Recap: The Story So Far
Markets face problems with:
- Externalities (Coase, Demsetz)
- Public goods, common resources (Olson, Ostrom)
- High transaction costs
There are situations where we may want to act collectively
- Providing public goods, club goods, common pool resources
- Defining property rights
- Achieving justice
Choosing in Groups, Creating Politics
Methodological individualism: individuals have their own preferences, make choices, and bear the costs and benefits of any action
A group must make a choice to determine a single outcome that affects all individuals
Choosing in Groups, Creating Politics
- Easy when each member has the same preference for an outcome, then “we” prefer that outcome
- e.g. I prefer ,
- you prefer ,
- she prefers ,
- so “we” prefer
Choosing in Groups, Creating Politics
But what if we (likely) disagree?
- Need some procedure to aggregate our individual preferences into a single group preference
In this case, many (perhaps even most) members will disagree with the outcome chosen by the group
How/why are individuals members of a group obliged to accept the choice of the group, even when they disagree with it
A Puzzle
Jean-Jacques Rousseau
1712-1778
“[H]ow can a man be both free and subject to wills not his own[?]” (Book IV, Ch. 2, “Voting”),
Rousseau, Jean-Jacques, 1762, The Social Contract
Choosing in Groups, Creating Politics
Individuals choose, but groups do
Must be a single action/policy taken for the whole group
- One speed limit for a road, one set of swimming pool club rules, one defense budget, etc.
Constituting a Group
Very important then to consider how groups constitute themselves: deciding how to decide
The Greek word commonly translated as “constitution” is politea, more like the “soul” of a group
- self-identified identities, rights and obligations of citizens, a polis, etc.
Difference between a bunch of individuals and a group
Constituting a Group
Aristotle
384 B.C.-322 B.C.
“[T]he constitution is in a figure the life of the city,” (Book IV, Part XI)
“...shall we say that while the race of inhabitants, as well as their place of abode, remain the same, the city is also the same, although the citizens are always dying and being born, as we call rivers and fountains the same, althought the water is always flowing away and coming again? Or shall we say that the generßations of men, like the rivers, are the same, but that the state changes? For, since the state is a partnership, and is a partnership of citizens in a constitution, when the form of government changes, and becomes different, then it may be supposed that the state is no longer the same...And if this is true it is evident that the sameness of the state consists chiefly in the sameness of the constitution [politea], and it may be called or not called by the same name, whether the inhabitants are the same or entirely different,” (Book III, Part I).
Aristotle, Politics
Features of a Constitution
A constitution contains rules about deciding how to decide
Need not be formal, or written down
Everyone must unanimously consent to the constitution, so that you are obliged to follow the outcomes of politics that you disagree with
Features of a Constitution
- Source of sovereignty: account of the source of the group’s sovereignty, e.g. citizens’ consent, a contract, or a historical event or legacy
- Membership: provisions for allowing (or denying) entry into the group
- Collective domain: rules to define and limit the scope of what the group may or may not demand of or do to its members (What is mine vs. ours)
- Decision rules: rules for deciding how to decide normal business for the group choosing outcomes or policies
- Citizenship obligations: rules to define and limit what members can demand of the group
- Amendment: rules for deciding how to decide how to change the rules
- Exit: rules for allowing (or denying) exit from the group
The Social Compact
Jean-Jacques Rousseau
1712-1778
“There is but one law which, from its nature, needs unanimous consent. This is the social compact; for civil association is the most voluntary of all acts...Apart from this primitive contract, the vote of the majority always binds all the rest. This follows from the contract itself. But it is asked how can a man be both free and subject to wills not his own. How are the opponents at once free and subject to laws they have not agreed to?”
“I retort that the question is wrongly put. The citizen gives his consent to all laws, including those which are passed in spite of his opposition, and even those which punish him when he dares to break any of them,” (Book IV, Ch. 2, “Voting”),
Rousseau, Jean-Jacques, 1762, The Social Contract
Some Useful Definitions
Politics: a set of rules that we all agree are legitimate that will determine how we decide as a group
- Makes one collective decision for the group, even though many will disagree with the decision
Constitution: set of rules for deciding how and what a group will be able to decide
- Constitutional rules supersede politics
Democracy: a particular decision rule where an outcome is chosen for the group if any of its members agree
Freedom of Association
- By joining a group, you are consenting to be coerced (to follow outcomes you disagree with), so very important how groups are constituted:
- We must be able to negotiate and choose (constitutional) rules that we can all consent to
- Need to have freedom of association, to choose among many groups to join
Freedom of Association
Difference between constitution and Constitution (a club vs. the Nation-State)
The problem is not coercion, it’s monopoly
Back to Exchange and Transaction Costs
In a voluntary exchange, both parties expect to be made better off
The best justification for reallocation of resources (even via coercion) is consent
Parties would like to enter into binding contracts with each other, but significant transaction costs!
- trust; enforcement
The Fundamental Transformation
Oliver Williamson
1932-
Economics Nobel 2009
A contract between two parties constitutes a “fundamental transformation” from ex ante competitive market to an ex post bilateral monopoly
- Two parties depend on one another’s performance to jointly capture the gains from exchange
- Committing inputs into the relationship is a specific investment, possibly sunk cost
Creates the possibility of post-contractual opportunism by the parties
The Fundamental Transformation
This bilateral dependency creates “quasi rents” from cooperation that might be appropriated by a party
Need to contract ex ante to protect ex post possibility of someone threatening to appropriate the rents
Inability to prevent this may cause parties to inefficiently avoid making agreements!
Non-Credibility AKA “Cheap Talk”
“Talk is cheap”
- Low cost to making promises/threats you don’t intend to carry out
Promises and threats without commitment will not change equilibrium behavior (with perfect information)
If you try to bluff in poker, and your rivals know what cards you have, they will call your bluff
Non-Credibility AKA “Cheap Talk”
Promises or threats must be incentive-compatible to work
- Threat/promise-maker must actually stand to benefit from performing the threat/promise or suffer from not performing it
In game theory terms: strategy must be subgame perfect
Promises
Consider a agency/investment/trust game
Principal decides to invest money ($100) with Agent
- Investment grows to $200
Agent can then keep or share the returns with Principal
Promises
- Only one Nash equilibrium: {Don't, Keep}
Promises
Only one Nash equilibrium: {Don't, Keep}
What if before game began, Agent said to Principal:
“If you Invest, I will Share”
Promises
Only one Nash equilibrium: {Don't, Keep}
What if before game began, Agent said to Principal:
“If you Invest, I will Share”
- Not a credible promise
Appropriable Quasi-Rents
Benjamin Klein
1943-
"Coase's fundamental insight [was] that transaction, coordination, and contracting costs must be considered explicitly in explaining the extent of vertical integration...[We] explore one particular cost of using the market system-the possibility of postcontractual opportunistic behavior," (p.297)
"The particular circumstance we emphasize as likely to produce a serious threat of this type of reneging on contracts is the presence of appropriable specialized quasi rents. After a specific investment is made and such quasi rents are created, the possibility of opportunistic behavior is very real. Following Coase's framework, this problem can be solved in two possible ways: vertical integration or contracts," (p.298)
Klein, Benjamin, Robert G Crawford, and Armen A Alchian, 1978, "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process," Journal of Law and Economics 21(2): 297-326
Asset Specificity: Example
Suppose one party owns a generic asset - trucks
- High opportunity cost - easily resold or put to other uses
Another party owns a highly specific asset - highly specialized machines
- Next best alternative use is a boat anchor
Asset Specificity: Example
Suppose a contract between them creates $50,000 of joint net value for the owner of the generic asset and the owner of the specific asset
Can't recontract until next year
Once the contract is signed, the owner of the generic asset threatens to pull out of the contract
- Demands $49,000 of the "quasi-rents of cooperation"
Asset Specificity: Example
Foreseeing such contractual hazards parties will be reluctant to cooperate
Or will choose a less specialized and less efficient technology
What is Needed: Credible Commitment
Odysseus and the Sirens by John William Waterhouse, Scene from Homer's The Odyssey
What Doesn't Kill You Makes You Stronger
Thomas Schelling
1921—2016
Economics Nobel 2005
“Bargaining power"..s that the advantage goes to the powerful, the strong, or the skillful. It does, of course, if those qualities are defined to mean only that negotiations are won by those who win...The sophisticated negotiator may find it difficult to seem as obstinate as a truly obstinate man,” (p.22).
“Bargaining power [is] the power to bind oneself,” (p.22).
Vertical Integration in Firms
One solution in markets is vertical integration: the firm internalizes a stage of production in the supply chain
- Often by buying its supplier
Avoids hold up problems and post-contractual opportunism
Vertical Integration in Firms
Benjamin Klein
1943-
"Long-term contracts used as alternatives to vertical integration can be assumed to take two forms: (1) an explicitly stated contractual guarantee legally enforced by the government or some other outside institution, or (2) an implicit contractual guarantee enforced by the market mechanism of withdrawing future business if opportunistic behavior occurs...[However, they are] often very costly solutions. They entail costs of specifying possible contingencies and the policing and litigation costs of detecting violations and enforcing the contract in the courts..every contingency cannot be cheaply specified in a contract or even known and because legal redress is expensive..." (p.303)
Klein, Benjamin, Robert G Crawford, and Armen A Alchian, 1978, "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process," Journal of Law and Economics 21(2): 297-326
Vertical Integration in Firms: Example
17th Century England
Trial of Charles I
English Civil Wars (1642-1651)
Parliamentarians defeat Royalists
- Try and execute King Charles I
Growing recognition that even the king is not above the law
Growing intolerance of arbitrary invasions of individual rights
Hobbes: Modern Pluralism
Thomas Hobbes
1588-1679
"[T]here is no such finis ultimus (utmost aim) nor summum bonum (greatest good) as is spoken of in the books of the old moral philosophers...And therefore voluntary actions and inclinations of all men tend not only to [attaining a contented life] differ only in the way [in] which produce the effect desired, (Ch. XVIII).
Hobbes, Thomas, 1651, Leviathan: Or the Matter, Forme and Power of a Commonwealth, Ecclesiasticall and Civil
Thomas Hobbes: State of Nature
Thomas Hobbes
1588-1679
"In [the state of nature], there is no place for Industry; because the fruit thereof is uncertain; and consequently no Culture of the Earth...no Knowledge of the face of the Earth; no account of Time; no Arts; no Letters; no Society; and which is worst of all, continuall feare, and danger of violent death; And the life of man, solitary, poore, nasty, brutish, and short, (Ch. XVIII).
Hobbes, Thomas, 1651, Leviathan: Or the Matter, Forme and Power of a Commonwealth, Ecclesiasticall and Civil
Thomas Hobbes: War of All Against All
Hobbes
Thomas Hobbes
1588-1679
"Nature hath made men so equal in the faculties of body and mind...From this equality of ability ariseth equality of hope in the attaining of our ends...And from this diffidence of one another, there is no way for any man to secure himself so reasonable as anticipation..to master the persons of all men he can so long till he see no other power great enough to endanger him...[M]en have no pleasure...in keeping company where there is no power able to overawe them all. (Ch. XVIII).
Hobbes, Thomas, 1651, Leviathan: Or the Matter, Forme and Power of a Commonwealth, Ecclesiasticall and Civil
Hobbes
Thomas Hobbes
1588-1679
"And because the condition of man...is a condition of war of every one against every one...it followeth that in such a condition every man has a right to every thing, even to one another's body. And therefore, as long as this natural right of every man to every thing endureth, there can be no security to any man...The first fundamental law of nature is: to seek peace and follow it (Ch. XVIV).
Hobbes, Thomas, 1651, Leviathan: Or the Matter, Forme and Power of a Commonwealth, Ecclesiasticall and Civil
The Hobbesian Dilemma
Thomas Hobbes
1588-1679
"For the Lawes of Nature (as Justice, Equity, Modesty, Mercy, and (in summe) Doing To Others, As Wee Would Be Done To,) if themselves, without the terrour of some Power, to cause them to be observed, are contrary to our naturall Passions, that carry us to Partiality, Pride, Revenge, and the like. And Covenants, without the Sword, are but Words, and of no strength to secure a man at all, (Ch. XVIII).
Hobbes, Thomas, 1651, Leviathan: Or the Matter, Forme and Power of a Commonwealth, Ecclesiasticall and Civil
The Hobbesian Dilemma
- Consider society a prisoner's dilemma for social cooperation or conflict:
- : everyone else obeys the law, but I don't
- : everyone obeys the law
- : no one obeys the law
- : I obey the law, but no one else does
The Hobbesian Dilemma
Nash equilibrium: everyone defects!
Socially optimal equilibrium: everyone cooperates
Hobbes' insight: no individual has an incentive to cooperate when everyone defects!
The Hobbesian Solution I
The Hobbesian Solution
Thomas Hobbes
1588-1679
"The only way to erect such a common power, as may be able to defend them from the invasion of foreigners, and the injuries of one another, and thereby to secure them in such sort as that by their own industry and by the fruits of the earth they may nourish themselves and live contendely, is to confer all their power and strength upon one man, or upon one assembly of men, that may reduce all their wills, by plurality of voices, unto one will:...and therein to submit their wills, everyone one to his will, and their judgments to his judgment," (Ch. XVII).
Hobbes, Thomas, 1651, Leviathan: Or the Matter, Forme and Power of a Commonwealth, Ecclesiasticall and Civil
The Hobbesian Solution
Thomas Hobbes
1588-1679
"It is a real unity of them all in one and the same person, made by covenant of every man with every man, in such manner as ife every man should say to every man: I authorise and give up my right of governing myself to this man, or to this assembly of men, on this condition; that thou give up, thy right to him, and authorise all his actions in like manner. This done, the multitude so united in one person is called a COMMONWEALTH," (Ch. XVII).
Hobbes, Thomas, 1651, Leviathan: Or the Matter, Forme and Power of a Commonwealth, Ecclesiasticall and Civil
The Hobbesian Solution
The State is our commitment device
Citizens (in principle) sign a social contract, i.e. a "constitution" that deliberately restricts their liberties
In each of our interests to give up some liberties that restrict the liberties of others (e.g. theft, violence)
In exchange, we empower the State as our agent to punish those of us that fail to uphold the social contract
The Social Compact, Once Again
Jean-Jacques Rousseau
1712-1778
“There is but one law which, from its nature, needs unanimous consent. This is the social compact; for civil association is the most voluntary of all acts...Apart from this primitive contract, the vote of the majority always binds all the rest. This follows from the contract itself. But it is asked how can a man be both free and subject to wills not his own. How are the opponents at once free and subject to laws they have not agreed to?”
“I retort that the question is wrongly put. The citizen gives his consent to all laws, including those which are passed in spite of his opposition, and even those which punish him when he dares to break any of them,” (Book IV, Ch. 2, “Voting”),
Rousseau, Jean-Jacques, 1762, The Social Contract