The Sharecropping Problem, and Optimal Innovation

Why do we ever innovate?

People are not capable of doing everything alone. They hire agents to act for them, and pay them either a fixed rate, or some percentage of the product. At the same time, people despise uncertainty and fluctuation in income. We would like to keep a constant rate, even if our total income is smaller. When you are perfectly able to specify what needs to be done, there is no problem with this. When, however, you cannot tell ahead of time what could or should be done, nor can you easily ascertain each person’s contribution to a project, there is no way to guarantee that the socially optimal actions take place, or that people will get the desired level of risk-taking.

i. The case of the sharecropper

Imagine that there are only two people, who want to use land and capital inputs that one party owns in order to create food. We shall take for granted that any state of affairs which is preferable to both parties is better, and the goal is to get the most food with the least amount of effort. The renter and the owner both may possess private information which would increase the efficiency of the farm. 

Let’s suppose the owner hires the worker to work the fields. He pays a fixed quantity, and in return gets whatever is left. The obvious problem is that, if monitoring is costly, the employee is only motivated to do as much as is needed to not have production fall below what is necessary for either to survive. If they expend more work, they get nothing for it. The owner could promise to pay for productivity improvements, but is unlikely to succeed for several reasons. It is hard to assess whose efforts led to what productivity. Moreover, the owner could always simply get the productivity improvement, and not pay for it. The farmer, fearing this, may never invest in the improvement at all. 

Ok, so what if we split the proceeds of the land, 50-50, or any other arbitrary fraction. This is what sharecropping is. You can set it such that the average payment is at least as good as what either party would get under another arrangement. Now the problem is that we have put a tax upon any improvement. An investment costing 100 and yielding 150 is obviously good, and would be worthwhile if people received all of their marginal return, but not if they receive half. At the extreme end, giving all of the excess returns to the farmer, and charging a fixed rent, would simply replicate the problem of employment, in the other direction. In Freakonomics, they compare when realtors sell their own home, versus when they sell your home. Because realtors are only paid a fraction of the total sale, they don’t bargain as hard as they possibly could when it’s your home. When they receive the whole of the sale — that is, they own the home — the house stays on the market longer, and the sale price is higher. 

This interpretation of sharecropping is different from some of the classic takes on sharecropping. They take the technology frontier as given, and look for inefficiencies in producing at that optimum. If you do take this, then all contractual arrangements converge on the same level of production. Alternatively, they argue, in turn, against employment, because it is expensive to monitor employees; and against fully renting, because of incomplete insurance markets. Splitting the proceeds is the ideal middle ground. (Consult section II.C of Stiglitz’s Nobel address for a more full coverage of this). That insurance markets are incomplete does explain a lot, especially in the developing world — expanding insurance markets can lead to enormous gains in worker welfare. Ken Arrow argues that people are unable to insure speculative ventures, like innovation, though he focuses on moral hazard rather than imperfect information per se. With monitoring problems, though, if you at least know what should be done, you can construct a system with arbitrarily low costs to monitor. When you cannot even imagine what is to be done, such a system is impossible. What have they shirked? I believe that innovation is the most important thing in the world. The possible gains from merely maxing out production with some set of technology is tiny, compared to changing the technology frontier outward. There is no easy, mechanistic way to reach better outcomes.

ii. Some implications 

We should expect the division of returns between owner and renter to reflect the likelihood of either to generate productivity increases. An absentee landlord would be more likely to charge a fixed rent with a long term contract. In fact, if someone expects to be able to make no productive improvements whatsoever, they Might sell the plot of land entirely. A more involved landlord would favor a more variable rent, or would prefer sharecropping. The enclosure movement in England should be seen as a byproduct of the printing press and elite literacy. Because the educated landholders could now get ideas over how to improve productivity, they demanded greater control over their land, and hired farmers as laborers.  Joel Mokyr emphasizes the proliferation of learned societies in England. You need to learn about modern crop rotation from elsewhere — it is not something easily stumbled upon by accident. Before the spread of literacy, this would be pointless — the baron of the 1300s knows nothing more than farmers, and is totally ignorant of the local conditions of the land. They would have nothing to add.

This may be stretching a presumption of efficiency too far, but it may be possible to infer the relative role of different inputs in improving the efficacy of labor from who owns the residual. The *share* of income reflects other considerations, but the division of rights should just reflect this. Thinking of American slaveholding, (and drawing largely from “Time on the Cross”) we should expect agricultural laborers to be paid a fixed “wage”, and indeed they were. (Their surplus was expropriated, and employment was not free. Nevertheless, food and such is analogizable to a wage). In employment where skill and quality is harder to elicit, such as blacksmithing, we should expect to see slaves have variable pay, and indeed we do. Even within agricultural pursuits, you see this changing structure. The cotton trade was very profitable and needed no input into the methods of production, so we would expect wages to be more fixed. In Virginia, where farms were more generalist, we see far more slaves engaged in private trading, paying fees to the owner, rather than have their activities be entirely directed by him. Even when not everyone is free, we can still tend toward efficiency.

iii. The all-importance of culture

When the relationship between the two parties is expected to last a long time, and the arrangements are not especially complicated, the social loss won’t be too great. They can build up mutual trust that their contributions will be recognized, and act as though the other person won’t be shirking. When relationships are short, you can defect. (Obligatory reference to the Kreps-Milgrom-Roberts-Wilson Gang of Four). When things are uncertain, you have no reason to believe the game will last. You will shirk on contributing, and so will everyone else. Things are worse when determining who was responsible for what is close to impossible. 

This is why culture matters. “Culture” is the belief that others will do right by you. It is what is meant by a “company culture”. People can have an internalized preference for doing the productive thing, not because it is in your narrowly defined self-interest, but because it is the right thing to do. An employee goes and tells about an idea for saving the company money, not because he necessarily expects to be paid, but because it’s something you take pride in. Meanwhile, the employer pays bonuses and rewards efforts, not because it is in their self-interest, but because it is the right thing to do. 

This explains some puzzles of equity compensation. That it is to align the incentives of the employee with the company is patently ridiculous. A middle manager has but a minute impact on the stock price of a large multinational corporation. That they might own a few tens of thousands of dollars in stock does not make it worthwhile to invest in productive improvements, when the company is worth billions. The equity is entirely symbolic. It is a gift. It is to make someone feel a part of the team, and to buy into the idea that you *should* make the company better.

Economists like Garett Jones identify trust as being of central importance to a nation developing. When I first read that, it seemed unlikely. My imagination was limited. Why would it matter whether I expect my wallet to be returned if I leave it in a store? Now I understand. Trust runs deep. It is the belief that you can and should act in unspecifiable ways to improve productivity. It is the belief that you shouldn’t shirk when no one is watching, not because you will be penalized, but because it is the right thing to do. We could not possibly hope to enforce every contract through the courts, just as we could not hope to catch every criminal if everyone was a crook. All systems rely on people knowing not to abuse them.

Economic theory can abstract too much. People’s preferences are not immutable, and this really matters. They are shaped by the expectations of others. A belief that one should be productive, for its own sake, is one of the key reasons why nations grow. I believe that two countries, differing only in their attitudes toward entrepreneurship, will diverge in their outcomes. We should think highly of those who create prosperity and new technologies.