopt a new mechanism for assigning new doctors to their first hospital, whereas those policymakers used to be reluctant to accept these theoretical arguments or experimental evidence from other countries.

Finally, Prof. Roth also voiced support for Esther Duflo’s view that economists have an important role to play as “plumbers”. This involves analysing and finding solutions for the ways in which markets do not perform well, due to some unforeseen practical obstacles not accounted for in the relevant economic model. In this respect, Prof. Roth talked about economists’ design of a matching market for kidney donors. Often friends or family members are unable to donate a kidney to a patient due to incompatibility of the donor and recipient, but this problem could be solved through a cross-matching mechanism whereby a donor-recipient pair is matched with another donor-recipient-pair in order to achieve compatibility.

However, in practice doctors often end up rejecting such matches for medical reasons in unforeseen ways. Economists designing this market are therefore faced with a practical problem to solve, namely how to elicit doctors’ preferences in such a way that once a kidney is matched to a patient, the doctor does not ultimately reject the organ for the operation.

Prof. Christopher A. Sims, Princeton University

Prof. Sims’ conProf.Chris Simstribution was concerned with developments in his own field of monetary policy, including the 2008/2009 financial crisis, and he began by pointing out that many central bank employees (including the heads of central banks) graduated with PhDs in economics, and therefore economics is certain to have a practical influence on monetary policy. In this respect, Prof. Sims believes that the effects of the financial crisis would have been far more serious if Ben Bernanke (and other policymakers) had not relied on the lessons of the Great Recession of the 1930s in implementing dramatically expansionary policies in response to the crisis.

In order to provide further context for his discussion of the financial crisis and the policy response in the United States, Prof. Sims noted that the policy prescriptions of monetarism had been a mistake, and that instead of aiming only at a constant growth rate of money, monetary policy should use interest rates as a tool to smooth fluctuations in economic activity. According to Prof. Sims, this shift in focus did indeed result in increased stability in the period leading up to the financial crisis.

Nevertheless, the overwhelming majority of economists, and in particular those in charge of monetary policy, did not predict the financial crisis, and the question has been asked why they were not able to do so. However, according to Prof. Sims, the role of economists in this instance can be compared to that of seismologists. In the same way that seismologists cannot predict earthquakes, but can only analyse them and provide very broad guidelines on when they might be likely to occur, recessions are inherently unpredictable, and economists should not be expected to predict them in advance.

A further question addressed by Prof. Sims is why the Fed chose to keep interests rates so low in the years leading up to the financial crisis. According to Prof. Sims, the Fed did have a rationale in adopting this policy, namely that it recognised the risks of falling into the kind of trap experienced by Japan since the 1990s, where the economy experiences low growth and the central bank is unable to provide monetary stimulus due to the zero lower bound on the interest rate. Nevertheless, it remains an open question whether the Fed should have better weighed these risks against the risk of creating a crisis through an extended period of low interest rates.

A further interesting possibility raised by Prof. Sims, although he did not address it conclusively,  is whether the post-monetarist stability leading up to the crisis paradoxically served to increase its severity. Here Prof. Sims again used an earthquake metaphor: if engineers design structures that are more resistant to earthquakes, this could allow a society both to construct more buildings, and to construct taller buildings that hold more people. In this way the original technology designed to protect the society against earthquakes could increase the expected damage of a very serious earthquake. In the same way, increased economic stability could have contributed to the deregulation and expansion of the financial sector which amplified the effects of the financial crisis.

Ultimately Prof. Sims expressed the view that economics as a field cannot carry the blame for an event such as the financial crisis. Which monetary policy is appropriate at a given moment is a hard problem, and economists should not carry the blame for attempting to tackle such problems, which are important to analyse, even if they are not completely successful in solving them.

10 Years, 5 Leading Economists: The BGSE Anniversary Roundtable (Part 1)

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On Friday, 31 March, the BGSE played host to a number of Nobel laureates and other leading academics from around the world as part of its 10th Anniversary Celebrations. The first event of the weekend was a roundtable discussion with five eminent academic guests about “The Practical Influence of Economic Research”. This post highlights some of the main points to come out of the contributions of the first three speakers: Prof. Richard Blundell, Prof. Matthew Jackson and Prof. Anne Krueger.

Prof. Richard Blundell, University College London

blundell-photoWith the help of attendant BGSE staff, Prof. Blundell overcame a minor hiccup with his microphone to speak on the practical influence of his research in the microeconomics of public policy and tax reform, and argued that the evidence economists present can have an important impact on government policy. As an example, he referred to the Mirrlees Review, which was produced under the auspices of the UK’s Institute for Fiscal Studies (IFS), and published in 2011, with the aim to  “identify the characteristics of a good tax system for any open developed economy in the 21st century, assess the extent to which the UK tax system conforms to these ideals, and recommend how it might realistically be reformed in that direction.”

According to Prof. Blundell, the Mirrlees Review has been successful in identifying flaws in the UK tax system (and those of other countries), such as effective marginal tax rates that decrease over certain ranges of income levels, and that differ across different sources of income, such as earned income, self-employment income and dividend income.  Tax benefits for low-income members of the population also tend to be unnecessarily complex and difficult to understand. These aspects of developed economies’ tax systems carry particular weight in the context of increased inequality and decreasing incomes at the lower end of the income distribution.

Prof. Blundell also argued that the Mirrlees Review has had some success in addressing these flaws, referring to the fact that a number of UK lawmakers have accepted some of its core proposals, and that the Review has been widely translated and distributed around the world.

Prof. Matthew O. Jackson, Stanford University

mojackson.jpgProf. Jackson started his presentation with a question that would be referred to a number of times by other speakers in the contributions that followed: what is (and what should be) the role of economists in society? Prominent economists have offered different definitions of their role since the inception of the field, variously likening the profession to those of artists, ethicists, story-tellers, scientists, engineers and, most recently, plumbers. Prof. Jackson focused mainly on the contrasting characterisation of economics as story-telling (as propounded by Robert Lucas) or as a science.

According to the story-telling view, economists deliberately work in an “unrealistic”, simplified world in order to tell us useful things about the real world using the power of imagination and ideas. In contrast, seeing economists as scientists doing the same kind of work as, for example, physicists, would imply that economists are engaged in discovering universally applicable laws of how markets work, and how firms and consumers make decisions. Ultimately Prof. Jackson highlighted how many of the most exciting recent advances in economics appear to fit better with the characterisation of economists as engineers or plumbers, such as recent developments in market design and development policy.

Prof. Jackson concluded by pointing out the potential practical implications of his own research on economic and social networks, and how modern technological tools can help us to better understand such networks. As an example, he referred to a figure produced using Python, showing how the US Senate had become more partisan over time, by drawing connections between senators that voted for the same legislation across party lines, and illustrating how the number of connections between Democrats and Republicans had declined over time.

Prof. Anne Krueger, The Johns Hopkins University

Prof. Krueger hiakrueger.jpgghlighted two ways in which economists exercise practical influence, namely by providing evidence that influences policy, and by providing blueprints to follow when change happens too fast for appropriate evidence to be gathered.

Regarding the former avenue of influence, Prof. Krueger’s points were in line with those made by Prof. Blundell.  Her most important example was India’s use of a small scale industry (SSI) reservation policy for more than 60 years, through which the Indian government reserved the production of certain goods to firms that employed fewer than a specific threshold of employees. Economists ultimately produced convincing evidence that this policy was not allowing firms in the reservation industries to exploit economies of scale, thereby rendering them uncompetitive relative to producers of the same goods in other countries. According to Prof. Krueger, this economic evidence helped to convince the Indian government to scale back and ultimately do away with its SSI reservation policy, to the benefit of Indian businesses in the affected industries.

Prof. Krueger made a similar argument concerning the cost of protecting employment through the use of import constraints, and referred to an example in the US where the costs of higher prices to consumers of import protection were many multiples greater than the employment income saved through that protection.  Prof. Krueger argued that by attaching figures to these costs in dollar terms, economists could influence lawmakers to adopt better policies.

Finally, Prof. Krueger referred to the 2008 financial crisis as an instance where economists had formulated a blueprint for responding to a rapidly changing situation, partly based on research on the Great Depression. Prof Krueger argued that this blueprint, which among other things called for large monetary and fiscal stimulus, had probably prevented a more serious recession following the crisis. As a further example, she mentioned the Mexican sovereign debt crisis of 1982, and argued that the structural reforms proposed by economists as a blueprint following the crisis have helped Mexico to achieve a better economic position than it otherwise may have done.

Continue with Part 2, which covers presentations by Prof. Alan Roth and Prof. Christopher Sims

2017 Competition Curtain Raiser, Part 1: Excessive Pricing

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This is the first in a series of posts highlighting competition issues and cases that are set to drive the debate in Europe this year.

Pfizer and Flynn Pharma: a major decision from the CMA

On 7 December 2016, the United Kingdom’s (UK’s) Competition and Markets Authority (CMA) issued a potentially precedent-setting decision against pharmaceutical producer Pfizer and distributor Flynn Pharma, imposing a fine of nearly £90 million for excessive pricing.

In September 2012, Pfizer sold the distribution rights to its anti-epilepsy drug Epanutin (phenytoin sodium) to Flynn Pharma, which debranded (or “genericised”) the drug, with the effect that it was no longer subject to price regulation. Following the sale, Pfizer increased its price for phenytoin sodium to Flynn Pharma by between 780% and 1,600% relative to the price at which it had previously sold the drug in the UK, and in turn Flynn Pharma increased the wholesale price of the drug to between 2,300% and 2,600% of the former price.

A key feature of phenytoin sodium appears to be that patients taking the drug cannot readily switch to the same drug manufactured by another producer, since even minor differences in production processes could affect the efficacy of the drug in treating epilepsy in individual patients. Therefore, despite the fact that the drug was genericised, the CMA appears to have found that Pfizer and Flynn Pharma retained a de facto monopoly over the sale of the drug to existing patients taking Epanutin. Such a finding would also imply that alternative epilepsy treatments were not viable substitutes for phenytoin sodium in respect of the relevant patients, and were therefore not included in the definition of the relevant market.

The excessive pricing debate

The prohibition of excessive or unfair pricing by dominant firms is a controversial part of UK and European competition law (it has no meaningful counterpart in US legislation or case law). On the one hand, there are strong economic arguments, at least from a static point of view, for preventing a dominant firm from exploiting its monopoly position by charging prices higher than the theoretical competitive price. One of the key results of microeconomic theory (and indeed the foundation of competition policy) is that monopoly pricing lowers overall welfare compared to a competitive market outcome, since the monopoly maximises profits by producing a less-than-efficient quantity of the relevant good and selling it at a higher-than-efficient price.

However, enforcing a prohibition against excessive pricing presents various difficulties. One of these is to establish a benchmark price against which the actual price charged by the dominant firm is to be evaluated, and deciding whether the margin above this benchmark is excessive. According to the CMA press release, it appears to have had regard both to the initial regulated price of phenytoin sodium, and the price charged by Pfizer in other European countries, in reaching a finding of excessive pricing.

It is important to note, however, that there is no inherent reason why such prices should represent useful comparators. In other words, although a price increase of 2,600% naturally appears alarming at first glance, a range of factors could have resulted in the initial price being very low, especially if it was regulated. In this case, Pfizer and Flynn Pharma argue that the regulated price of Epanutin in the UK prior to September 2012 had been loss-making. It remains to be seen how the CMA established a relevant benchmark when its non-confidential decision is made public.

A further risk in enforcing a prohibition of excessive pricing, partly related to the issue discussed above, is that it could have a negative impact on firms’ dynamic incentives to invest across the economy. For example, over-enforcement could prevent a firm from earning economic profits where it has innovated in order to gain a temporary competitive advantage. More generally, over-enforcement runs the risk of creating uncertainty, and thereby lowering incentives to invest, if businesses fear that their future profits will be capped by a competition authority at a level which they cannot predict in advance.

For such reasons, economists such as Massimo Motta and Jorge Padilla (both teaching in the Competition masters at BGSE)  have proposed that excessive pricing provisions should be enforced only in cases where there is little or no prospect of the relevant market eventually correcting itself, and where a sector regulator would not be better placed than the competition authority to intervene (among further restrictive conditions). In this case the CMA may have concluded that the inability of other phenytoin sodium producers to compete for existing Epanutin patients created such a situation where entry is infeasible. Even so, the question remains whether this issue could not better be addressed through amending existing drug price regulation. The release of the CMA’s final decision is likely shed more light on this issue.

What to look out for in 2017

In the meantime, Flynn Pharma has appealed the CMA’s decision to the Competition Appeals Tribunal (CAT). 2017 could therefore reveal how the CAT views the different considerations surrounding excessive pricing, and to what extent the CMA decision will be applicable to other drugs and industries. The finding of excessive pricing also raises the prospect that Flynn Pharma’s customers, and specifically the UK Department of Health, could sue it for damages resulting from the high price, which would raise further interesting issues in so-called “private”  excessive pricing enforcement.

References

Evans, D.S. & Padilla, A.J. 2005. “Excessive Prices: Using Economics to Define Administrable Legal Rules”. Journal of Competition Law and Economics 1(1), pp. 97–122.

Motta, M & de Streel, A. 2007. “Excessive Pricing in Competition Law: Never say Never?” The Pros and Cons of High Prices, pp. 14-46. Swedish Competition Authority.

Markets or organisations? UPF guest lecture by Robert Gibbons

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Image source: UPF

If an alien came to earth from outer space wearing glasses that show organizations in pink, and markets in green, what would it see? Would it see more green, and describe our activities on earth as a market economy, or more pink, pointing to an organizational economy? What systematic differences would it notice between underlying circumstances that give rise to green systems, and circumstances that give rise to pink, and would the quality of the outcomes differ for markets and organizations? Finally, would the alien be able to give any advice on how to improve outcomes where we try to solve problems by means of organizations?

Continue reading “Markets or organisations? UPF guest lecture by Robert Gibbons”