79. Capitalism and Freedom, Part 2

Note: This post is the seventy-ninth in a series about government and commercial ethics. Click here for the full listing of the series. The first post in the series has more detail on the book 'Systems of Survival' by Jane Jacobs which inspired this series.

This week's post is a follow-up on last week's post on the book 'Capitalism and Freedom' by Milton Friedman.

Last week I promised to explore in more detail an example of where Milton Friedman got carried away with his 'market good, government bad' mindset. The specific topic I want to cover is Friedman's comment that,

"The view has been gaining widespread acceptance that corporate officials and labor leaders have a 'social responsibility' that goes beyond serving the interests of their stockholders or their members. This view shows a fundamental misconception of the character and nature of a free economy. In such an economy, there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.¹"

As we'll see, the trouble with this statement is that while it is true that businesses have an obligation to pursue profits, Friedman unnecessarily constrains their other moral obligations, ruling out things like taking action to fight pollution as being a violation of a company's duty to pursue profits first.

This will be a lazy post for me, since I'm going to let Joseph Heath do most of the talking, via his essay, "A Market Failures Approach to Business Ethics" Really, you'd be better off just reading Heath's whole essay - it's easy to follow and not particularly long, but I'll summarize the main points here that are relevant to our Systems of Survival theme.

Heath first argues that the obligation of the business to earn profits is not a simple reflection of self-interest on the part of company shareholders but rather is a moral duty. The profits earned are a reflection of the ability of the shareholders ability to deploy resources where they are wanted/needed by the population - so the greater the profit, the greater the gain to society, and hence the duty to earn profits.

Naturally, many people will find this a little hard to swallow. Heath reasons that one reason people find this difficult to accept is that, unlike say a doctor's obligation to their patients, the obligation of a a manager to make profits is more like the indirect role played by trial lawyers in which an action which in and of itself has little moral justification (making money for shareholders / defending accused criminals) has value because of the role it plays within a system with various parts.

Heath:

"We understand implicitly that the professional conduct of doctors is to be entirely governed by their obligations to their patients, and thus that they are not permitted to let considerations of self-interest intrude. Profit-maximization has precisely the same status for managers.

...

Health is widely regarded as a good thing, and thus the doctor’s actions serve to promote a state of affairs that is morally desirable. This makes the doctor’s actions directly justifiable, even intrinsically altruistic. Things are more complicated in the case of business. It is not clear that profits are intrinsically good. Furthermore, when a manager makes a decision that disadvantages workers in order to benefit owners, the profit maximization imperative generates a distributive transfer that is by no means morally sanctioned. In fact, under the typical set of circumstances, the transfer will be regressive, and thus problematic from the moral point of view.

The asymmetry arises from the fact that profit maximization is only indirectly justified. It is useful to note that this problem is one that business ethics shares with legal ethics. The adversarial trial system imposes upon lawyers an obligation to do whatever is in their power to defend or advance the interests of their client, even when these interests are highly refractory to the concerns of justice. Thus the professional obligations of lawyers often conflict with the imperatives of everyday morality. What justifies their behaviour is the fact that they operate in the context of an institution with differentiated roles. The desirable outcome is a product of the interaction between individuals acting in these roles, none of whom are actually seeking that outcome. Justice is best served when there is both vigorous prosecution and vigorous defence.

Thus the effective trial lawyer 'promotes an end which is no part of his intention.'"

Next, Heath explains that the moral duty to seek profit flows from the first theorem of welfare economics which states that economic (pareto) efficiency is maximized when a bunch of conditions known collectively as 'perfect competition' are met, with one of the conditions being a number of firms competing to make the most profits.

Heath:

"Thus the primary reason for introducing the profit motive into the economy is to secure the operation of the price mechanism. The price mechanism is in turn valued for its efficiency effects. It allows us to minimize waste. The formal proof of this is often referred to as 'the first fundamental theory of welfare economics” (hereafter FFT), or else, in a nod to Adam Smith, the 'invisible hand theorem.' The central conclusion is that the outcome of a perfectly competitive market economy with be Pareto optimal – which means that it will not be possible to improve any one person’s condition without worsening someone else's."

Where things get tricky is that there are a number of other conditions for perfect competition (recall our earlier posts on Walter Schultz's 'Moral Conditions of Economic Efficiency')

The trouble is that competition only leads to efficiency if a number of conditions are met, the most commonly recognizes ones being the avoidance of force and fraud. As Heath notes, Friedman implicitly recognizes these moral obligations when he insists that the responsibility of the business is to, "to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud."

Where Friedman gets into trouble is in ignoring other possible violations of economic efficiency, most notably, the loss of efficiency caused by externalities that aren't priced into a business' products. For example, if company A drives company B out of business by offering lower prices, not because company A was better managed than company B but because company A lowered costs by dumping toxic chemicals into the water supply instead of paying to treat them like company B did, then this is not a gain in efficiency for society.

Heath:

"Despite some confusion, it is clear that Friedman's managers have genuine ethical responsibility to shareholders, and that this responsibility is derived from the FFT. The problem is that Friedman arbitrarily limits the set of obligations to those that support only some of the many Pareto conditions.

For example, Friedman argues that pollution reduction is one of the illegitimate responsibilities pressed upon managers in the name of 'social responsibility.' But pollution is a negative externality – a cost associated with some economic activity that is transferred to a third party without compensation. These externalities exist because the set of markets is incomplete. We cannot exercise property rights over the air that we breathe, for example. As a result, while we can charge people for dumping noxious substances on land that we own, we cannot do the same when they dump it in the air. For this reason, one of the Pareto conditions specifies that there must be no externalities. Any corporation that pollutes is essentially profiting from a market imperfection. This means that there is no difference, from the moral point of view, between deception and pollution – both represent impermissible profit-maximization strategies.

Friedman's decision to prohibit deception, while giving the wink to environmental degradation, is arbitrary and unmotivated."

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¹ This quote is from Capitalism and Freedom, page 133, but you can also refer to Friedman's article, "The Social Responsibility of Business is to Increase its Profits," which covers the topic of this post specifically.

68. Selfishness, Altruism and Rationality, Part 1

Note: This post is the sixty-eighth in a series about government and commercial ethics. Click here for the full listing of the series. The first post in the series has more detail on the book 'Systems of Survival' by Jane Jacobs which inspired this series.

This week's topic is the book, Selfishness, Altruism and Rationality, by Howard Margolis

Margolis' goal in this book is to extend the Economic Theory of Rational Choice so that it covers political situations as well as Economic ones.

He opens the book with a quote from James Coleman which eloquently outlines the problem, while also covering our now familiar choice between two versions of self-interest,

"Classical economic theory always assumes that the individual will 'act in his interest'; but it never examined carefully the entity to which 'his' refers. Often, as when households are taken as the unit for income and consumption, it is implicitly assumed that 'the family' or 'the household' is the entity whose interest is being maximized. Yet this is without theoretical foundation, merely a convenient but slipshod device. In this case, as in many others (e.g. when a man is willing to contribute much, even his life, to national defense, rather than use a strategy that will push the cost onto others), men act as if the 'his' referred to some entity larger than themselves. That is, they appear to act in terms, not of their own interest, but of the interest of a collectivity or even of another person. Indeed, if they did not do so, the basis for society could hardly exist.

Yet how can this be reconciled with the narrow premise of individual interest ... we could simply solve the problem by fiat, letting 'his' refer to whatever entity the individual appeared to act in the interest of. This would obviously make the theory trivially true, and never disconfirmable. A more adequate solution is one which states the conditions under which the entity in whose interests he acts will be something other than himself."

We saw in the last post that James Buchanan was willing to settle for a theory that based human motivation solely on the desire for material gain, arguing that the desire for material gain is always present to some degree in people.

But Margolis isn't willing to settle so easily,

"A satisfactory theory of social choice requires a model of individual choice that is consistent with the way human beings are observed to behave. Yet, even after a generation of work on the problem of applying the economic 'rational choice' perspective to social choice, often leading to striking results, this fundamental problem remains unresolved. We still lack a model that accommodates (without fudging) such obvious observations as that citizens bother to vote and do not always cheat when no one is looking. A resolution of this difficulty can be expected to require some departure from conventional assumptions."

Margolis goes on to indicate that, in his opinion, the main difference between situations which can modelled fruitfully using the traditional model and situations requiring a new model is that situations where the old model works are economic in nature whereas situations where a new model is required are political in nature (echoes of Mancur Olson specifically indicating that this theories on collective action only applied to economic groups, not groups formed for no-economic reasons.

Says Margolis,

"This classical model is profoundly shaped by its root concern with the problems of the marketplace. But in politics we are dealing with goods allocated largely through some coercive process, not through voluntary market transactions; and political 'goods' (such as justice) are often inherently unmarketable. Nonmarket effects (externalities) which are aberrations - market failures, which one seeks to correct - for most economists are the central feature of political life for political scientists.

We can expect that Samuelson's notion of public goods (which can best be understood as a generalization of the notion of externalities) would play a central role in any viable formal theory of politics, and indeed that is the case. It is not too strong a statement to say that societies, and hence politics exist because public goods exist."

Margolis spends a chapter illustrating his argument that the classical rational choice models fails to handle political situations via a series of 3 examples:

* Voting
* Repeated Prisoner's Dilemmas
* Public Goods

In the case of voting, the rational choice model fails to explain why people might go the trouble of voting even when they know their vote won't affect the outcome.

In the case of the repeated Prisoner's Dilemma, the model fails to explain why people will generally cooperate even though on any given iteration they could gain by defecting against the other player in the dilemma.

In the case of public goods, the model fails to explain why people will make contributions to things that are publicly available to everyone. Margolis asks us to imagine a hypothetical man named Smith who is planning a $10 donation to his favourite charity. The classical economic model says that Smith would do this because he wants the charity to have $10 more available to it than it does currently.

But now imagine Smith finds out that someone else has just donated $10 to the charity. Under the classical model, Smith, realizing that his favourite charity is now $10 richer just as he wanted it to be, no longer feels a need to make a donation.

Of course in reality there may be some relationship between how much money a charity has raised and how much people contribute, but it is nowhere near this strong a relationship. Clearly there must be something more to Smith's motivation than simply wanting the charity to be $10 richer, but the classical model has no answer to what that might be.

Margolis argues that there are two altruistic motivations that need to be taken into consideration. We have an altruistic motivation based on wanting other people to have more, and an altruistic motivation based on wanting to contribute our fair share (what Margolis calls 'participation').

Margolis also notes that all of his examples are prisoner's dilemma type situations, which is not surprising since the Prisoner's Dilemma is the formalization of situations where what is in the self-interest of participants is opposed to the group interest.

In the next post we will look at the solution that Margolis proposes in order to create a model of rational choice that can model human behaviour accurately in the case of prisoner's dilemma / public goods type situations.

37. Envy

Note: This post is the thirty-seventh in a series. Click here for the full listing of the series.

Envy is considered one of the seven deadly sins, the ten commandments came out strongly against it and if Wikipedia is to be believed, it doesn't go over well in Islam or Buddhism either.

So what's so bad about envy?

Joseph Heath has an excellent essay on the topic of envy which can be read here.

Heath explains how envy can interfere with pareto-efficiency:

"The Pareto principle states that if a proposed change in the condition of society makes at least one person happier, and does not make anyone else unhappy, then that change should be regarded as an improvement. This principle forms the conceptual core of modern welfare economics, and exercises enormous influence in contemporary discussions of justice and equality. It does, however, have an Achilles’ heel. When an individual experiences envy, it means that the happiness of others itself becomes a source of unhappiness. As a result, envy has the potential to block any and all Pareto improvements. Making one person better off will automatically make someone else worse off, so there will be no point talking about efficiency gains."

Envy translates your gain automatically into my loss much in the same manner that a positional externality does. However, whereas nothing much can be done about a pure positional externality, envy can be reduced by the virtue of a people who will not allow themselves to feel worse simply because someone else has made a gain.

Heath notes that because of the problems that envy causes for economic theories of pareto-efficiency, theorists generally treat envy as an 'illegitimate' preference and exclude it from their model,

"Thus John Rawls assumes that rational agents behind the veil of ignorance 'do not take an interest in one another's interests.' Similarly, David Gauthier excludes any 'tuistic' preferences from consideration in his bargaining theory."

The problem is that, no man is an island and people may have good reason to be concerned about their relative position, which would imply that they need to be concerned about the position of everybody else. If a Canucks fan is upset that the Flames win a game against some other team, it may be that he hates the Flames and hates to see them do well, but it may also be that a Flames victory has a negative affect on the Canucks chances to make the playoffs, or win the division, or get home ice advantage. The question is where to draw the line between an illegitimate feeling of envy and a legitimate cause for concern. Heath provides an example:

"Imagine in a situation in which my neighbour acquires an air conditioner. This is a purely private transaction between himself and the merchant. Unfortunately, as a consequence of this purchase, I may find myself, on sweltering days, glaring enviously across the yard, resenting the comfort enjoyed by my neighbour and his family. Does this undermine the win-win character of the transaction between the neighbour and the merchant? There is a very strong moral intuition which suggests that, in this sort of case, the loss of welfare that I experience from my neighbour's new acquisition should not count as a consideration that speaks against the transaction.

On the other hand, the air-conditioner might also make a lot of noise, which keeps me awake at night. Then we might not want to regard the purchase as purely a private matter between the neighbour and the merchant. I become an unwilling participant, and my loss of welfare, it seems, should count for something. Economists would say that in this case the transaction creates a 'negative externality.' Thus when we talk about markets, the 'laundering' of preferences normally occurs in the decision that we make about which external effects of a transaction to treat as 'externalites' – and thus as part of the 'social cost' of an action."

The problem as Heath notes, is that "Despite the intuitive attractiveness of these distinctions, it is difficult to formulate a precise articulation of the underlying logic."

Heath spends the bulk of his paper working through the subtleties of trying to make that formulation and how to form policies that might recognize the value of people's legitimate concerns about their relative standing, while at the same time not providing legitimacy to simple envy. It's well worth reading, but too complex to summarize in detail here.

Heath concludes,

"The reasons for wanting to launder out envy from our social welfare judgements are for the most part sound. It is very important that we be able to identify win-win transformations in social outcomes, without being held back by people who get upset at the mere fact that somebody else is winning. The problem is that our preferences cannot be separated cleanly from one another, simply because our judgments – the very concepts that we use to articulate our needs and desires – have a deeply relative character.

...

If all of our desires were of this type, and everything were relative, then there would be no problem. The human race would have been locked into a state of hedonic homeostasis since its inception. The problem is that the relativity of our desires admits of degrees. As a result, it is possible to achieve Pareto improvements by shifting resources out of areas that have the structure of a zero-sum game, and into areas where improvements in absolute welfare level are still possible."

---

The more general point I want to make is that the commercial, trade based system functions best when people and their preferences are independent of one another. This post was an example where people's welfare was negatively correlated (your gain is my loss or your loss is my gain (i.e. schadenfreude)). There can be other issues when people's welfare is positively correlated which I might get into in a later post.

To some extent, this is just re-covering earlier ground on the problems caused in markets by negative and positive externalities, but I though it was worthwhile showing how these externalities can have a basis in human emotion as well as in the physical world and that, where human emotion triggers negative externalities, it has been suppressed using moral means as far back as the Book of Exodus when God told his people, "You shall not covet your neighbor’s house; you shall not covet your neighbor’s wife, or male or female slave, or ox, or donkey, or anything that belongs to your neighbor."

36. Positional Externalities

Note: This post is the thirty-sixth in a series. Click here for the full listing of the series.

Today's topic is a particular type of negative externality known as positional externalities. They're called 'positional' because they relate to areas where what matters is one's position relative to how others are doing, as opposed to some absolute measure. i.e. Trying to win the gold medal rather than trying to set a world record.

Wikipedia describes positional externalities as follows:

Positional externalities refer to a special type of externality that depends on the relative rankings of actors in a situation. Because every actor is attempting to "one up" other actors, the consequences are unintended and economically inefficient.

One example is the phenomenon of "over-education" (referring to post-secondary education) in the North American labour market. In the 1960s, many young middle-class North Americans prepared for their careers by completing a bachelor's degree. However, by the 1990s, many people from the same social milieu were completing master's degrees, hoping to "one up" the other competitors in the job market by signalling their higher quality as potential employees. By the 2000s, some jobs which had previously only demanded bachelor's degrees, such as policy analysis posts, were requiring master's degrees. Some economists argue that this increase in educational requirements was above that which was efficient, and that it was a misuse of the societal and personal resources that go into the completion of these master's degrees.

Another example is the buying of jewelry as a gift for another person, e.g. a spouse. For Husband A to show that he values Wife A more than Husband B values Wife B, Husband A must buy more expensive jewelry than Husband B. As in the first example, the cycle continues to get worse, because every actor positions him or herself in relation to the other actors. This is sometimes called keeping up with the Joneses.

One solution to such externalities is regulations imposed by an outside authority. For the first example, the government might pass a law against firms requiring master's degrees unless the job actually required these advanced skills.

Competition for positional goods is a zero sum game, in that any gain made by one person is exactly offset by losses to another. If I move up from having the third nicest house on the block to having the second nicest, someone else has moved down from second to third. Therefore, whether competition in these areas is beneficial to society or not depends on whether any positive side effects from the act of competition outweigh the resources devoted to an area in which no gains can be made.

In 'The Efficient Society' Joseph Heath recounted a story of native leaders who competed with each other on the basis of who could afford to destroy more of their own possessions. This is an extreme case of competition for status with negative side effects.

Generally, there will be a greater gain to society if people focus on achieving absolute improvements rather than relative ones. For example, innovation that allows every house on the street to have indoor plumbing is more valuable than everybody on the street competing to see who can have the biggest house. To the extent that people concern themselves with status rather than looking for improvements to their lives that don't involve comparison/competition with others, greater gains will be made, because this approach will reduce the presence of negative positional externalities.

32. Moral Conditions of Economic Efficiency, Part 3

Note: This post is the thirty-second in a series. Click here for the full listing of the series.

Chapter 4 of 'The Moral Conditions of Economic Efficiency', by Walter Schultz, takes on the notion that even though strict rational eogists may not be able to achieve economic efficiency immediately, their behaviour will settle into an efficient pattern as they (strictly rationally) adopt rules that prevent their selfishness from keeping them from achieving efficient outcomes.

For example, back here, I quoted a Washington Post article which read,

"[Alan] Greenspan had an unusual take on market fraud, Born recounted: "He explained there wasn't a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him."

Schultz first argues that, although coordination type situations (e.g. choosing which side of the road to drive on) enable strict rational egoists to form rules that are to everyone's benefit, exchange is not a coordination type situation. The reason is that a coordination situation allows everyone to achieve an optimal result, whereas in exchange, each person's best option is to get what the other person is offering without parting with anything themselves, by way of force or fraud if necessary. But it's not possible for both parties to come out ahead on exchange by cheating each other, so this makes exchange a collective action or Prisoner's Dilemma type problem.

Next, Schultz argues that 'the shadow of the future', i.e. concerns about what might happen in the future, will not cause strict rational egoists to refrain from force and fraud. I'm not sure I quite follow Schult'z argument on this point, so I'll quote him,

"we have already shown that strict rational egoists will always choose the best feasible means to achieve their most highly valued social state, so when similar situations emerge [in the future] inefficient outcomes result."

As best I can tell, Schultz is arguing that strict rational egoists are not capable of prudence in the sense of weighing the benefits of theft/fraud now against the benefits of cooperation over the long run. Schultz could make the case that this sort of prudence is itself a moral rule that does not belong in our sketch of the strict rational egoist but he doesn't make this argument explicitly.

The question of whether (strict) self-interest leads to cooperative behavior in collective action problems that are repeated is one that has been much studied and I will likely come back to it later on in the series. For now, I'll simply note that despite morals against force and fraud, and the presence of a government that will punish you if you are caught in such activities, we are far from eliminating these behaviours entirely, so the 'shadow of the future' (as game theorist refer to the effect where concerns about future results influence present decisions) may help some, but it seems incapable of playing the role Greenspan imagined it playing, where no rules against fraud are necessary.

In chapter 5, Schultz discusses externalities. He defines externalities as follows: "An externality is an uncompensated cost or benefit that may be intentional, accidental or incidental."

...and clarifies that...

"Acts of theft and fraud directly affect the well-being of consumers and exemplify intentional externalities. Harm resulting from negligence or from an accident exemplifies an accidental externality. Externalities also include incidental effects of the acts of production and consumption."

He goes on to comment that, "To assume that all externalities are absent and that every agent behaves competitively is to set aside the role of morality. The system of moral constraints presented in Chapter 6 secures competitive behaviour and eliminates intentional externalities but makes no provision for the internalization of accidental and incidental externalities."

Schultz then claims that:

1) A system of moral normative constraints precludes externalities due to intentional consequences of nonmarket action.

2) A system of moral normative constraints and conventions rectifies accidental and incidental externalities.

3) Moral normative constraints and conventions coordinate expectations and thereby reduce transaction costs

4) Moral normative constraints are the logical limits of the commodification of desire.

Schultz explains the first 3 points: "We have established the first claim. Claims (2) and (3) are based on the general goals of tort law, property law and contract law, respectively, and have been established."

To be honest, it wasn't clear to me how claims 2 and 3 have been established, but never mind.

Schultz says no more on the first 3 points and devotes the rest of the chapter to an explanation of point 4, arguing that the desires of people that we recognize in calculating the effects of externalities are limited by the rights that people need to have in order to secure economic efficiency. In other words, my desire to have you a slave is not recognized as a valid preference since if you don't have autonomy to make your own decisions we won't achieve the same efficiency that we might have (because you can't pursue your preferences properly, if you are my slave).


---

In chapter 6, Schultz sets out what he sees as the moral conditions of economic efficiency. Note that where I might say, for example, that people need to follow a moral rule to 'be honest', Schultz instead says, using the same example, that people have a 'right to true information' and that people also have a moral incentive to respect that right. It amount to the same thing, as far as I can tell.

The Moral Conditions of Economic Efficiency per Schultz:

1) Property Rights - meaning that people can't mess with your stuff and you can do what you want with your stuff.

2) Right to True Information (that is relevant to a potential exchange) - meaning that you shouldn't tell your car insurance company that your car is just for personal use, when really you drive to work and back every day.

3) A right to welfare - Schultz recognizes that given a choice between stealing or starving, people will and should choose the latter because the right to life takes precedence over the efficiency based rights. Plus Schultz makes an insurance argument (that seems a bit out of place) that it is more efficient for basic welfare to be assured centrally than for everyone to self-insure against deprivation.

4) A right to autonomy - without autonomy, people can't make exchanges that match their preferences, so autonomy is a precondition for trade as we understand it even being possible.

Schultz also notes that we need some mechanism by which people are held accountable for their behaviour in recognizing these rights as well as a set of conventions for setting prices and conventions and normative constraints for commodifying desire and for rectifying the results of accidental and intentional externalities.

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I realize that this post doesn't really show all that clearly how Schultz gets to his final requirements, but that's likely because it wasn't all that clear to me reading the book.

31. Moral Conditions of Economic Efficiency, Part 2

Note: This post is the thirty-first in a series. Click here for the full listing of the series.

Chapter 2 of 'The Moral Conditions of Economic Efficiency', by Walter Schultz, sets out to answer the question, "Can a population of strict rational egoists achieve efficient allocations of commodities in the absence of moral normative constraints?"

To answer this question, Schultz first constructs a social situation that depicts ' Strict Rational Egoism'. It is defined by 9 parameters.

The first 2 parameters describes the preferences held by agents (people who are strict rational egoists) in this model:

(p1) Each agent's preferences range over alternative social states defined solely in terms of their own consumption bundles

(p2) Agent's preference relations are stable. rational and locally non-satiated

The first basically says that people prefer one situation to another based on how much stuff they get (and not based on how much stuff other people get, or what people think of them, etc.)

The second basically just says that, whatever they have, they want more (and also that their preferences 'make sense' - they don't prefer apples to bananas, bananas to pears and pears to apples, and they don't prefer chicken to steak one minute and steak to chicken the next)

The next 3 parameters define how agents make decisions:

(p3) Agents' goals are selected according to a utility maximization criterion (i.e. the more the better)

(p4) Agents' beliefs depend only on information (and not on, for example, force of habit)

(p5) Agents are sufficiently and instrumentally rational (i.e. people try to get the most results for the smallest effort/expenditure of resources, think back to Patience saying how she never gives out money she doesn't have to).

The next two parameters define the positive (physical) limits of the situation.

(p6) Agents are constrained by a perfectly competitive market: numerous participants, homogeneous products, freedom of exit and entry, and perfect information (I covered perfect competition back here)

(p7) Agents control finite resources (seems reasonable)

The last two parameters define the social, or normative limits of the situation

(p8) There are no moral rules (that's what makes strict rational egoism 'strict'!)

(p9) There are conventions to equilibriate supply and demand (in other words, there is a mechanism for setting prices)


After setting out his 9 parameters, Schultz launches into a multi-page proof of the first welfare theorem, namely that the equilibrium result of perfect competition will be a pareto-optimal allocation of resources (i.e. nobody can be made better off without anyone being made worse off). The proof basically comes down to pointing out that if two people could make a trade that would benefit both of them (give them more satisfaction), they will, since they want more (by definition) and there is nothing stopping them from making the trade.

The reason Schultz goes through the proof in detail is to note that it relies on some elements that go beyond his 9 parameters defining strict rational egoism. In particular, it relies on 'price-taking' behaviour by people (i.e. people make no effort / have no ability to influence prices) and it also relies on specifying that externalities do not exist.

Schultz goes on in chapter 3 to explain how we can't assume that people act as 'price-takers' (externalities are covered in a later chapter and a later post) because they choose to trade at a given price even when they could take some alternative action (e.g. just take stuff from people, or trick them into giving it to you) because one of the given parameters (p5) says they wouldn't act that way, and if we remove (p5) then that will make the proof of the first theorem fail as well (if people aren't trying to get all they can, the market won't lead to a Pareto-efficient final outcome). So the only way out is to assume that people are not capable of committing acts of fraud or force that would let them get what they want. But the physical reality of markets means that people will have these opportunities.

Schultz explains how in a market where prices are set by an auctioneer (a common economic model of how prices are set), even if people refrain from using force and outright fraud, they can simply misrepresent how much they are willing to pay for certain items and this will benefit them at the expense of others (much in the manner that one seldom enters a negotiation by stating up front just how much they would be willing to pay for an item), causing the outcome not to reach a Pareto optimal outcome.

Another way out would be to assume some sort of Leviathan style referee who prevents/punishes force or fraud - but if the referee is a strict rational egoist (and everybody is in this model) then they will logically use their superior force to simply take everything they want.

Finally, the only solution left is a normative constraint, either directly on the market participants, or on the referee. People must decide for themselves not to take advantage of opportunities for force and fraud where they inevitably arise.

In a nutshell, what Schultz is saying is that when proofs of the economic efficiency of trade assume that people are 'price-takers' they are assuming a certain moral behaviour (restraint from force and fraud even where this would be beneficial to the person in question) that is inconsistent with people being strict rational egoists.

Note that *if* people could read each others minds so that they could never be fooled, and *if* there were not just a large, but an infinite number of buyers and sellers in the market and *if* everyone was capable of effortlessly defending possession of all their goods against any attempts at theft, and *if* we similarly assumed away any other possibilities for non-price taking behaviour, then we could agree that strict rational egoists could reach pareto-optimal outcomes.

The point is that once we take into consideration real factors that affect almost all real markets (people can't read minds, people *can* steal things and deceive others), the 'invisible hand' notion that people can achieve a good outcome (economic efficiency) by pursuing their own interests (via strict rational egoism) fails, unless supplemented by moral rules.

In the language of the previous post, in a world of people like Patience, economic efficiency will fail because Patience lacks a willingness to act as a price-taker, whereas in a world of people like Mal, it will succeed, and the difference between them is a difference in morals - Patience is a strict rational egoist, Mal is not.

4. Network Effects

links to Part 1, Part 2 and Part 3

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The prisoner’s dilemma of the last post was a particular case of negative externalities. This post covers a particular type of positive externalities known as network effects.

Wikipedia, as always, is here to helpfully summarize:

In economics and business, a network effect (also called a network externality) is the effect that one user of a good or service has on the value of that product to other people.

The classic example is the telephone. The more people own telephones, the more valuable the telephone is to each owner. This creates a positive externality because a user may purchase their phone without intending to create value for other users, but does so in any case.

The expression "network effect" is applied most commonly to positive network externalities as in the case of the telephone. Negative network externalities can also occur, where more users make a product less valuable, but are more commonly referred to as "congestion" (as in traffic congestion or network congestion).
Over time, positive network effects can create a bandwagon effect as the network becomes more valuable and more people join, in a positive feedback loop.

So I make a transaction with the phone company that is a win-win for me and the phone company and also for everyone else (a positive externality) who already has a deal with the phone company. The size of my win in the transaction with the phone company depends on how many existing users there are, so after I sign up, the next person to sign up gets an even bigger win, and so on.

In addition to actual networks, standards often have the same structure. If I am using a particular computer file format, every other person who uses that format helps me since I can look at their files without needing to change the format first. The same goes for operating systems, where Windows was able to become the de facto standard for so many years. One of the reasons there is a strong push for open standards in many areas is to avoid having one individual or group extract monopoly rents from all those using the standard in the same manner that Bill Gates became the wealthiest man in the world.

Note that in situations with network effects, there is an initial phase in which relatively small investments / ideas / luck can tip the scales between various people attempting to set up the new standard and then a later phase when one (in some cases two or three) network has emerged victorious and it would take a huge investment of resources or a significant change in the situation in order to remove them from their leadership position.

This is one way to understand the internet gold rush of the 90's. Investors understood that the internet opened up new situations where network effects were strong and that initial investments in money losing companies could pay off later if they were able to win the battle to become the standard. Ebay (the best example of network effects since if you're selling something you want to use the site with the most buyers and vice-versa so every new user benefits all the other users) founder Pierre Omidyar is now a multi-billionaire, much like Bill Gates.

2. Actions, Transactions and Externalities

Note: This is the second in a multi-part series, part 1 here.

In the first installment I forgot to mention that in addition to summarizing a bunch of books/arguments, I was also going to need to make a few posts here and there explaining some of the terms and concepts used in these books. This post covers the concepts of actions, transactions and externalities.

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For the purposes of this series of posts I want to use the word 'action' to mean those activities primarily involving just one person (e.g. I go into the orchard and pick some fruit, I decide to go back to school, I decide to save money rather than buying a new car) and 'transaction' to mean activities that primarily involve two people (e.g. I pay my tuition to a college, I steal a fruit from my neighbour etc.) Naturally there’s some grey area in these definitions but I think the distinction between actions primarily involving just one party and transactions involving two parties is clear enough to be useful.

The next concept I want to mention is the idea of an externality. This is a term primarily used in economics, but there's nothing specifically 'economic' about it. All it refers to is the idea that an action or transaction might have an impact on other parties that were not part of the original action/transaction.

Where those impacts are negative, we refer to a negative externality, where those impacts are positive, we refer to a positive externality.

For example I drive to the car dealership to buy a new car. I have an action (driving to the dealership) and a transaction (exchanging my money for the car) with the salesman. But there are impacts of this action and transaction on other parties besides myself and the car salesman.

By driving there, I am releasing carbon dioxide into the atmosphere that may damage the climate and cause harm to people who had nothing to do with me driving to the car dealership – this is a negative externality.

On the other hand, perhaps I have friends and family members who used to always need to give me a ride places and now I can drive on my own or give them rides – so my car purchase contains a positive externality for these people.

On the other (other) hand, my neighbours may now derive less satisfaction from their car because I have a newer, fancier car then they do and they may feel the need to go buy a better car of their own – so there is a negative externality for them. And so on.

It’s a simple concept, but a very important one, so I wanted to explain it as clearly as possible before we continued on.

For more on externalities, here is the excellent wikiepdia entry, which has a number of examples, goes into more detail on a number of interesting fronts and defines an externality as follows:

'In economics, an externality or spillover of an economic transaction is an impact on a party that is not directly involved in the transaction. In such a case, prices do not reflect the full costs or benefits in production or consumption of a product or service.'