Markets

1. Markets

2. Recap: the Hobbesian dilemma • Coercive solution to the problem of order has two problems • Logical inconsistency • Why would rational egoists surrender their sovereignty in the state of nature? • Empirically dubious • Too expensive • Too oppressive • Central authority may not exist

3. Two ways out of the Hobbesian dilemma • Reject self-interested behavioral assumptions • If people are not rational egoists, then no war or all against all: cooperation easier to attain • Then we’re back to the Individuals section. But, as we have seen, those theories also have their weaknesses. • Reject the conclusion that rational egoists produce a war of all against all • Instead, rational egoists can live in peace

4. A fundamental question • Is it possible for self-interested individuals to produce an orderly society without an external authority?

5. Hayek on order Order exists when people are able to form accurate expectations

6. Two sources – and types – of order • Taxis = ‘made orders’ • Produced by human design (e.g. Hierarchies as discussed in the last section, includes organizations) • Kosmos = ‘spontaneous orders’ • Orderly structures that are the product of the interaction of many people, but are not the product of human design (e.g. Markets)

7. Complex Not limited to what a human mind can master Abstract Perception requires mental reconstruction Has no particular purpose Simple Complexity limited to what a human mind can master Concrete Its existence can be intuitive, perceived by perception Serves the purpose of the maker(s) Kosmos vs. Taxis

8. What will a spontaneous order look like? • Hard to predict • Depends on • Characteristics of the environment • Initial position of the elements • Rules governing behavior of the elements

9. Differences between rules in planned and spontaneous orders • Rules in planned orders (e.g. organizations) • Are for the performance of assigned tasks (e.g. bureaucratic rules) • Rules in spontaneous orders • Are independent of purpose • Affect a very large, but indeterminate, number of persons

10. Hayek: Draw the theory Predictable patterns of behavior Individual preferences Individual behavior consistent with preferences

11. Hayek’s theory • Hayek argues that self-interested individuals can produce a world of stable expectations • But is this world necessarily cooperative? • Does self-interested action lead people to behave in ways that contribute to group welfare?

12. Thomas Schelling

13. Schelling’s residential segregation model • Shows that people who have a very mild preference for living with their own kind (a bit more than 1/3 of their neighbors)– and no preference to live in a segregated neighborhood – are likely to create segregated neighborhoods • This outcome is NOT intended by anyone • Without a norm or a law (against racism), segregation a likely outcome

14. Schelling • Schelling’s work suggests that the interaction of self-interested individuals does not necessarily produce outcomes that contribute to group welfare

15. Schelling: Draw the theory Segregation Preference for some neighbors similar to self Individual stays/ moves

16. Adam Smith (1723-1790)

17. Smith • Argued that rational egoists can create social order (not just coordination, but also cooperation)

18. Smith’s principal behavioral assumption • People are self-interested

19. Wall Street • Illustrates the radicalism of the assumption of rational egoism • However, the lesson of Wall Street is Darwinian – not Smithian • Gekko's aim is to produce the fittest firms • Smith's aim is to produce economic growth for society as a whole.

20. Implications of this assumption • Man’s self-interest  a propensity to truck, barter, and exchange one thing for another • Exchange improves individual welfare • This propensity critical for social order • Social order produced in societies having institutions that foster economic development – thus increasing wealth.

21. Why economic development leads to social order • When most people are poor, they cannot be happy. An increase in wealth increases well-being. • E.g. ‘a rising tide raises all boats’

22. A paradox? Hobbes versus Smith • Hobbes and Smith both start from the same rational egoistic behavioral assumption • Hobbes: there will be a war of all against all • Smith: selfish people can cooperate in producing greater wealth • How can they reach such opposing conclusions from the same premises?

23. Zero-sum versus positive-sum games • For Hobbes, social interaction is zero-sum • In a zero-sum game, resources are fixed • E.g. dividing up a birthday cake

24. Zero-sum versus positive-sum games, cont’d • For Smith, social interaction is positive-sum • In a positive-sum game, resources are expanding; specialization  greater production • Moreover, exchange  individual welfare • Both parties to an exchange are better off afterward than they were before: • Unless there is deception or a misunderstanding of the facts, a voluntary exchange must make both parties better off. Even though no additional goods are produced by the act of trading, the welfare of society is increased because each individual acquires goods that are more suited to his or her desires

25. The division of labor • Why does Smith see the world as a positive sum game? • Because, when people specialize, they can produce more wealth than if they tried to produce everything by themselves

26. Example: pin-making • By himself, each man can produce from 1 to 20 pins a day • By dividing pin-making into 18 different operations, each man can produce 4800 pins a day

27. Origins of the division of labor • Slight differences in natural talents in different people – the principle of comparative advantage • Self-interest leads to specialization in the presence of comparative advantage • And specialization leads to greater productivity • a self-reinforcing system

28. Specialization  exchange • With the division of labor, people no longer produce what they want to consume themselves. • Workers in the pin factory cannot live on pins; they need food, clothing, etc. • Specialization can only occur if there is some mechanism by which workers producing pins could exchange their wares with workers producing food and clothing

29. Smith summary • Unlike Hobbes, Smith sees social interaction as a positive sum game in which people gain from exchange Free trade  Wealth Wealth  Contentment and willingness to comply Compliance  Social order

30. A spontaneous order • Man’s interest in exchange leads him ‘to promote an end which was no part of his intentions’

31. Smith: Draw the theory Wealth Social order Propensity to truck and barter (self-interest) Specialization & exchange Content, willing to cooperate Individual cooperation

32. Smith • How do we know if the theory has merit? • Look at the empirical world

33. Implications of Smith’s theory for policy • Economic growth (and, hence, social order) is best assured by promoting free as against regulated markets (e.g. laissez-faire) • The doctrine known as liberalism holds that • Collusion between producers is socially harmful • Tariffs and other government imposed barriers to trade are socially harmful • Government policies that encourage monopolies (common in Europe during Smith’s lifetime) are socially harmful • e.g. US Sherman Anti-Trust act • Findings of law against Microsoft

34. The minimal state • Smith’s arguments justify a minimal (‘night-watchman’)statewhich • Protects citizens against violence, theft and fraud, enforces contracts, etc. • Object of government • like a maintenance squad of a factory; sees to it that the mechanism which regulates production of goods and services is kept in working order (Hayek 232). • Not a strong state that intervenes much more directly in the economy • Similar arguments used to advocate anarchy as a viable solution to the problem of order

35. Questions about Smith’s theory • Distributional issues • Class – a source of disorder ? • Exchange – and even the division of labor – presuppose privateproperty rights • If private property rights can only be produced by the state, then we are right back in Hobbes’ box • Social order also requires normative content (Hayek) • Where does this come from in the theory?

36. Critique, cont’d • By itself, Smith’s theory cannot explain how rational egoists can cooperate in establishing a state • Social order depends on both spontaneous and planned orders – both markets and governments (Hayek)

37. Robert Axelrod

38. Axelrod • In Smith’s world, why don’t people just take what the other has to offer and renege on their end of the deal? • Smith assumes the existence of a minimal government • Axelrod suggests another possibility

39. The concept of equilibrium in social science • Equilibrium = an outcome that conforms to the (realistic) expectations of its participants • E.g. a state of affairs in which no participant can expect to increase his welfare by changing his behavior

40. Cooperative and non-cooperative equilibria • Cooperative equilibria provide optimal welfare to participants • Many social norms are cooperative equilibria • Non-cooperative equilibria provide suboptimal welfare to participants • Ex: the Hobbesian state of nature

41. Cooperative equilibria are problematic • We often end up with sub-optimal equilibria • this is another way of talking about the same old problem of social order

42. The prisoner’s dilemma (PD) • There are a host of different social situations that constitute sub-optimal equilibria • The PD is a famous way of representing what is common to all of these different situations

43. PD, cont’d • There are 2 players, designated • Row • Column • They have 2 choices • Cooperate • Defect • Each must choose simultaneously, without knowing what the other will do

44. PD, cont’d • No matter what the other does, defection produces a higher payoff than cooperation • This is known as the non-cooperative equilibrium • The dilemma • If both players defect, both do worse than if they had cooperated

45. PD, cont’d

46. PD, cont’d • It pays to defect if you think the other player will cooperate (5>3) • But it also pays to defect if you think the other player will defect (1>0) • Thus, it is better to defect no matter what you think the other player will do • And the same goes for the other player • So, if the players are rational egoists, then both will defect

47. PD, cont’d • If both players defect, then each gets 1 • If both players cooperate, however, then each gets 3 • Since 3>1, mutual defection is a sub-optimal equilibrium • E.g. both players would have been better off if they had cooperated

48. Examples of sub-optimal equilibria • Overutilization of common pool resources • Overfishing • Overgrazing of common fields • Pollution from profit-making factories (where the air is a common pool resource) • Proliferation of SUVs • Etc.

49. 2 sources of sub-optimal outcomes in the world • 1. The PD • The structure of the PD specifies that actors are rational egoists • If people were altruists, then their payoffs would not be those in the PD game • The highest payoff would be for cooperation regardless of what the other player would choose • As a result, the cooperative equilibrium would be much easier to attain

50. Sources of sub-optimality, cont’d • 2. Coordination • If a game has two or more coordination equilibria, even altruists can fail to produce cooperative outcomes • Ex: it doesn’t matter whether drivers use the right or the left sides of the road, so long as everybody does the same thing • Solution to coordination problems: conventions • Self-enforcing, because no one has an incentive to violate them • When conventions have distributional consequences, they are difficult to arrive at (require bargaining)