Markets

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

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

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

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

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)

Kosmos vs. Taxis 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)

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

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

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

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?

Thomas Schelling

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

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

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

Adam Smith ( )

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

Smith’s principal behavioral assumption People are self-interested

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.

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.

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’

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?

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

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

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

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

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

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

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

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

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

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

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

The minimal state Smith’s arguments justify a minimal (‘night- watchman’) state which 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

Questions about Smith’s theory Distributional issues Class – a source of disorder ? Exchange – and even the division of labor – presuppose private property 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?

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)

Robert Axelrod

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

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

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

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

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

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

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

PD, cont’d Column player Row playerCooperateDefect Cooperate R=3, R=3 Reward for mutual cooperation S=0, T=5 Sucker’s payoff, and temptation to defect Defect T=5, S=0 Temptation to defect and sucker’s payoff P=1, P=1 Punishment for mutual defection

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

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

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.

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

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)

Fundamental question In situations with the characteristics of a PD Game, is it possible for cooperation to emerge without a central control?

Axelrod’s solution The iterated PD Axelrod’s The Evolution of Cooperation A PD computer tournament, with each player using a strategy of his own choosing, competing with all other strategies Strategies included All C All D Random C, D, etc

Axelrod’s tournament Players were recruited from experts in game theory from all disciplines and many different countries An indefinite number of 2-person PD games Each participant (= strategy) played against each other The winning strategy: Tit-for-Tat Always cooperate on the first round; defect only after the other player has defected

Requirements of the result Cooperation is based on reciprocity Mechanism = mutual retaliation The ‘shadow of the future’ is important enough to make this reciprocity stable A finite number of plays  unraveling of cooperation Not knowing the time of our death  an indefinite number of plays of the game

Axelrod: Draw the theory Iterated PD Individual anticipates the future Individual plays tit-for-tat Cooperative equilibrium

Axelrod How do we know if the theory has merit? Look at the empirical world

Trench warfare in WWI TFT emerges on the battlefront

A possible implication of the result In the long run is it rational for rational egoists to cooperate, and to establish social order? If so, then social order might arise even in the absence of much government authority

Limitations of the analysis It assumes the possibility of a durable identity of the parties, and the repetition of the circumstances of the game It assumes the possibility of an iterated PD, but this condition was imposed by the experimenter This condition violates the description of the Hobbesian state of nature (Pizzorno, in Bourdieu/Coleman)

Limitations, cont’d It assumes that players continue to play with one another indefinitely in the future If the number of plays is determined in advance, cooperation unravels Implications of the fact that we do not know the date of our death

Limitations, cont’d It is based on 2-person games, but social order is an N-person game Since reciprocity is the engine of the solution, to sustain cooperation one must know whether your partner cooperated or defected during the last play of the game E.g. the solution requires monitoring capacity Monitoring capacity is high in a 2-person game, but low in an N-person game Monitoring becomes too costly if N>25

Limitations, cont’d It ignores social structure

Beyond two-person games Researchers across disciplines have expanded beyond two person games They look at systems with many actors Relying on simple assumptions about actors, they observe how interactions produce macro-level patterns of behavior

Swarms The interactions of actors – whether they be ants, locusts, or people – can produce predictable patterns (Couzin)

Karl Polanyi

Polanyi’s historical critique of invisible-hand solutions The ‘double movement’ of market forces and social protection Previous to market society Purpose of trade: to obtain goods not available on the spot Trade builds community and solidarity between trading partners In non-market society, individuals are not rational egoists Maximize honor in tribal society Potlatch Kula Ring

Polanyi’s critique, cont’d Rise of market society Purpose of trade: to acquire goods at minimal cost Trade  antagonism between trading partners The market  rational egoism  social disorder

Polanyi, cont’d Free market treats labor, land, and capital as commodities People resent being treated as commodities Consequence: rise of state regulation of labor and public health Land subject to environmental degradation Consequence: rise of state regulation of land (National Park Service, etc.) Economy subject to fluctuation Consequence: rise of state financial regulation (central banks) protectionism

Polanyi, cont’d Social legislation restricts the freedom of the market Similar legislation enacted at the same time in countries with different Economies Political traditions Ideologies

Polanyi Empirical critique of the theory of spontaneous order: Both England and Prussia had free- trade policies, but replaced these with increased regulations (worker’s compensation, public utilities, etc.)

Theoretical critique: social order as a public good Three types of goods 1. Public goods Non-excludable You can’t keep anyone from consuming them Non-rival Not subject to ‘crowding’: my consumption of them doesn’t decrease your access to them ex: national defense Public parks Freeways Ocean fisheries The atmosphere Social order

Collective and private goods 2. Collective goods Non-excludable for members of a given group/society Rival 3. Private goods Fully excludable Rival

The free-rider problem Since public goods are non-excludable Rational egoists will free-ride rather than contribute to their production Because they can consume the public good without paying for it The same holds for the members of groups providing collective goods

Implications of the free-rider hypothesis Collective action (action in pursuit of public/collective goods) is highly problematic If it’s rational for me to free-ride, it’s rational for you to do so Hobbes revisited If people desire social order and are rational, they will not abide by the rule of law unless coerced to do so Parallel with PD Everyone will end up in the D/D box – especially because they have large numbers – no way out of the state of nature

Other examples Rational egoists will not vote in Presidential elections

Critiques of the invisible hand solution to social order Theoretical critique Limits to Axelrod’s results Due to the free-rider problem, exchange cannot lead to collective action Empirical critique Laissez-faire governments everywhere subject to increasing state regulation