Economics acquired its dismal reputation by pretending to be an exact science rather than a branch of mass psychology. In truth it is a narrative struggling to describe the aggregate behavior of humans. It seeks to cloak its uncertainties and shifting fashions with mathematical formulae and elaborate econometric computerized models.
So much is certain, though - that people operate within markets, free or regulated, patchy or organized. They attach numerical (and emotional) values to their inputs (work, capital) and to their possessions (assets, natural endowments). They communicate these values to each other by sending out signals known as prices.
Yet, this entire edifice - the market and its price mechanism - critically depends on trust. If people do not trust each other, or the economic "envelope" within which they interact - economic activity gradually grinds to a halt.
There is a strong correlation between the general level of trust and the extent and intensity of economic activity.
Francis Fukuyama, the political scientist, distinguishes between high-trust and prosperous societies and low-trust and, therefore, impoverished collectives. Trust underlies economic success, he argued in a 1995 tome.
Trust is not a monolithic quantity. There are a few categories of economic trust. Some forms of trust are akin to a public good and are closely related to governmental action or inaction, the reputation of the state and its institutions, and its pronounced agenda. Other types of trust are the outcomes of kinship, ethnic origin, personal standing and goodwill, corporate brands and other data generated by individuals, households, and firms.
I. Trust in the playing field To transact, people have to maintain faith in a relevant economic horizon and in the immutability of the economic playing field or "envelope". Put less obscurely, a few hidden assumptions underlie the continued economic activity of market players.
They assume, for instance, that the market will continue to exist for the foreseeable future in its current form. That it will remain inert - unhindered by externalities like government intervention, geopolitical upheavals, crises, abrupt changes in accounting policies and tax laws, hyperinflation, institutional and structural reform and other market-deflecting events and processes.
They further assume that their price signals will not be distorted or thwarted on a consistent basis thus skewing the efficient and rational allocation of risks and rewards.
Insider trading, stock manipulation, monopolies, hoarding - all tend to consistently but unpredictably distort price signals and, thus, deter market participation.
Market players take for granted the existence and continuous operation of institutions - financial intermediaries, law enforcement agencies, courts. It is important to note that market players prefer continuity and certainty to evolution, however gradual and ultimately beneficial. A venal bureaucrat is a known quantity and can be tackled effectively. A period of transition to good and equitable governance can be more stifling than any level of corruption and malfeasance. This is why economic activity drops sharply whenever institutions are reformed.
II. Trust in other players Market players assume that other players are (generally) rational, that they have intentions, that they intend to maximize their benefits and that they are likely to act on their intentions in a legal (or rule-based), rational manner.
III. Trust in market liquidity Market players assume that other players possess or have access to the liquid means they need in order to act on their intentions and obligations. They know, from personal experience, that idle capital tends to dwindle and that the only way to, perhaps, maintain or increase it is to transact with others, directly or through intermediaries, such as banks.
IV. Trust in others' knowledge and ability Market players assume that other players possess or have access to the intellectual property, technology, and knowledge they need in order to realize their intentions and obligations. This implicitly presupposes that all other market players are physically, mentally, legally and financially able and willing to act their parts as stipulated, for instance, in contracts they sign.
The emotional dimensions of contracting are often neglected in economics. Players assume that their counterparts maintain a realistic and stable sense of self- worth based on intimate knowledge of their own strengths and weaknesses. Market participants are presumed to harbor realistic expectations, commensurate with their skills and accomplishments. Allowance is made for exaggeration, disinformation, even outright deception - but these are supposed to be marginal phenomena.
When trust breaks down - often the result of an external or internal systemic shock - people react expectedly. The number of voluntary interactions and transactions decreases sharply. With a collapsed investment horizon, individuals and firms become corrupt in an effort to shortcut their way into economic benefits, not knowing how long will the system survive. Criminal activity increases.
People compensate with fantasies and grandiose delusions for their growing sense of uncertainty, helplessness, and fears. This is a self-reinforcing mechanism, a vicious cycle which results in under-confidence and a fluctuating self esteem. They develop psychological defence mechanisms.
Cognitive dissonance ("I really choose to be poor rather than heartless"), pathological envy (seeks to deprive others and thus gain emotional reward), rigidity ("I am like that, my family or ethnic group has been like that for generations, there is nothing I can do"), passive- aggressive behavior (obstructing the work flow, absenteeism, stealing from the employer, adhering strictly to arcane regulations) - are all reactions to a breakdown in one or more of the four aforementioned types of trust.
Furthermore, people in a trust crisis are unable to postpone gratification. They often become frustrated, aggressive, and deceitful if denied. They resort to reckless behavior and stopgap economic activities.
In economic environments with compromised and impaired trust, loyalty decreases and mobility increases.
People switch jobs, renege on obligations, fail to repay debts, relocate often. Concepts like exclusivity, the sanctity of contracts, workplace loyalty, or a career path - all get eroded. As a result, little is invested in the future, in the acquisition of skills, in long term savings. Short- termism and bottom line mentality rule.
The outcomes of a crisis of trust are, usually, catastrophic: Economic activity is much reduced, human capital is corroded and wasted, brain drain increases, illegal and extra-legal activities rise, society is polarized between haves and haves-not, interethnic and inter-racial tensions increase. To rebuild trust in such circumstances is a daunting task. The loss of trust is contagious and, finally, it infects every institution and profession in the land. It is the stuff revolutions are made of.
The public outcry against executive pay and compensation followed disclosures of insider trading, double dealing, and outright fraud. But even honest and productive entrepreneurs often earn more money in one year than Albert Einstein did in his entire life. This strikes many - especially academics - as unfair. Surely Einstein's contributions to human knowledge and welfare far exceed anything ever accomplished by sundry businessmen? Fortunately, this discrepancy is cause for constructive jealousy, emulation, and imitation. It can, however, lead to an orgy of destructive and self-ruinous envy.
Such envy is reinforced by declining social mobility in the United States. Recent (2006-7) studies by the OECD (Organization for Economic Cooperation and Development) clearly demonstrate that the American Dream is a myth. In an editorial dated July 13, 2007, the New-York Times described the rapidly deteriorating situation thus: "... (M)obility between generations - people doing better or worse than their parents - is weaker in America than in Denmark, Austria, Norway, Finland, Canada, Sweden, Germany, Spain and France. In America, there is more than a 40 percent chance that if a father is in the bottom fifth of the earnings' distribution, his son will end up there, too. In Denmark, the equivalent odds are under 25 percent, and they are less than 30 percent in Britain.
America's sluggish mobility is ultimately unsurprising.
Wealthy parents not only pass on that wealth in inheritances, they can pay for better education, nutrition and health care for their children. The poor cannot afford this investment in their children's development - and the government doesn't provide nearly enough help.
In a speech earlier this year, the Federal Reserve chairman, Ben Bernanke, argued that while the inequality of rewards fuels the economy by making people exert themselves, opportunity should be "as widely distributed and as equal as possible." The problem is that the have-nots don't have many opportunities either".
Still, entrepreneurs recombine natural and human resources in novel ways. They do so to respond to forecasts of future needs, or to observations of failures and shortcomings of current products or services.
Entrepreneurs are professional - though usually intuitive - futurologists. This is a valuable service and it is financed by systematic risk takers, such as venture capitalists.
Surely they all deserve compensation for their efforts and the hazards they assume? Exclusive ownership is the most ancient type of such remuneration. First movers, entrepreneurs, risk takers, owners of the wealth they generated, exploiters of resources - are allowed to exclude others from owning or exploiting the same things. Mineral concessions, patents, copyright, trademarks - are all forms of monopoly ownership. What moral right to exclude others is gained from being the first? Nozick advanced Locke's Proviso. An exclusive ownership of property is just only if "enough and as good is left in common for others". If it does not worsen other people's lot, exclusivity is morally permissible. It can be argued, though, that all modes of exclusive ownership aggravate other people's situation. As far as everyone, bar the entrepreneur, are concerned, exclusivity also prevents a more advantageous distribution of income and wealth.
Exclusive ownership reflects real-life irreversibility. A first mover has the advantage of excess information and of irreversibly invested work, time, and effort. Economic enterprise is subject to information asymmetry: we know nothing about the future and everything about the past.
This asymmetry is known as "investment risk". Society compensates the entrepreneur with one type of asymmetry - exclusive ownership - for assuming another, the investment risk.
One way of looking at it is that all others are worse off by the amount of profits and rents accruing to owner- entrepreneurs. Profits and rents reflect an intrinsic inefficiency. Another is to recall that ownership is the result of adding value to the world. It is only reasonable to expect it to yield to the entrepreneur at least this value added now and in the future.
In a "Theory of Justice" (published 1971, p. 302), John Rawls described an ideal society thus: "(1) Each person is to have an equal right to the most extensive total system of equal basic liberties compatible with a similar system of liberty for all. (2) Social and economic inequalities are to be arranged so that they are both: (a) to the greatest benefit of the least advantaged, consistent with the just savings principle, and (b) attached to offices and positions open to all under conditions of fair equality of opportunity".
It all harks back to scarcity of resources - land, money, raw materials, manpower, creative brains. Those who can afford to do so, hoard resources to offset anxiety regarding future uncertainty. Others wallow in paucity.
The distribution of means is thus skewed. "Distributive justice" deals with the just allocation of scarce resources.
Yet, even the basic terminology is somewhat fuzzy. What constitutes a resource? what is meant by allocation? Who should allocate resources - Adam Smith's "invisible hand", the government, the consumer, or business? Should it reflect differences in power, in intelligence, in knowledge, or in heredity? Should resource allocation be subject to a principle of entitlement? Is it reasonable to demand that it be just - or merely efficient? Are justice and efficiency antonyms? Justice is concerned with equal access to opportunities.
Equal access does not guarantee equal outcomes, invariably determined by idiosyncrasies and differences between people. Access leveraged by the application of natural or acquired capacities - translates into accrued wealth. Disparities in these capacities lead to discrepancies in accrued wealth.
The doctrine of equal access is founded on the equivalence of Men. That all men are created equal and deserve the same respect and, therefore, equal treatment is not self evident. European aristocracy well into this century would have probably found this notion abhorrent.
Jose Ortega Y Gasset, writing in the 1930's, preached that access to educational and economic opportunities should be premised on one's lineage, up bringing, wealth, and social responsibilities.
A succession of societies and cultures discriminated against the ignorant, criminals, atheists, females, homosexuals, members of ethnic, religious, or racial groups, the old, the immigrant, and the poor. Communism - ostensibly a strict egalitarian idea - foundered because it failed to reconcile strict equality with economic and psychological realities within an impatient timetable.
Philosophers tried to specify a "bundle" or "package" of goods, services, and intangibles (like information, or skills, or knowledge). Justice - though not necessarily happiness - is when everyone possesses an identical bundle. Happiness - though not necessarily justice - is when each one of us possesses a "bundle" which reflects his or her preferences, priorities, and predilections. None of us will be too happy with a standardized bundle, selected by a committee of philosophers - or bureaucrats, as was the case under communism.
The market allows for the exchange of goods and services between holders of identical bundles. If I seek books, but detest oranges - I can swap them with someone in return for his books. That way both of us are rendered better off than under the strict egalitarian version.
Still, there is no guarantee that I will find my exact match - a person who is interested in swapping his books for my oranges. Illiquid, small, or imperfect markets thus inhibit the scope of these exchanges. Additionally, exchange participants have to agree on an index: how many books for how many oranges? This is the price of oranges in terms of books.
Money - the obvious "index" - does not solve this problem, merely simplifies it and facilitates exchanges. It does not eliminate the necessity to negotiate an "exchange rate". It does not prevent market failures. In other words: money is not an index. It is merely a medium of exchange and a store of value. The index - as expressed in terms of money - is the underlying agreement regarding the values of resources in terms of other resources (i.e., their relative values).
The market - and the price mechanism - increase happiness and welfare by allowing people to alter the composition of their bundles. The invisible hand is just and benevolent. But money is imperfect. The aforementioned Rawles demonstrated (1971), that we need to combine money with other measures in order to place a value on intangibles.
The prevailing market theories postulate that everyone has the same resources at some initial point (the "starting gate"). It is up to them to deploy these endowments and, thus, to ravage or increase their wealth. While the initial distribution is equal - the end distribution depends on how wisely - or imprudently - the initial distribution was used.
Egalitarian thinkers proposed to equate everyone's income in each time frame (e.g., annually). But identical incomes do not automatically yield the same accrued wealth. The latter depends on how the income is used - saved, invested, or squandered. Relative disparities of wealth are bound to emerge, regardless of the nature of income distribution.
Some say that excess wealth should be confiscated and redistributed. Progressive taxation and the welfare state aim to secure this outcome. Redistributive mechanisms reset the "wealth clock" periodically (at the end of every month, or fiscal year). In many countries, the law dictates which portion of one's income must be saved and, by implication, how much can be consumed. This conflicts with basic rights like the freedom to make economic choices.
The legalized expropriation of income (i.e., taxes) is morally dubious. Anti-tax movements have sprung all over the world and their philosophy permeates the ideology of political parties in many countries, not least the USA. Taxes are punitive: they penalize enterprise, success, entrepreneurship, foresight, and risk assumption.
Welfare, on the other hand, rewards dependence and parasitism.
According to Rawles' Difference Principle, all tenets of justice are either redistributive or retributive. This ignores non-economic activities and human inherent variance.
Moreover, conflict and inequality are the engines of growth and innovation - which mostly benefit the least advantaged in the long run. Experience shows that unmitigated equality results in atrophy, corruption and stagnation. Thermodynamics teaches us that life and motion are engendered by an irregular distribution of energy. Entropy - an even distribution of energy - equals death and stasis.
What about the disadvantaged and challenged - the mentally retarded, the mentally insane, the paralyzed, the chronically ill? For that matter, what about the less talented, less skilled, less daring? Dworkin (1981) proposed a compensation scheme. He suggested a model of fair distribution in which every person is given the same purchasing power and uses it to bid, in a fair auction, for resources that best fit that person's life plan, goals and preferences.
Having thus acquired these resources, we are then permitted to use them as we see fit. Obviously, we end up with disparate economic results. But we cannot complain - we were given the same purchasing power and the freedom to bid for a bundle of our choice.
Dworkin assumes that prior to the hypothetical auction, people are unaware of their own natural endowments but are willing and able to insure against being naturally disadvantaged. Their payments create an insurance pool to compensate the less fortunate for their misfortune.
This, of course, is highly unrealistic. We are usually very much aware of natural endowments and liabilities - both ours and others'. Therefore, the demand for such insurance is not universal, nor uniform. Some of us badly need and want it - others not at all. It is morally acceptable to let willing buyers and sellers to trade in such coverage (e.g., by offering charity or alms) - but may be immoral to make it compulsory.
Most of the modern welfare programs are involuntary Dworkin schemes. Worse yet, they often measure differences in natural endowments arbitrarily, compensate for lack of acquired skills, and discriminate between types of endowments in accordance with cultural biases and fads.
Libertarians limit themselves to ensuring a level playing field of just exchanges, where just actions always result in just outcomes. Justice is not dependent on a particular distribution pattern, whether as a starting point, or as an outcome. Robert Nozick "Entitlement Theory" proposed in 1974 is based on this approach.
That the market is wiser than any of its participants is a pillar of the philosophy of capitalism. In its pure form, the theory claims that markets yield patterns of merited distribution - i.e., reward and punish justly. Capitalism generate just deserts. Market failures - for instance, in the provision of public goods - should be tackled by governments. But a just distribution of income and wealth does not constitute a market failure and, therefore, should not be tampered with.
In the catechism of capitalism, shares represent the part- ownership of an economic enterprise, usually a firm. The value of shares is determined by the replacement value of the assets of the firm, including intangibles such as goodwill. The price of the share is determined by transactions among arm's length buyers and sellers in an efficient and liquid market. The price reflects expectations regarding the future value of the firm and the stock's future stream of income - i.e., dividends.
Alas, none of these oft-recited dogmas bears any resemblance to reality. Shares rarely represent ownership.
The float - the number of shares available to the public - is frequently marginal. Shareholders meet once a year to vent and disperse. Boards of directors are appointed by management - as are auditors. Shareholders are not represented in any decision making process - small or big.
The dismal truth is that shares reify the expectation to find future buyers at a higher price and thus incur capital gains.
In the Ponzi scheme known as the stock exchange, this expectation is proportional to liquidity - new suckers - and volatility. Thus, the price of any given stock reflects merely the consensus as to how easy it would be to offload one's holdings and at what price.
Another myth has to do with the role of managers. They are supposed to generate higher returns to shareholders by increasing the value of the firm's assets and, therefore, of the firm. If they fail to do so, goes the moral tale, they are booted out mercilessly. This is one manifestation of the "Principal-Agent Problem". It is defined thus by the Oxford Dictionary of Economics: "The problem of how a person A can motivate person B to act for A's benefit rather than following (his) self- interest".
The obvious answer is that A can never motivate B not to follow B's self-interest - never mind what the incentives are. That economists pretend otherwise - in "optimal contracting theory" - just serves to demonstrate how divorced economics is from human psychology and, thus, from reality.
Managers will always rob blind the companies they run.
They will always manipulate boards to collude in their shenanigans. They will always bribe auditors to bend the rules. In other words, they will always act in their self- interest. In their defense, they can say that the damage from such actions to each shareholder is minuscule while the benefits to the manager are enormous. In other words, this is the rational, self-interested, thing to do.
But why do shareholders cooperate with such corporate brigandage? In an important Chicago Law Review article whose preprint was posted to the Web a few weeks ago - titled "Managerial Power and Rent Extraction in the Design of Executive Compensation" - the authors demonstrate how the typical stock option granted to managers as part of their remuneration rewards mediocrity rather than encourages excellence.
But everything falls into place if we realize that shareholders and managers are allied against the firm - not pitted against each other. The paramount interest of both shareholders and managers is to increase the value of the stock - regardless of the true value of the firm. Both are concerned with the performance of the share - rather than the performance of the firm. Both are preoccupied with boosting the share's price - rather than the company's business.
Hence the inflationary executive pay packets.
Shareholders hire stock manipulators - euphemistically known as "managers" - to generate expectations regarding the future prices of their shares. These snake oil salesmen and snake charmers - the corporate executives - are allowed by shareholders to loot the company providing they generate consistent capital gains to their masters by provoking persistent interest and excitement around the business. Shareholders, in other words, do not behave as owners of the firm - they behave as free-riders.
The Principal-Agent Problem arises in other social interactions and is equally misunderstood there. Consider taxpayers and their government. Contrary to conservative lore, the former want the government to tax them providing they share in the spoils. They tolerate corruption in high places, cronyism, nepotism, inaptitude and worse - on condition that the government and the legislature redistribute the wealth they confiscate. Such redistribution often comes in the form of pork barrel projects and benefits to the middle-class.
This is why the tax burden and the government's share of GDP have been soaring inexorably with the consent of the citizenry. People adore government spending precisely because it is inefficient and distorts the proper allocation of economic resources. The vast majority of people are rent-seekers. Witness the mass demonstrations that erupt whenever governments try to slash expenditures, privatize, and eliminate their gaping deficits. This is one reason the IMF with its austerity measures is universally unpopular.
Employers and employees, producers and consumers - these are all instances of the Principal-Agent Problem.
Economists would do well to discard their models and go back to basics. They could start by asking: Why do shareholders acquiesce with executive malfeasance as long as share prices are rising? Why do citizens protest against a smaller government - even though it means lower taxes? Could it mean that the interests of shareholders and managers are identical? Does it imply that people prefer tax-and-spend governments and pork barrel politics to the Thatcherite alternative? Nothing happens by accident or by coercion. Shareholders aided and abetted the current crop of corporate executives enthusiastically. They knew well what was happening.
They may not have been aware of the exact nature and extent of the rot - but they witnessed approvingly the public relations antics, insider trading, stock option resetting , unwinding, and unloading, share price manipulation, opaque transactions, and outlandish pay packages. Investors remained mum throughout the corruption of corporate America. It is time for the hangover.
Conservative sociologists self-servingly marvel at the peaceful proximity of abject poverty and ostentatious affluence in American - or, for that matter, Western - cities. Devastating riots do erupt, but these are reactions either to perceived social injustice (Los Angeles 1965) or to political oppression (Paris 1968). The French Revolution may have been the last time the urban sans- culotte raised a fuss against the economically enfranchised.
This pacific co-existence conceals a maelstrom of envy.
Behold the rampant Schadenfreude which accompanied the antitrust case against the predatory but loaded Microsoft. Observe the glee which engulfed many destitute countries in the wake of the September 11 atrocities against America, the epitome of triumphant prosperity. Witness the post-World.com orgiastic castigation of avaricious CEO's.
Envy - a pathological manifestation of destructive aggressiveness - is distinct from jealousy.
The New Oxford Dictionary of English defines envy as: "A feeling of discontented or resentful longing aroused by someone else's possessions, qualities, or luck ...
Mortification and ill-will occasioned by the contemplation of another's superior advantages".
Pathological envy - the fourth deadly sin - is engendered by the realization of some lack, deficiency, or inadequacy in oneself. The envious begrudge others their success, brilliance, happiness, beauty, good fortune, or wealth.
Envy provokes misery, humiliation, and impotent rage.
The envious copes with his pernicious emotions in five ways: 1. They attack the perceived source of frustration in an attempt to destroy it, or "reduce it" to their "size". Such destructive impulses often assume the disguise of championing social causes, fighting injustice, touting reform, or promoting an ideology. 2. They seek to subsume the object of envy by imitating it. In extreme cases, they strive to get rich quick through criminal scams, or corruption.
They endeavor to out-smart the system and shortcut their way to fortune and celebrity. 3. They resort to self-deprecation. They idealize the successful, the rich, the mighty, and the lucky and attribute to them super-human, almost divine, qualities. At the same time, they humble themselves. Indeed, most of this strain of the envious end up disenchanted and bitter, driving the objects of their own erstwhile devotion and adulation to destruction and decrepitude. 4. They experience cognitive dissonance. These people devalue the source of their frustration and envy by finding faults in everything they most desire and in everyone they envy. 5. They avoid the envied person and thus the agonizing pangs of envy.
Envy is not a new phenomenon. Belisarius, the general who conquered the world for Emperor Justinian, was blinded and stripped of his assets by his envious peers. I - and many others - have written extensively about envy in command economies. Nor is envy likely to diminish.
In his book, "Facial Justice", Hartley describes a post- apocalyptic dystopia, New State, in which envy is forbidden and equality extolled and everything enviable is obliterated. Women are modified to look like men and given identical "beta faces". Tall buildings are razed.
Joseph Schumpeter, the prophetic Austrian-American economist, believed that socialism will disinherit capitalism. In "Capitalism, Socialism, and Democracy" he foresaw a conflict between a class of refined but dirt-poor intellectuals and the vulgar but filthy rich businessmen and managers they virulently envy and resent. Samuel Johnson wrote: "He was dull in a new way, and that made many people think him great." The literati seek to tear down the market economy which they feel has so disenfranchised and undervalued them.
Hitler, who fancied himself an artist, labeled the British a "nation of shopkeepers" in one of his bouts of raging envy. Ralph Reiland, the Kenneth Simon professor of free enterprise at Robert Morris University, quotes David Brooks of the "weekly Standard", who christened this phenomenon "bourgeoisophobia": "The hatred of the bourgeoisie is the beginning of all virtue' - wrote Gustav Flaubert. He signed his letters 'Bourgeoisophobus' to show how much he despised 'stupid grocers and their ilk ... Through some screw-up in the great scheme of the universe, their narrow-minded greed had brought them vast wealth, unstoppable power and growing social prestige".
Reiland also quotes from Ludwig van Mises's "The Anti- Capitalist Mentality": "Many people, and especially intellectuals, passionately loathe capitalism. In a society based on caste and status, the individual can ascribe adverse fate to conditions beyond his control. In ... capitalism ... everybody's station in life depends on his doing ... (what makes a man rich is) not the evaluation of his contribution from any 'absolute' principle of justice but the evaluation on the part of his fellow men who exclusively apply the yardstick of their personal wants, desires and ends ... Everybody knows very well that there are people like himself who succeeded where he himself failed. Everybody knows that many of those he envies are self-made men who started from the same point from which he himself started. Everybody is aware of his own defeat. In order to console himself and to restore his self- assertion, such a man is in search of a scapegoat. He tries to persuade himself that he failed through no fault of his own. He was too decent to resort to the base tricks to which his successful rivals owe their ascendancy. The nefarious social order does not accord the prizes to the most meritorious men; it crowns the dishonest, unscrupulous scoundrel, the swindler, the exploiter, the 'rugged individualist'".
In "The Virtue of Prosperity", Dinesh D'Souza accuses prosperity and capitalism of inspiring vice and temptation.
Inevitably, it provokes envy in the poor and depravity in the rich.
With only a modicum of overstatement, capitalism can be depicted as the sublimation of jealousy. As opposed to destructive envy - jealousy induces emulation. Consumers - responsible for two thirds of America's GDP - ape role models and vie with neighbors, colleagues, and family members for possessions and the social status they endow.
Productive and constructive competition - among scientists, innovators, managers, actors, lawyers, politicians, and the members of just about every other profession - is driven by jealousy.
The eminent Nobel prize winning British economist and philosopher of Austrian descent, Friedrich Hayek, suggested in "The Constitution of Liberty" that innovation and progress in living standards are the outcomes of class envy. The wealthy are early adopters of expensive and unproven technologies. The rich finance with their conspicuous consumption the research and development phase of new products. The poor, driven by jealousy, imitate them and thus create a mass market which allows manufacturers to lower prices.
But jealousy is premised on the twin beliefs of equality and a level playing field. "I am as good, as skilled, and as talented as the object of my jealousy." - goes the subtext - "Given equal opportunities, equitable treatment, and a bit of luck, I can accomplish the same or more".
Jealousy is easily transformed to outrage when its presumptions - equality, honesty, and fairness - prove wrong. In a paper recently published by Harvard University's John M. Olin Center for Law and titled "Executive Compensation in America: Optimal Contracting or Extraction of Rents?", the authors argue that executive malfeasance is most effectively regulated by this "outrage constraint": "Directors (and non-executive directors) would be reluctant to approve, and executives would be hesitant to seek, compensation arrangements that might be viewed by observers as outrageous".
Game Theory
Consider this: Could Western management techniques be successfully implemented in the countries of Central and Eastern Europe (CEE)? Granted, they have to be adapted, modified and cannot be imported in their entirety. But their crux, their inalienable nucleus - can this be transported and transplanted in CEE? Theory provides us with a positive answer. Human agents are the same everywhere and are mostly rational. Practice begs to differ. Basic concepts such as the money value of time or the moral and legal meaning of property are non existent.
The legal, political and economic environments are all unpredictable. As a result, economic players will prefer to maximize their utility immediately (steal from the workplace, for instance) - than to wait for longer term (potentially, larger) benefits. Warrants (stock options) convertible to the company's shares constitute a strong workplace incentive in the West (because there is an horizon and they increase the employee's welfare in the long term). Where the future is speculation - speculation withers. Stock options or a small stake in his firm, will only encourage the employee to blackmail the other shareholders by paralysing the firm, to abuse his new position and will be interpreted as immunity, conferred from above, from the consequences of illegal activities.
The very allocation of options or shares will be interpreted as a sign of weakness, dependence and need, to be exploited. Hierarchy is equated with slavery and employees will rather harm their long term interests than follow instructions or be subjected to criticism - never mind how constructive. The employees in CEE regard the corporate environment as a conflict zone, a zero sum game (in which the gains by some equal the losses to others). In the West, the employees participate in the increase in the firm's value. The difference between these attitudes is irreconcilable.
Now, let us consider this: An entrepreneur is a person who is gifted at identifying the unsatisfied needs of a market, at mobilizing and organizing the resources required to satisfy those needs and at defining a long-term strategy of development and marketing. As the enterprise grows, two processes combine to denude the entrepreneur of some of his initial functions. The firm has ever growing needs for capital: financial, human, assets and so on. Additionally, the company begins (or should begin) to interface and interact with older, better established firms. Thus, the company is forced to create its first management team: a general manager with the right doses of respectability, connections and skills, a chief financial officer, a host of consultants and so on. In theory - if all our properly motivated financially - all these players (entrepreneurs and managers) will seek to maximize the value of the firm. What happens, in reality, is that both work to minimize it, each for its own reasons. The managers seek to maximize their short-term utility by securing enormous pay packages and other forms of company-dilapidating compensation. The entrepreneurs feel that they are "strangled", "shackled", "held back" by bureaucracy and they "rebel". They oust the management, or undermine it, turning it into an ineffective representative relic. They assume real, though informal, control of the firm. They do so by defining a new set of strategic goals for the firm, which call for the institution of an entrepreneurial rather than a bureaucratic type of management. These cycles of initiative-consolidation-new initiative-revolution- consolidation are the dynamos of company growth.
Growth leads to maximization of value. However, the players don't know or do not fully believe that they are in the process of maximizing the company's worth. On the contrary, consciously, the managers say: "Let's maximize the benefits that we derive from this company, as long as we are still here." The entrepreneurs-owners say: "We cannot tolerate this stifling bureaucracy any longer. We prefer to have a smaller company - but all ours." The growth cycles forces the entrepreneurs to dilute their holdings (in order to raise the capital necessary to finance their initiatives). This dilution (the fracturing of the ownership structure) is what brings the last cycle to its end. The holdings of the entrepreneurs are too small to materialize a coup against the management. The management then prevails and the entrepreneurs are neutralized and move on to establish another start-up. The only thing that they leave behind them is their names and their heirs.
We can use Game Theory methods to analyse both these situations. Wherever we have economic players bargaining for the allocation of scarce resources in order to attain their utility functions, to secure the outcomes and consequences (the value, the preference, that the player attaches to his outcomes) which are right for them - we can use Game Theory (GT).
A short recap of the basic tenets of the theory might be in order.
GT deals with interactions between agents, whether conscious and intelligent - or Dennettic. A Dennettic Agent (DA) is an agent that acts so as to influence the future allocation of resources, but does not need to be either conscious or deliberative to do so. A Game is the set of acts committed by 1 to n rational DA and one a- rational (not irrational but devoid of rationality) DA (nature, a random mechanism). At least 1 DA in a Game must control the result of the set of acts and the DAs must be (at least potentially) at conflict, whole or partial. This is not to say that all the DAs aspire to the same things.
They have different priorities and preferences. They rank the likely outcomes of their acts differently. They engage Strategies to obtain their highest ranked outcome. A Strategy is a vector, which details the acts, with which the DA will react in response to all the (possible) acts by the other DAs. An agent is said to be rational if his Strategy does guarantee the attainment of his most preferred goal.
Nature is involved by assigning probabilities to the outcomes. An outcome, therefore, is an allocation of resources resulting from the acts of the agents. An agent is said to control the situation if its acts matter to others to the extent that at least one of them is forced to alter at least one vector (Strategy). The Consequence to the agent is the value of a function that assigns real numbers to each of the outcomes. The consequence represents a list of outcomes, prioritized, ranked. It is also known as an ordinal utility function. If the function includes relative numerical importance measures (not only real numbers) - we call it a Cardinal Utility Function.
Games, naturally, can consist of one player, two players and more than two players (n-players). They can be zero (or fixed) - sum (the sum of benefits is fixed and whatever gains made by one of the players are lost by the others).
They can be nonzero-sum (the amount of benefits to all players can increase or decrease). Games can be cooperative (where some of the players or all of them form coalitions) - or non-cooperative (competitive). For some of the games, the solutions are called Nash equilibria. They are sets of strategies constructed so that an agent which adopts them (and, as a result, secures a certain outcome) will have no incentive to switch over to other strategies (given the strategies of all other players).
Nash equilibria (solutions) are the most stable (it is where the system "settles down", to borrow from Chaos Theory) - but they are not guaranteed to be the most desirable.
Consider the famous "Prisoners' Dilemma" in which both players play rationally and reach the Nash equilibrium only to discover that they could have done much better by collaborating (that is, by playing irrationally). Instead, they adopt the "Paretto-dominated", or the "Paretto- optimal", sub-optimal solution. Any outside interference with the game (for instance, legislation) will be construed as creating a NEW game, not as pushing the players to adopt a "Paretto-superior" solution.
The behaviour of the players reveals to us their order of preferences. This is called "Preference Ordering" or "Revealed Preference Theory". Agents are faced with sets of possible states of the world (=allocations of resources, to be more economically inclined). These are called "Bundles". In certain cases they can trade their bundles, swap them with others. The evidence of these swaps will inevitably reveal to us the order of priorities of the agent.
All the bundles that enjoy the same ranking by a given agent - are this agent's "Indifference Sets". The construction of an Ordinal Utility Function is, thus, made simple. The indifference sets are numbered from 1 to n.
These ordinals do not reveal the INTENSITY or the RELATIVE INTENSITY of a preference - merely its location in a list. However, techniques are available to transform the ordinal utility function - into a cardinal one.
A Stable Strategy is similar to a Nash solution - though not identical mathematically. There is currently no comprehensive theory of Information Dynamics. Game Theory is limited to the aspects of competition and exchange of information (cooperation). Strategies that lead to better results (independently of other agents) are dominant and where all the agents have dominant strategies - a solution is established. Thus, the Nash equilibrium is applicable to games that are repeated and wherein each agent reacts to the acts of other agents. The agent is influenced by others - but does not influence them (he is negligible). The agent continues to adapt in this way - until no longer able to improve his position.
The Nash solution is less available in cases of cooperation and is not unique as a solution. In most cases, the players will adopt a minimax strategy (in zero-sum games) or maximin strategies (in nonzero-sum games). These strategies guarantee that the loser will not lose more than the value of the game and that the winner will gain at least this value. The solution is the "Saddle Point".
The distinction between zero-sum games (ZSG) and nonzero-sum games (NZSG) is not trivial. A player playing a ZSG cannot gain if prohibited to use certain strategies. This is not the case in NZSGs. In ZSG, the player does not benefit from exposing his strategy to his rival and is never harmed by having foreknowledge of his rival's strategy. Not so in NZSGs: at times, a player stands to gain by revealing his plans to the "enemy". A player can actually be harmed by NOT declaring his strategy or by gaining acquaintance with the enemy's stratagems. The very ability to communicate, the level of communication and the order of communication - are important in cooperative cases. A Nash solution: 1. Is not dependent upon any utility function; 2. It is impossible for two players to improve the Nash solution (=their position) simultaneously (=the Paretto optimality); 3. Is not influenced by the introduction of irrelevant (not very gainful) alternatives; and 4. Is symmetric (reversing the roles of the players does not affect the solution).
The limitations of this approach are immediately evident.
It is definitely not geared to cope well with more complex, multi-player, semi-cooperative (semi-competitive), imperfect information situations.
Von Neumann proved that there is a solution for every ZSG with 2 players, though it might require the implementation of mixed strategies (strategies with probabilities attached to every move and outcome).
Together with the economist Morgenstern, he developed an approach to coalitions (cooperative efforts of one or more players - a coalition of one player is possible).
Every coalition has a value - a minimal amount that the coalition can secure using solely its own efforts and resources. The function describing this value is super- additive (the value of a coalition which is comprised of two sub-coalitions equals, at least, the sum of the values of the two sub-coalitions). Coalitions can be epiphenomenal: their value can be higher than the combined values of their constituents. The amounts paid to the players equal the value of the coalition and each player stands to get an amount no smaller than any amount that he would have made on his own. A set of payments to the players, describing the division of the coalition's value amongst them, is the "imputation", a single outcome of a strategy. A strategy is, therefore, dominant, if: (1) each player is getting more under the strategy than under any other strategy and (2) the players in the coalition receive a total payment that does not exceed the value of the coalition. Rational players are likely to prefer the dominant strategy and to enforce it.
Thus, the solution to an n-players game is a set of imputations. No single imputation in the solution must be dominant (=better). They should all lead to equally desirable results. On the other hand, all the imputations outside the solution should be dominated. Some games are without solution (Lucas, 1967).
Auman and Maschler tried to establish what is the right payoff to the members of a coalition. They went about it by enlarging upon the concept of bargaining (threats, bluffs, offers and counter-offers). Every imputation was examined, separately, whether it belongs in the solution (=yields the highest ranked outcome) or not, regardless of the other imputations in the solution. But in their theory, every member had the right to "object" to the inclusion of other members in the coalition by suggesting a different, exclusionary, coalition in which the members stand to gain a larger payoff. The player about to be excluded can "counter-argue" by demonstrating the existence of yet another coalition in which the members will get at least as much as in the first coalition and in the coalition proposed by his adversary, the "objector". Each coalition has, at least, one solution.
The Game in GT is an idealized concept. Some of the assumptions can - and should be argued against. The number of agents in any game is assumed to be finite and a finite number of steps is mostly incorporated into the assumptions. Omissions are not treated as acts (though negative ones). All agents are negligible in their relationship to others (have no discernible influence on them) - yet are influenced by them (their strategies are not - but the specific moves that they select - are). The comparison of utilities is not the result of any ranking - because no universal ranking is possible. Actually, no ranking common to two or n players is possible (rankings are bound to differ among players). Many of the problems are linked to the variant of rationality used in GT. It is comprised of a clarity of preferences on behalf of the rational agent and relies on the people's tendency to converge and cluster around the right answer / move.
This, however, is only a tendency. Some of the time, players select the wrong moves. It would have been much wiser to assume that there are no pure strategies, that all of them are mixed. Game Theory would have done well to borrow mathematical techniques from quantum mechanics. For instance: strategies could have been described as wave functions with probability distributions.
The same treatment could be accorded to the cardinal utility function. Obviously, the highest ranking (smallest ordinal) preference should have had the biggest probability attached to it - or could be treated as the collapse event. But these are more or less known, even trivial, objections. Some of them cannot be overcome. We must idealize the world in order to be able to relate to it scientifically at all. The idealization process entails the incorporation of gross inaccuracies into the model and the ignorance of other elements. The surprise is that the approximation yields results, which tally closely with reality - in view of its mutilation, affected by the model.
There are more serious problems, philosophical in nature.
It is generally agreed that "changing" the game can - and very often does - move the players from a non- cooperative mode (leading to Paretto-dominated results, which are never desirable) - to a cooperative one. A government can force its citizens to cooperate and to obey the law. It can enforce this cooperation. This is often called a Hobbesian dilemma. It arises even in a population made up entirely of altruists. Different utility functions and the process of bargaining are likely to drive these good souls to threaten to become egoists unless other altruists adopt their utility function (their preferences, their bundles). Nash proved that there is an allocation of possible utility functions to these agents so that the equilibrium strategy for each one of them will be this kind of threat. This is a clear social Hobbesian dilemma: the equilibrium is absolute egoism despite the fact that all the players are altruists. This implies that we can learn very little about the outcomes of competitive situations from acquainting ourselves with the psychological facts pertaining to the players. The agents, in this example, are not selfish or irrational - and, still, they deteriorate in their behaviour, to utter egotism. A complete set of utility functions - including details regarding how much they know about one another's utility functions - defines the available equilibrium strategies. The altruists in our example are prisoners of the logic of the game. Only an "outside" power can release them from their predicament and permit them to materialize their true nature. Gauthier said that morally-constrained agents are more likely to evade Paretto-dominated outcomes in competitive games - than agents who are constrained only rationally. But this is unconvincing without the existence of an Hobesian enforcement mechanism (a state is the most common one). Players would do better to avoid Paretto dominated outcomes by imposing the constraints of such a mechanism upon their available strategies. Paretto optimality is defined as efficiency, when there is no state of things (a different distribution of resources) in which at least one player is better off - with all the other no worse off. "Better off" read: "with his preference satisfied". This definitely could lead to cooperation (to avoid a bad outcome) - but it cannot be shown to lead to the formation of morality, however basic. Criminals can achieve their goals in splendid cooperation and be content, but that does not make it more moral. Game theory is agent neutral, it is utilitarianism at its apex. It does not prescribe to the agent what is "good" - only what is "right". It is the ultimate proof that effort at reconciling utilitarianism with more deontological, agent relative, approaches are dubious, in the best of cases. Teleology, in other words, in no guarantee of morality.
Acts are either means to an end or ends in themselves.
This is no infinite regression. There is bound to be an holy grail (happiness?) in the role of the ultimate end. A more commonsense view would be to regard acts as means and states of affairs as ends. This, in turn, leads to a teleological outlook: acts are right or wrong in accordance with their effectiveness at securing the achievement of the right goals. Deontology (and its stronger version, absolutism) constrain the means. It states that there is a permitted subset of means, all the other being immoral and, in effect, forbidden. Game Theory is out to shatter both the notion of a finite chain of means and ends culminating in an ultimate end - and of the deontological view. It is consequentialist but devoid of any value judgement.
Game Theory pretends that human actions are breakable into much smaller "molecules" called games. Human acts within these games are means to achieving ends but the ends are improbable in their finality. The means are segments of "strategies": prescient and omniscient renditions of the possible moves of all the players. Aside from the fact that it involves mnemic causation (direct and deterministic influence by past events) and a similar influence by the utility function (which really pertains to the future) - it is highly implausible. Additionally, Game Theory is mired in an internal contradiction: on the one hand it solemnly teaches us that the psychology of the players is absolutely of no consequence. On the other, it hastens to explicitly and axiomatically postulate their rationality and implicitly (and no less axiomatically) their benefit-seeking behaviour (though this aspect is much more muted). This leads to absolutely outlandish results: irrational behaviour leads to total cooperation, bounded rationality leads to more realistic patterns of cooperation and competition (coopetition) and an unmitigated rational behaviour leads to disaster (also known as Paretto dominated outcomes).
Moreover, Game Theory refuses to acknowledge that real games are dynamic, not static. The very concepts of strategy, utility function and extensive (tree like) representation are static. The dynamic is retrospective, not prospective. To be dynamic, the game must include all the information about all the actors, all their strategies, all their utility functions. Each game is a subset of a higher level game, a private case of an implicit game which is constantly played in the background, so to say. This is a hyper-game of which all games are but derivatives. It incorporates all the physically possible moves of all the players. An outside agency with enforcement powers (the state, the police, the courts, the law) are introduced by the players. In this sense, they are not really an outside event which has the effect of altering the game fundamentally.
They are part and parcel of the strategies available to the players and cannot be arbitrarily ruled out. On the contrary, their introduction as part of a dominant strategy will simplify Game theory and make it much more applicable. In other words: players can choose to compete, to cooperate and to cooperate in the formation of an outside agency. There is no logical or mathematical reason to exclude the latter possibility. The ability to thus influence the game is a legitimate part of any real life strategy. Game Theory assumes that the game is a given - and the players have to optimize their results within it. It should open itself to the inclusion of game altering or redefining moves by the players as an integral part of their strategies. After all, games entail the existence of some agreement to play and this means that the players accept some rules (this is the role of the prosecutor in the Prisoners' Dilemma). If some outside rules (of the game) are permissible - why not allow the "risk" that all the players will agree to form an outside, lawfully binding, arbitration and enforcement agency - as part of the game? Such an agency will be nothing if not the embodiment, the materialization of one of the rules, a move in the players' strategies, leading them to more optimal or superior outcomes as far as their utility functions are concerned.
Bargaining inevitably leads to an agreement regarding a decision making procedure. An outside agency, which enforces cooperation and some moral code, is such a decision making procedure. It is not an "outside" agency in the true, physical, sense. It does not "alter" the game (not to mention its rules). It IS the game, it is a procedure, a way to resolve conflicts, an integral part of any solution and imputation, the herald of cooperation, a representative of some of the will of all the players and, therefore, a part both of their utility functions and of their strategies to obtain their preferred outcomes. Really, these outside agencies ARE the desired outcomes. Once Game Theory digests this observation, it could tackle reality rather than its own idealized contraptions.