Game developers, Tiebout competition, and the winner's curse

Regular readers of this blog (or students I have taught in ECONS102) will know that I'm not a fan of subsidising particular industries, especially when it is the industries themselves that are crying out for the subsidies. Cue Calvin and Hobbes:

So, last month's news about the gaming development incentives in Australia was a little disturbing to me. As NBR reported (paywalled):

The Australian government’s recently announced 30% tax offset for game developers could lead to a brain drain if not matched by New Zealand, an industry body has warned.

Australia’s next federal budget will include a 30% refundable tax offset for video game development as part of the government’s National Digital Economy Package.

Australia’s Interactive Games and Entertainment Association said the break would spur the creation of new Australian game development studios, accelerate the growth of existing Australian studios, and attract blockbuster game studios to Australia, creating jobs along the way.

On this side of the Tasman, New Zealand Game Developers Association chair Chelsea Rapp said the Australian tax offset would give Australian studios a massive leg-up over their New Zealand peers.

New Zealand has an existing incentive programme for film, which has successfully attracted major projects to the country, but video games are specifically excluded from the scheme.

Rapp said the NZGDA had been campaigning for this sort of government support for nearly 10 years.

There are several interrelated issues here. First, as I note in my ECONS102 class, lobbying the government to get your firm (or your industry) a better deal is essentially a socially wasteful activity. Economists refer to it as 'rent seeking' - in this case, the New Zealand gaming development industry is seeking to gain some economic rent from the taxpayer in the form of the subsidy. It's socially wasteful to add a subsidy to an existing industry, because a subsidy leads to a deadweight loss (unless there are offsetting positive externalities, which are not apparent in this case). However, if a large enough proportion of gaming developers were really going to move to Australia, the loss of economic welfare from the lost industry could (in theory) be larger than the deadweight loss of the subsidy. That might justify a subsidy.

However, that brings us to the second issue - how much should government be willing to pay to keep a gaming development industry that is threatening to move overseas. Certainly, the government shouldn't be willing to pay more than the total economic welfare that the industry generates (or, more accurately, the economic welfare that the proportion of the industry that would otherwise move overseas generates). Paying just enough so that the gaming development industry decides to stay would be the best option. A smart gaming development industry would recognise this, and play off governments against each other, leading to Tiebout competition. Tiebout competition is a 'race to the bottom', where governments compete to offer the most generous subsidies and other support, so that the gaming developers will operate in their country. This almost ensures that the 'winning' government would end up paying out all of the potential economic welfare gains directly to the gaming development industry itself.

But it gets worse. Since no government has a perfect understanding of just how much the gaming development industry is worth, the government that 'wins' the Tiebout competition will almost certainly to be the government that most over-estimates the value of the gaming development industry. This is what is referred to as the winner's curse. Over-estimating the value of the gaming development industry will mean over-incentivising it, paying too much relative to the economic welfare that it generates.

Thankfully, at this stage the New Zealand government hasn't fallen into this trap. Gaming developers don't need to be subsidised, and we definitely don't need to be in a race to the bottom to attract them here. It's bad enough that we do this for movie production, where it already doesn't pay off.

This isn't what the 'year of delivery' was supposed to be delivering

It had to happen. When the government is willing to give Amazon (market capitalisation ~US$870 billion) a subsidy of up to $300 million to make a Lord of the Rings TV series, that's a clear signal to other big corporates that there is free money on offer, if they can just find a way to put the squeeze on the government. It doesn't even appear to take much in the way of lobbying. If a big corporate threatens some lost jobs, especially in the regions, the government will let them feed at the trough.

And so, up next we have Rio Tinto (market capitalisation ~US$87 billion), as the New Zealand Herald reported yesterday:

The global mining giant Rio Tinto coughs and this country's power companies catch a $2 billion cold. That's the amount of money wiped off their balance sheets following yet another threat hanging over the future of the Tiwai Pt aluminium smelter, Southland's biggest employer by a country mile.

Why have the companies' shareholders got the shivers? The smelter uses 13 per cent of the country's electricity and if they close down their pot lines, cheap electricity will flood the market meaning profits will be lower.

That's just one of the reasons why power generators want the smelter to continue. But the biggest reason should be for the people of Southland where 1000 jobs would be directly at stake with a flow on to 3500 people dependent on the flow-on opportunities of the business.

Tiwai Pt gets a cut price power deal from Meridian, from the nearby Manapouri hydro plant that's been supplying it for almost 50 years.

There's now yet another threat from Rio Tinto to close the plant. The last one was six years ago when it said it'd be shutting up shop at the end of 2016, but decided against it after the Key Government came to the table with $30 million and with a warning from Bill English that it'd be the last bite at the cherry.

If you thought the bulk of the government's higher-than-expected surplus was going to be spent on social housing (or any housing, for that matter), reducing child poverty, or improving mental health, you might want to think again. According to the government, this was the "year of delivery" - it's becoming clear that the year of delivery meant stacks of cash being delivered by the government to big corporates.

Yes, I'm angry. You should be too.

Arnold Kling on public choice theory and lobbying

In my ECONS102 class, we discuss the lobbying activities of firms with market power. The motivation for that discussion is that firms with market power make a large profit (how large the profit is depends in part on how much market power they have), so they have an incentive to use some of the profits (their economic rent) to maintain their market power. They can do this by lobbying government to avoid excess regulation. However, that simple exposition doesn't explain the full range of lobbying activities that firms engage in, and it doesn't explain why consumers don't engage in lobbying (e.g. for lower prices) to the same extent that producers do.

On Medium last week, Arnold Kling wrote an interesting article on why costs increase in some industries faster than others. However, on the above point it was this bit that caught my attention:

In reality, you do not produce everything in the economy. You are much more specialized in production than in consumption. This makes you much more motivated to affect public policy in the sector where you produce than in the sector where you consume.

In theory, government policy is supposed to promote the general welfare. But as a producer, your goal for government policy is to increase demand and restrict supply in your industry. If you are in the field of education, you want to see more government spending devoted to education, tuition grants and subsidies for student loans, in order to increase demand. You want to make it difficult to launch new schools and colleges, in order to restrict supply. If you run a hospital, you want the government to subsidize demand by providing and/or mandating health insurance coverage. But you want to restrict supply by, for example, requiring prospective hospitals to obtain a “certificate of need.” If you are a yoga therapist, you want the government to mandate coverage for yoga therapy, but only if it is provided by someone with the proper license.

Think about an average consumer (and worker), considering how much effort to put into lobbying the government for a policy change. They might be quite motivated to engage in lobbying government in terms of their employment or wages (e.g. subsidising wages, or introducing occupational licensing), where they are a producer, and can capture a lot of the gains from a policy change. In that case, the benefit to be gained from the policy change will affect them a lot, and may offset the cost of the effort of lobbying. However, they will be much less motivated to engage in lobbying government in terms of consumption goods. In the latter case, the benefit is much lower than lobbying in terms of employment or wages, while the cost is likely to be about the same.

This explanation also relates to the idea of rational ignorance. Consumers individually face only a small cost of a policy (like a subsidy on sugar farmers) that provides a large benefit to producers. The producers have a great incentive to lobby against losing the policy (or in favour of gaining it), but consumers have only a small incentive to lobby in favour of eliminating the policy (or against it being implemented in the first place).

There's a lot more of interest in Kling's article. Market power and lobbying is just one of many reasons why costs increase faster in some industries or sectors than others.

The economics of corporate lobbying

In my ECONS102 class, we talk about market power and monopoly firms, and in the context of that discussion, we talk about corporate lobbying. Specifically, we discuss it in the context of rent-seeking behaviour (as I have previously blogged about here). The assumption of firms conducting lobbying for rent-seeking reasons is that they do so in order to protect (or enhance) their profits in the future. So, firms that engage in rent-seeking should be expected to be more profitable (net of their rent-seeking expenditure) than those that don't engage.

A recent paper by Zhiyan Cao (University of Washington Tacoma), Guy Fernando (SUNY Albany), Arindam Tripathy (UW Tacoma), and Arun Upadhyay (Florida International University), published in the Journal of Corporate Finance (sorry I don't see an ungated version anywhere online) challenges this result. The authors contrast between two different theories of how corporate political activity (including lobbying, but also contributions to political campaigns, etc.) would affect profitability:

The stewardship theory views lobbying as an inherent part of firm strategy. The rationale is that since government regulations and actions can shape a firm's business conditions, lobbying could be an effective means to help firms stay informed of regulatory agenda, obtain political information to adjust their business decisions in a timely fashion, and to encourage (discourage) those regulatory decisions that are beneficial (detrimental) to a firm when possible. Under this theory, lobbying expenditure is considered an outlay with a high return on investment (ROI)...

...a new paradigm that attempts to explain corporate lobbying focuses on the agency problems... Specifically, managers may divert corporate resources directly to strengthen their own political connections through lobbying activities without bringing tangible benefits to the firm.

So, the stewardship theory suggests a positive relationship between lobbying and profits, but agency theory suggests a neutral or even negative relationship between lobbying and profits, because managers are doing what is in their own personal best interests and not necessarily those of the firm. Cao et al. suggest some specific examples of principal-agent problems associated with lobbying, including:

First, lobbying may channel funds for political causes that are dear to the CEO, but do not affect (or adversely affect) the firm...

...Second, lobbyists (who are agents of their clients, the firms) may misrepresent the lobbying activities to their clients and direct corporate funds to causes dear to the lobbyists... Third, the firm (and presumably the majority shareholders) may channel firm money to political activities that are inimical to the beliefs and philosophies of the non-controlling shareholders... Finally, corporate political activity can be chosen by incompetent CEOs who are unable to lead their firms to meet new challenges in the marketplace and overestimate the effectiveness of lobbying as a means to enroll government welfare in the face of competition. Managers may also be more likely to shirk when they expect to resort to political connections through lobbying.

Using data on 18,075 firm-years from 2186 unique firms over the period from 1998 to 2016, they find support for agency theory as a dominant factor:

...we find a negative and significant association between lobbying activities and firm performance. This negative association persists when we explicitly control for the endogeneity of corporate lobbying. We further show that the negative association may be partly explained by the fact that lobbying spending by a firm overall provides limited tangible benefits when it comes to helping the firm obtain more government contracts or improve the frequency of getting a bill passed in the US Congress. This suggests that agency costs (e.g., inefficient use of corporate funds) in lobbying activities appear to dominate the strategic benefits that firms may obtain from lobbying.

This is a nice paper, and includes a very thorough set of robustness checks and checks using alternative econometric specifications. So, the results are very believable. However, two things suggest to me that this is far from the last word on the relationship between corporate lobbying and profits. First, the quality of lobbying expenditure clearly matters as much as (if not more than) the quantity of corporate lobbying. This is a very difficult problem to address in an econometric model, since high-quality corporate lobbying could be most simply defined as lobbying that results in a favourable outcome. However, definitional issues aside it is likely that firms that engage in higher quality lobbying are more likely to improve their profits as a result. So, failing to account for the quality of lobbying is a potentially important issue for this research.

Second, there is a public goods aspect to at least some lobbying expenditure, which is not accounted for in the paper. If Firm A lobbies against a particular law that would impose restrictions on their industry (or on business more generally), the all firms in the same industry (or in all industries, depending on the extent of coverage of the law) would benefit. If the lobbying was successful, Firm A would receive a benefit (higher profits), but face the cost of lobbying. Other firms in the same industry (or generally) would receive higher profits, but face no corresponding lobbying cost. To an econometric model, this would look like a negative relationship between lobbying expenditure and profits. So, for this reason I don't think we can take the negative relationship between lobbying and profits from this paper as being purely an agency problems result.

Corporate lobbying is an important feature of modern politics. The paper has some interesting figures on the extent of lobbying which illustrate this, including the peak lobbying expenditure of Pfizer, which by itself spent over US$63 million on lobbying in 2009. Clearly, this is an issue that needs to be kept in the spotlight.

[HT: Marginal Revolution, back in January]

Lobbyists, rent seeking and deadweight losses

The rise of lobbying in New Zealand has been in the news recently, as Bryce Edwards explained in his regular Political Roundup column in the New Zealand Herald a couple of weeks ago:

Political lobbying is a growth industry in New Zealand. And lobbyists are going to be particularly busy over the next year.

Edwards charts the rise of 'hyper-partisan' lobby groups Hawker Britton and its right-wing counterpart Barton Deakin. It's an interesting read, along with the many links to other articles embedded within it.

Of course, lobbyists are ultimately being employed by firms that are seeking favourable policy settings. Perhaps they are looking for lighter-handed regulation for themselves, or more regulation of their competitors. Economists refer to this sort of activity as rent-seeking, and in ECON100 and ECON110 I discuss it as one of the key reasons that we might consider monopolies (or firms with market power more generally) to be unfavourable for society. Those firms make large profits, and therefore have a large incentive to use some of those profits to protect their market position through lobbying. If government is seeking to regulate their industry or to open it to more competition (or the firms are worried that the government might contemplate doing so), then those firms will employ lobbyists to dissuade governments from those policies that won't favour the firm.

When I was an undergraduate student, I struggled to see how rent seeking was negative for society. Obviously, it seems ethically problematic. But if you take a general equilibrium framework, then if the firm spends some of its profits on lobbyists, that simply becomes income for the lobbyists, and total welfare remains effectively the same (or maybe it even increases due to the producer surplus in the labour market for lobbyists).

However, that position forgets that the market operates across multiple periods. The firm with market power is generating a deadweight loss (for an explanation of why, see the first part of this earlier post). That deadweight loss arises because the firm with market power is able to price above marginal cost. If the government was to open the market to more competition or to regulate prices, then that would force the price down and increase total welfare in the market. Therefore, if the actions of the lobbyists prevents the regulation or the competition, then it has a cost to society that can be measured by the future deadweight losses that continue to accrue. So, lobbying does potentially have real negative consequences for society, and so as a society we should care about the actions of lobbyists and their interactions with our politicians.

Uber vs. Taxi Federation (lobbying in the wild)

I've had some interesting conversations with my students this semester about the lobbying activities of firms. Some of them expressed surprise and wondered to what extent lobbying occurs in New Zealand, given that lobbying is estimated to cost more than US$800 million per year in the U.S.

In ECON100 and ECON110 we discuss lobbying as a form of rent-seeking, where the monopolist uses some of its profits (its economic rents) to protect its privileged monopoly position (such as by maintaining barriers to entry into their market). We can extend this to any firm (or firms) in imperfect competition, where they are making high profits. However, firms may also lobby government in order to remove barriers to entry into the market, in order to allow them to compete where they would otherwise be locked out of the market.

A recent example for New Zealand is the ongoing showdown between Uber and the Taxi Federation. Both sides are lobbying government - the Taxi Federation wants to keep high barriers to market entry, and Uber wants to remove them.

How is this lobbying playing out? The Taxi Federation is conducting "an unrelenting campaign to see [Uber] shutdown...", including attacking Uber on safety and crime, and pricing. Obviously, it's in the Taxi Federation's best interests to minimise competition - this ensures that they maintain cosy control over the number of registered taxi operators (although see my 2013 post on market competition among taxis in Wellington).

On the other side, Uber is employing specialist lobbying consultants Saunders Unsworth to pitch to government the benefits of increased competition, and to reduce the barriers to market entry, which currently include each driver needing three endorsements on their licence, with total costs upwards of $1500. Without lower entry barriers, it will be difficult for Uber drivers to compete in the market.

Who will win the lobbying battle? It's anyone's guess, and will ultimately depend on who does the better job of bending the politicians' ears, particularly given that consumers themselves don't appear to be particularly vocal on this issue.