Friday 29 June 2012

No transitional gains traps?

Don Wittman is right: the transitional gains trap is a bit of a puzzle.

Recall first how the transitional gains trap works. One a rent-seeker has a rent conferred upon him, the value of that rent is capitalized into whatever draws the rent: the quota permit for Canadian dairy farmers; the taxicab medallion for New York taxi firms; the liquor licence for permit holders in places where licences are in restricted supply, for example. After that capitalization happens, the owner of the permit earns only a normal return on the total value of his capital, including the capitalized value of his regulatory rents. Permits change hands such that whoever earned the windfall initial gain takes his rent and leaves; eventually, nobody who currently owns the permits has earned any kind of excess return by having owned them. But try to get rid of the regulatory inefficiency that draws the rent and each and every one of these permit holders will scream blue murder as you're wiping out a good chunk of their capital: some permit holders could easily go bankrupt over it if they took out loans to buy the business and both they and the bank were counting on a continuing flow of regulatory rents.

Now, Wittman would rightly point out that if this is really so inefficient, there has to be a move that buys out the losers out of the gains to the winners. If it's Kaldor-Hicks efficient, this has to be the case. If you run the compensation, then the policy switch is Pareto-efficient.

The usual answer is that the transactions costs are too high to prevent the move towards more efficient policy. But in the case of taxis, or the Canadian dairy cartel, that really doesn't seem to be the case. For dairy, as I've suggested many times, all you need to do is put a tax on dairy products in Canada at the same time as you abolish all of the tariffs on imports and abolish supply management. The tax keeps the price to consumers a bit below where it was prior to the shift and is sufficient to pay off the bonds you issue to buy out the quota holders.

But, there's a reason that opaque transfers are preferred. That reason? Voters. Don't believe me? Read the comments section on Stephen Gordon's Globe and Mail piece where he suggests my "tax dairy and buy out the cartel" solution. For example:


I read the word screaming clear TAX.

We want to TAX dairy to make it even more expensive to 34 million Canadians who have to pay off $30 billion dollars in outstanding quota values.
Opaque transfers are opaque. Nobody understands tax incidence, never mind this kind of thing.

Add in the generalized worries about trade, insecurity issues about the Americans, and just general weirdness about food, and you wind up with voter support for a policy that makes them worse off. I'd batted back some of these fallacies. Even if Canada gets rid of supply management, Canada will still have a dairy sector; if Canadians want to ban GE milk, or milk where hormones are used in production, they can do it by direct regulation; and, if Canadian dairy farmers want to form a voluntary cooperative to get some efficiencies of scale while avoiding being contract operators for others, Canada has a strong tradition of agricultural cooperatives.

The best counter-argument I've heard is that the government can't constrain itself against bailing out farmers, so the one-off payment is likely to be followed by some additional support down the line. But isn't it better for government to try to come up with some mechanisms for self-discipline? It's a general purpose technology worth developing. And it's hard to believe that the costs of any potential future support package would trump the cost the supply management system imposes every year with certainty.

Martha Hall Findlay, Canadian Liberal Party leadership contender, makes the case for abolishing supply management in combination with a temporary tax on dairy used to fund a transitional support package for dairy farmers. She suggests the main problem is overcoming dairy farmer resistance and points out that dairy farmers are a trivially small proportion of the voting population; there's no reason that the Conservatives, or anyone else, couldn't just abolish the system, lose every single dairy farmer vote, and not expect much difference in the allocation of seats in Parliament.

I love Findlay's proposal. But I worry that the problem isn't the angry dairy farmers voting against incumbents. Rather, it's angry dairy farmers putting up ads on TV scaring voters about imported milk combined with voters really not understanding that a temporary tax on milk, under this system, reduces the cost of milk rather than increasing it.

I expect that the Canadian Dairy Cartel will use the threat of this kind of public campaign to negotiate for a bigger payout. So it's good to see the folks at EconomyLab helping to inoculate voters against the "make voters dumber" campaign that's likely to come. But if Stephen Gordon or Mike Moffatt were to put something up slowly explaining why free trade in agriculture won't mean that Canadian consumers are suddenly forced to drink poisoned milk, that would probably also be pretty useful. I know it's obvious to us, but it isn't obvious to the folks who can veto the play.


  1. I still think you're over-complicating the "opaque" part. Suppose I'm Peter from Office Space. I don't work hard, but not because I'm lazy -- the amount of money you'd have to pay me to work harder is less than the amount my employers would gain. So should I go to my bosses and offer them this Pareto improving deal? I suppose the result might be Kaldor Hicks efficient, but I don't think it'll turn out well for me. This only works because my eight bosses don't realize how much I slack off.

    So if I have a taxi medallion or some farm subsidies, I could give the public an Econ 101 lesson, explain how it's economically inefficient and really we'd all be better off if they canceled the program and just paid me off, but I think I'll stick with my Pareto inefficient subsidy.

  2. I wrote an article on this awhile back:
    I think it depends a lot on the level of political sympathy. Cab drivers, for example, probably couldn't recreate the medallion system if it were abolished tomorrow, but farmers might take their one time payoff and just recapture the political system at a later date.

  3. I am not convinced whether the buy in practice is likely to be Pareto improving. If it is Pareto improving, then why would Canadian dairy farmers be against it? Surely each farmer would individually support a Pareto improving change? Perhaps the scheme is not perfectly Pareto improving because of firm heterogeneity. If inframarginal gains to firms from supply management are greater than the gain to the marginal firm, then paying each firm the marginal net present value of the restrictive policy will leave most worse off than under supply management. Similarly paying each firm the average benefit (if known and if greater than the marginal benefit) will still anger half the farmers.

    James Oswald has an excellent point as well. Perhaps politicians today cannot be sure that their policies will not be reversed later. They might then be better off campaigning for binding free trade agreements to be sure that future governments do not re-institute the policy. Of course if this were the case then the dairy farmers would be tempted to support the policy change, take the cash, then campaign vociferously to get the policy reinstated.

  4. Nobody's proposed doing it with full compensation as yet. Even Findlay's plan has only partial compensation. Dairy will hold out for higher compensation.

    Hard to imagine that they could re-institute supply management after abolishing it.

  5. Agree - if it's expressively appealing to help farmers ex ante, it will be ex post. But it is hard to imagine an alternative form of assistance being anywhere near as awful as supply management. And, a free market has been a stable equilibrium in NZ for more than 20 years.

  6. That's why I want the economists to be pointing out how the opaque transfers screw customers....

  7. What do you think: Is permanent land ownership a transitional gains trap? Here's my reasoning:

  8. No. People make investments in capital around the land that last longer than 17 years; your system completely wrecks incentives.

  9. Yes, I've thought about that, which is why I promised (in a footnote, admittedly) to change all the details when I explained the mechanism for allocating land. Here's the explanation of the mechanism:
    I'd be interested to hear your comments on how effectively you think it restores the right incentives.

  10. Have you had time to look at my second post on this topic? If not, don't worry; I can try to find someone else to give me some feedback (suggestions are welcome). I just thought you might be interested, since it involves an auction process, avoiding any need for a central authority to try to guess land values.

    Also, I describe a strategy that allows the owner of improvements to avoid paying more than the unimproved value of the land, so that incentives to invest in improvements remain intact. I'm not completely sure about this strategy, though (I simplified the discussion by considering only one rival bidder), and I'm wondering if some form of combinatorial auction might better achieve the same purpose.

  11. Not going to get to it 'till this batch of grading is done, sorry...

  12. Fair enough. Thanks for letting me know.

  13. Okay, I've now written another post, describing a variant of a Vickrey–Clarke–Groves auction. I believe that this will ensure that the owner of improvements to land will pay only the unimproved value of the land, if they want to retain access to the land.

    The first part of the second post I linked to is still relevant; I've put a link in the middle, so you know when to jump out to my newer post.

    I'll probably be away from my computer for most of the rest of the week, so even if you finish grading before Monday (which I'm guessing you won't), there's no hurry to get back to me this week.