A Scientist for Every Issue

What sparked my interest in economic history was actually a book which had very little to do with the past. It was ‘The Cult of Statistical Significance’ by Steven Ziliak and Deirdre McCloskey.  The book was, as you have probably guessed about statistics; furthermore the authors argued that statistics was having a negative effect on the way that economists undertook research. They argued that economists liked to appear scientific and one of the ways to do so was to use statistical significance. A clean cut, simple procedure that gives a right or wrong answer appeals because it seems to offer a degree of certainty to a researcher’s findings. Does smoking lead to an increase in the use of other drugs? Do a t-test and you have your answer. However what exactly does the test of statistical significance prove? The answer, to the authors, was not much.

I am not going to talk more about this debate here (as it is quite technical, divisive and will likely bore the pants off anyone that isn’t interested in doing research in the social and natural sciences). One of the points that I did take away and thought would be interesting to talk about, was that economists can benefit from grounding their work in a wider context.

How to Build a Discipline from the Ground Up

This is where economic history can really play a part. Firstly modern neoclassical economics, the stuff that gives us supply and demand diagrams and the toolkit for how a central bank should be run, is based on a number of key assumptions about the nature of the world. Many of the debates on these assumptions happened over a hundred years ago.

Take for example the theory of value. What should the price of a good be? Should it be decided by how much of each input goes into its production?  Or should it be decided by how much use that people get out of it? Why don’t we just let the market decide and take that as its value? If the first case is true then is the value of the internet, which as a service is very cheap to provide for each user, valueless? Likewise if we use the third option and let the market decide then the internet is still pretty cheap. However, people clearly get a lot out of the internet. It has created a great deal of what economists call consumer surplus; that is what consumers get in value above and beyond the price they pay.

Trial and error, a 10000 year experiment

Secondly it allows us to enrich many of the theories we have to explain the world as it is today. I am currently reading another book (this is the last I will mention I promise!) called ‘Structure and change in economic history’ by Douglas North. In the book he attempts to create a theory which can explain why economies over time fair well and poorly.

For example, we can explain why humans moved from a hunter gatherer society to organised agriculture. For the first million and a half or so years of our history humans occupied a very small area of the globe. There was a lot of space and so as our population grew there was little pressure on hunting resources as new groups or clans could simple move into territory unoccupied by other humans. However, as the world began to be filled up the amount of free space decreased. This caused a decline in the marginal benefit of hunting as there were fewer animals to go around, and there was no incentive for tribes to not exploit all of the animals that surrounded them. If they decided to not hunt a herd or buffalo, some other tribe would. Hunting suffered from what the tragedy of the commons. At some point, the marginal productivity of hunting must have fallen below that of agriculture. When this happened it became in the interest of tribes to start farming, as extra hunters had very little effect on how much game a tribe would catch. Over time agriculture became more and more productive (from breeding crops, improving techniques etc.) and eventually replaced hunting as the main form of food production.

There are no ways of testing such a theory, but it is interesting none the less. It also demonstrates how central property rights and natural resources, two items usually omitted from modern economical analysis, can be in examining the nature of the world.

As our society advances, we have to deal with the consequences of our previous actions. Environmental problems that resulted from unsustainable usage of limited resources on Earth is a prime example of this. Governments and international bodies now put a lot of effort into addressing this issue. The focus has been placed on raising awareness, and it has certainly become somewhat of a social trend (think about the movie Avatar). The question is whether giving people information alone will be enough. Will the knowledge motivate us to act?

It probably will in most cases… assuming everyone has the same moral standard (or can be succumbed to peer pressure). Supposedly moral individuals will act to protect the environment (at the cost of their present material benefits) because they care about the future generations, self-preservation and anything that is morally right. From the game theory perspective, their payoffs from protecting the environment is higher than from not protecting. However, people are different, and we cannot just assume that everyone will behave in a moral for us way. In the end, a person does not have to care about the future if he thinks he has no stakes in it. He will rather use the most of what he can access now and get a higher payoff from polluting. We can call him a selfish moral monster and humanity might become extinct because of his behaviour, but he will be dead by then anyway and does not care. This possibility is very difficult to accept.

Nevertheless, game theory allows this to happen. Game theorists are not concerned with the motives behind each individual action, they care only about the fact it has been chosen (hence must have given a higher payoff). Perhaps, this makes it easier for them to predict all possibilities and incorporate all types of behaviour. Given this, what can we do to protect our environment? In academic circles, the Tragedy of the Commons has been used for a long time to illustrate what will happen if we use resources unsustainably. However, not many focus on the actual solution to the problem, they clearly thought that showing people the problem is enough. We need to rely on something more than people’s morality. Mechanism Design is a branch of game theory that deals with this. It tries to change the conditions of the game in such a way that polluting will directly affect everyone negatively at present. This will in turn prompts each individual, no matter how moral he or she is, to act in the desired way for us.

John Lennon’s famous song Imagine is about the perfect utopian society, which in many sense is a communist society. It is the society most of us dream about. The idea of sharing resources responsibly is so great, but at the same time so unobtainable. However, game theory might just give us a clue on how to solve existing social problems and make little steps towards that imaginary perfect society.

John Lennon – Imagine

So, where does the trick lie? Apparently, it is all about branding and marketing (although some bottles water executives disagree). Apart from the convenient packaging, people are supposedly buying trendy brands. I guess in the end we do derive different types of utility from the same resource. Marketing in this case plays a huge role in the market growth.

This paradox does not completely ruin our perception of Economics, but it does make us realise that there are still many things we do not understand.

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A relationship between the environment and economics is inevitable as economics is the study of scarce resources, resources that we source from the environment around us. The Stern report, which was published in October 2006, was not the first study to discuss this relationship, however, Stern emphasised the cost of environmental degradation to us in terms of global gross domestic product (GDP, something economists could easily relate to) with shocking results.

According to Stern’s model a realistic projected world temperature increase in the next century of 5-6ºC would result in a 5–10% loss of global GDP with poor countries being be affected with a 10% loss of GDP. So what is global GDP? Again, according to Stern, 0.5% of global GDP is equal to $200billion so a loss of 5-10% equates to $2-$4 trillion, an unimaginable quantity.

However, Stern does not wallow in disaster or create colourful stories of probable Armageddon but focuses on what can be done, sprinkling a little hope on what is already a heavily discussed and gloomy topic. To counteract the effect of climate change a reduction of emissions by 80% is required, this cost are ‘low in comparison to inaction’. Keeping the CO2 emissions at reasonable levels will require an annual cost of 1% of global GDP according to central estimates. The problem with the estimation is that it depends on technology; if the development of low carbon emission technology is slow the costs will be higher, whereas if the technology is quickly developed the costs will be smaller.

Decreasing carbon emissions will not be an easy task, in terms of practicalities; adopting cleaner power, energy efficiency and transport technologies, present enough problems within themselves. But then the international aspect is added into the mix, some countries produce more then others, some can afford more then others, and some care more then others, so who takes charge? Stern does not believe individual action is sufficient. The Kyoto Protocol and the UN Climate framework are certainly a good basis for international co-operation but by no means are they enough, rather an ‘international vision of long-term goals’ is required within an international framework. This takes us deep into the bureaucratic nature of international organisations and their inefficiency, a complicated and avoidable topic.

So, according to Stern, there is hope. It is in our best interest to act sooner rather then later, not purely for monetary gains but also because of the effects of our actions on generations to come. So what if no action is taken? The report predicts an ever-increasing concentration of greenhouse gases leading to global temperature rising, in the long term, the probability of the temperature rising by 5ºC is 50%. We may not complain about having a warmer summer here in Britain but, for comparative reasons, a 5ºC increase is the same change in temperature that occurred between the last ice age and now. A remarkable change in the way lives are led will occur, fundamentally, the way we are living now is not sustainable and we must act to prevent any more irreversible damage.

Steps towards a better environment are gently being formed. More supermarkets are implementing a small fee for their plastic bags or incentives for reusing them. Car taxes depending on the amount of CO2 emissions have been introduced. The question is whether this will make enough of a difference. The goal is to reduce carbon emission by 80% yet Stern predicts that in 2050 half of our energy will still come from fossil fuels, the other half from renewable energy and nuclear (a disputed topic in itself).

What it all appears to boil down to is sustainability. We are not living in a sustainable way and future generations will suffer the consequences, Stern states that we are too late to alter what may happen in the next few decades but we can change what will happen in the next few centuries. A continuation of extreme weather patterns is likely to occur in the next few decades, the 2003 drought in Western Europe for example, or Hurricane Katrina.

So how do we overcome the market failure? By allocating the resources efficiently or by investing in research and technology? We have, so far, failed as an international system to efficiently allocate resources, but research and technology take time, a factor we don’t have the luxury of. Since publication the Stern review has experienced both positive and negative critical response with the report being deemed political.

For further reading on the subject
The Stern Report

Tim Harford on the Stern Report

So why do we still feel uncomfortable stepping through Tesco’s (or Sainsbury’s, Asda’s and Morrisons) ever more prevalent sliding doors, when they can claim to be cutting our bills without crucifying our consciences?

Economists, when allowed to look beyond the Competition Commission’s brief, also look at big retailers macro-economic effects. Supermarkets have been a major vehicle for the recent slowdown in UK, European and American inflation. There is controversy over the source of their cost savings (genuine efficiency gain, or squeezing of suppliers and employees under threat of low-cost outsourcing). But there is little doubt over the disciplining impact on the retail price index, which covers items mainly sold through the Big Four, with their 75% share of UK grocery sales.

The wide and persistent trade deficits run up by the UK and US also owe much to supermarkets, who trawl the world for lower-priced industrial products and more exotic foods. Former IMF Research Director Kenneth Rogoff, in a recent Project Syndicate comment, notes that more than 10% of US imports from China pass through leading US store chain WalMart (parent of Asda in the UK). WalMart produces 2% of US GDP and has been the world’s biggest employer since 1999, its 1.2m payroll giving its CEO more people to rule over than the King of Swaziland.

Rogoff also observes “ with some disbelief “ that ‘big box’ retailers led by WalMart account for half the past decade’s US productivity growth differential over Europe. Wider changes to the distribution system, largely driven by big supermarket purchasers, are responsible for another 25%. The humble shopkeepers seem to be responsible for much more of the much-vaunted productivity revival than high-technology innovations, flexible labour market reforms, educational improvements, corporate reorganisation by activist shareholders, or any of the other more commonly cited sources of greater efficiency.

This finding has echoes of a 1980s productivity paradox, when economists Stephen Roach and Robert Solow observed that massive American investment in information and communication technology (ICT) appeared to have done little to boost US productivity growth, except in the ICT industry itself. Similar discoveries were made in Europe, prompting an enquiry by the Department of Trade and Industry. Now it seems that supermarket groups ‘big boxes’, rather than technologists ‘black boxes’, are behind the recently superior productivity performance in the US and UK. If the rest of the EU, and Japan, want to match this Anglo-Saxon performance, they may need to drop their planning restrictions and allow a faster move from the market to the supermarket economy.

Wal-Mart remains as intervention-proof across the Atlantic as is Tesco in the UK, because it has delivered consistently lower prices to consumers (charging on average 25% less for food than its rivals, on the figures Rogoff quotes). Should these giants now be praised for generating the productivity gain that ultimately determines how fast our standards of living rise? That’s a difficult story to tell to the WalMart employees, notoriously paid 30% below the retail average, and often dependent on welfare top-ups to afford the goods in their own stores, according to material from Congressional enquiries.

Tesco accounted for half of the new retail space opened in the UK in 2006 and has tripled its store numbers in the past six years, raising its grocery market share to 31%. (Asda and Sainsbury’s vie for second place with around 16%). Almost 60% of the land bank held by UK supermarket chains for future development also belongs to Tesco, which could raise its market share to 40% if all those sites were turned into new stores.

These figures come from the Competition Commission, which this month presented interim findings of its latest enquiry into UK supermarket retailing (Coverage: AOL News). This is the third since 2000, when it probed the multiples market shares, pricing and supply-chain management. It looked again when Morrisons won the bid battle for Safeway in 2003. As before, the Commission expresses concerns over the way Tesco and its main rivals extract low prices from suppliers, and put competitive pressure on specialist retailers, whose numbers have stagnated since 2000 while supermarkets grew by almost 25%. But the report finds few competition grounds on which to challenge the chains, because of their tendency to charge lower prices than the shops they displace, and to raise them less fast than the general inflation index.

Tesco and Sainsbury’s have answered earlier criticism of hollowing-out the high street by returning to city centres, their strategy of complementing out-of-town with scaled down high street formats now being replicated by others, and forcing convenience stores to upgrade their distribution and own-brands. Accused of treating small suppliers as expendable, the Big Four have stepped up collaboration with them, helping food processors develop new products and subsidising farmers to go organic. Although retail pay is low, the big chains can point to better wages and benefits than many of the independents they displace. Now they are competing over ambitious plans to cut emissions, cut down packaging waste and declare themselves carbon neutral, following a lead improbably set by Asda’s American parent Wal-Mart.

If the government sees any need to challenge the Tescopoly, it is likely to do so by invoking last years Barker Enquiry which recommended a relaxation of planning laws to encourage more supermarket openings, relying on case-by-case checks to ensure that these widen local choice.

With their power to dictate terms over the rest of the supply chain, the Big Four may yet turn them from villains to heroes of the lobbyists once ranged against them. Already the groups advising them on environmental policy are hailing green moves by Tesco, and clothing/food chain Marks & Spencer, as serious steps towards a carbon-free consumerism (Coverage: Forum for the Future ; The Guardian).

What excites the environmentalists is precisely what makes economists afraid: the power of big retail intermediaries to dictate terms to suppliers and edit the choices of consumers. If Tesco decides its vegetables should be organic, its batteries rechargeable and its lightbulbs low-energy, it shakes up the parts of the production process that individual ethical buyers and suppliers cannot reach. Just as a judicious dose of dictatorship occasionally speeds the introduction of democracy, supermarkets armlock over those who stock them and shop in them,this might just come in useful when our supply chains are in need of radical change.