46. Asymmetrical Information

I should have covered this topic when I was talking more about the commercial syndrome, but better late than never.

Wikipedia offers the following definition for information asymmetry: "In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard."

The classic example of the problems caused by asymmetrical information is the used car market, thanks largely to a famous paper, "The Market for Lemons: Quality Uncertainty and the Market Mechanism (pdf)" published by George Akerlof in 1970.

If the customer is unable to tell a good car from a 'lemon' then the customer will be willing to pay a price that reflects the average value they can expect, given the percentage of lemons on the market. But the seller knows whether a car is a lemon or not, and if it isn't, then the seller knows that the car is worth more than what the customer is willing to offer. So the seller only offers bad cars at the price the customer will pay. But then the customer may become even more unwilling to pay as much, if all they seem to get are lemons. In an extreme case, the market could cease to exist altogether (Akerlof cites life insurance for seniors as a market which doesn't exist for this reason).

The basic structure here is that there is a gap in time between when an exchange is made and when the services are rendered (e.g. you pay for a car up front, but then expect it run for years), and this gap in time, combined with a lack of perfect information for either the buyer or seller, combines to create opportunities for fraud. Commercial folks have invented a wide array of mechanisms to combat this market-busting problem (e.g. warranties, trial periods, etc.) but the strongest bulwark has to be a general trait of honesty in commercial dealings.

Akerlof notes that where this honesty is lacking, economies remain underdeveloped.

When the seller is at the disadvantage (i.e. has less information than the customer), then the seller faces a problem known as 'adverse selection.' If an insurer offers a life insurance policy at a certain rate, then it takes the risk that the only people who will sign up at that rate are those who know that they will profit because their risk of death is higher than average (e.g. smokers, people with pre-existing conditions, bad family histories, etc.). People whose risk of death is lower than average will see the insurance as a bad deal.

Faced with the possibility of adverse selection, it will be in the interests of the insurance companies to all offer a very similar suite of products, as any variation from company to company will just give more options to people looking to choose a policy that will be of net benefit to them. Ideally, everyone would be forced to sign up for a standard insurance option and this would eliminate the risk of adverse selection (see Health Care, Universal).

Note how the motives of competition driven by maximization of individual self-interest become (in some ways) counter-productive in the face of asymmetrical information. Market participants need to pass up opportunities for fraud and dishonesty to help keep the market functioning. And sellers faced by adverse selection need to restrain their commercial instinct to grab market share by offering new or better terms than the competition lest they get saddled with a bag of lemons.

Note: Next Tuesday's post in the series may need to be delayed pending internet access, post-move.

45. Ties That Bind

My guardian-mindset brain is a little tired this week from a frenzy of commercial activity as I've been selling off many of my possession on craigslist in anticipation of moving at the end of the month. Have I mentioned I hate moving? - maybe once ... or twice, or ... well who's counting...

Point being, just a small, mostly incoherent, post this week.

Back in Francis Fukuyama's book 'Trust,' I remember him comparing Chinese society, which in his view resembled a 'tray of sand' to Japanese society which resembled something more solid like a pane of glass (I'd look up what he said exactly but my books are packed!).

Fukuyama's comment reminds me of the comments made by Hans Ritschl in 'Communal Economy and Market Economy,'

"Both the state economy and the free market economy presuppose a group of persons whom the economy encompasses and by whom it is carried. But there is a great difference in the form of social cohesion within these supporting groups. The free market economy rests on an exchange society: the relationship of the individual economic units with each other is merely 'social' in Tonnies' sense. Pictorially, the connection is mechanical rather than organic.

...

The principle of cohesion in the State is not that of society, but of community. ... 'All for each and each for all' is the motto of community. But the exchange society's motto is 'Chacun pour soi, Dieu pour nous tous'

...

In the principle of cohesion lies the primary fundamental difference between communal economy and market economy"

Ritschl' comments in turn reminded me of something that David Hume said,

"The happiness and prosperity of mankind, arising from the social virtue of benevolence and its subdivisions, may be compared to a wall, built by many hands, which still rises by each stone that is heaped upon it, and receives increase proportional to the diligence and care of each workman. The same happiness, raised by the social virtue of justice and its subdivisions, may be compared to the building of a vault, where each individual stone would, of itself, fall to the ground; nor is the whole fabric supported but by the mutual assistance and combination of its corresponding parts."

The common element in all these quotes is the notion of cohesion, or a whole that is more, or different, than the sum of its parts. A collection of molecules achieves shear strength and solidity, rather than just being a pile of sand. A collection of people forms a community rather than simply being a collection of individuals. A vault stands even though each individual stone would fall to the ground on its own and the vault would fall with the removal of any one stone.

Going back, as always, to the notion of the prisoner's dilemma, the two prisoner's each pursuing their own self-interest and getting heavy sentences after ratting each other out represent the individualistic grains of sand. If the prisoners had an attitude of 'all for one, and one for all' then the scheme by the police to get them to confess would fail. The behaviour of the two prisoners would cease to resemble the behaviour of two distinct individuals but would become indistinguishable from the actions of a single individual with a single will. Note that, by definition, a single individual, with a single will can not be affected by a prisoner's dilemma - only when there are two or more wills in play can a prisoner's dilemma type situation occur.

In the language of economics, classical economic models typically assume 'independent preferences' meaning that I only care about what I care about, and what you care about has no impact on what I care about (i.e. I am unmoved by your tears, or by your joy). But what Fukuyama and Ritschl and Hume were getting at was the notion of interdependent preferences. If I treat your preferences as being of equal weight to my own, and you do the same with me, then my preferences become dependent on yours and vice-versa. And note that this preference pattern will allow us both to act as if we shared a single will (for a more modern reference, think of the parent who asks a child what the other parent said before answering a request).

Ritschl was writing well before the development of game theory or the notion of a 'prisoner's dilemma' but it is clear he understood the point,

"In the exchange society, then, self-interest alone regulates the relations of the members; by contrast, the state economy is characterized by communal spirit within the community. Egotism is replaced by the spirit of sacrifice, loyalty and the communal spirit. In the exchange society, the individual is guided only by personal advantage; here, he thinks, feels and acts as a member of the community. His own interests take second place. The communal spirit is the principle on which rest community and State.

...

It is only when the nation is in the most desperate straits that the communal spirit of all merges into one great single will. In everyday political life there are necessarily a good many conceptions of the common weal, and they may combine with group or class interests and become tarnished by them. Yet each party pursues not only its group interest, but the realization of its own conception of the common weal."

The (still needing to be fleshed out) chain of reasoning here is that ethics like 'loyalty' and 'sacrifice' (not to mention respect for hierarchy and obedience) serve to create interdependent preferences that substitute a single will for a collection of individual ones (in marketplace terms think perfect competition replaced with perfect monopoly), and that this will better serve guardian goals.

After all, a group of people pursuing their self-interest (within the ethical guidelines of the commercial syndrome) will achieve an efficient distribution of goods, but following this behaviour in battle will lead to deserting and retreat, not victory (think Han Solo in Star Wars). In a battle, it is typically best for the army to act as if following a single will. Why? - that's a question for another time...

44. Social Limits to Growth

The book Social Limits to Growth by Fred Hirsch, has two primary themes:

1) As the economy grows over time, more and more of our consumption becomes status oriented / suffers from positional externalities, with the result being that greater economic activity doesn't necessarily make us better off, to the extent that most of that activity is just trying to keep up with (or get ahead of) the Jones.

2) Over time our society is becoming 'commercialized' in that more and more things are treated as a matter of commerce. And this commercialization, resting on an ethical system that promotes self-interest over public service, gradually erodes the ethical basis upon which society and the market based economy itself rest.

I think I've covered the first point fairly well (although Hirsch covers it in the most depth that I have seen in any reading to date), but I think it's worth spending a bit more time on this second point. Says Hirsch,

"The market system, left to itself, tends to fill this vacuum [in social organization] in the same way it fills others [through appeal to individual self-interest]; but here it may sabotage its own foundations. An extreme but pertinent example illustrates the wider point. If judges were regularly to sell their services and decisions to the highest bidder, not only the system of justice but also of property would be completely unstable ... If everything can be privately appropriated, including the judge, then nothing can be - for who will save the system from the first entrepreneur to be able to raise enough credit to buy the judge and everything else through him. As [economist Kenneth] Arrow put it: "Thus the definition of property rights based on the price system depends precisely on the lack of universality of private property and of the price system." Some minimum area of social obligation therefore has to be held. The problem is how to reconcile this social responsibility with the opposing mainstream of the market ethos."

Hirsch argues that those who theorize that politics runs along commercial lines of self-interest are mistaken,

"Economic theories of bureaucracy and of political action, which have been extensively developed in Virginia and in Chicago during recent years, are built exclusively in the individualistic norm. Political and bureaucratic activity are seen, in the same way as market activity, as means to private ends. As such, they tend to be inherently inefficient. The inference drawn by exponents of this approach is that the sphere of political action should be minimized.

An alternative inference flowing from the same analysis is that where individual preferences can be satisfied in sum only or most efficiently through collective action, privately directed behaviour may lose its inherent advantages over collectively oriented behaviour even as a means to satisfying individual preferences themselves, however self-interested."

Finally, Hirsch links his two main points by arguing that it the increased competition for status that results from positional goods taking up more and more of the economy (competition to get into the best schools, to get the best jobs, to own the best land, etc.) drives people away from concern for the public interest and towards self-interest by increasing the personal costs to giving a little ground in the battle for status by putting the social interest ahead of the personal interest.

There's a lot more in 'Limits to Growth' than I've covered here, I'd certainly recommend it to anyone interested in the topics I've covered in this series. It's a bit depressing that it came out in 1976 and yet so little progress had been made since then in even recognizing, let alone reacting to the social limits that he describes.

43. Common Pool Resources

Back in 1968, Garrett Hardin wrote an influential essay entitled, 'The Tragedy of the Commons'. Hardin started with the problem of what it is we should seek to maximize. He noted that with respect to human population there was a tradeoff between quality of life and quantity of population, concluding that, "The optimum population is, then, less than the maximum."

Hardin goes on to note, as I mentioned a while back, that in a situation where a group of people are sharing a common resource, the logic of the prisoner's dilemma (what's best for me diverges from what is best for the group) leads to tragedy,

"The tragedy of the commons develops in this way. Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes the day of reckoning, that is, the day when the long-desired goal of social stability becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy.

As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, "What is the utility to me of adding one more animal to my herd?" This utility has one negative and one positive component.

1. The positive component is a function of the increment of one animal. Since the herdsman receives all the proceeds from the sale of the additional animal, the positive utility is nearly + 1.

2. The negative component is a function of the additional overgrazing created by one more animal. Since, however, the effects of overgrazing are shared by all the herdsmen, the negative utility for any particular decision­making herdsman is only a fraction of - 1.

Adding together the component partial utilities, the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another.... But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit -- in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all."

Note the similarities to the example of harvesting a forest that I used in the last post and the similar introduction of the notion of limits.

Hardin goes on to note that what is moral depends on the context,

"That morality is system-sensitive escaped the attention of most codifiers of ethics in the past. "Thou shalt not…" is the form of traditional ethical directives which make no allowance for particular circumstances. The laws of our society follow the pattern of ancient ethics, and therefore are poorly suited to governing a complex, crowded, changeable world. Our epicyclic solution is to augment statutory law with administrative law. Since it is practically impossible to spell out all the conditions under which it is safe to burn trash in the back yard or to run an automobile without smog ­control, by law we delegate the details to bureaus. The result is administrative law, which is rightly feared for an ancient reason -- Quis custodies ipsos custodes? --Who shall watch the watchers themselves? John Adams said that we must have a "government of laws and not men." Bureau administrators, trying to evaluate the morality of acts in the total system, are singularly liable to corruption, producing a government by men, not laws.

Prohibition is easy to legislate (though not necessarily to enforce); but how do we legislate temperance? Experience indicates that it can be accomplished best through the mediation of administrative law. We limit possibilities unnecessarily if we suppose that the sentiment of Quis custodiet denies us the use of administrative law. We should rather retain the phrase as a perpetual reminder of fearful dangers we cannot avoid. The great challenge facing us now is to invent the corrective feedbacks that are needed to keep custodians honest. We must find ways to legitimate the needed authority of both the custodians and the corrective feedbacks."

The question of how to achieve temperance in the use of the commons is one that has been taken up in recent decades by Elinor Ostrom, winner of the 2009 Nobel Prize in Economics.

Ostrom starts by recounting three influential models: the tragedy of the commons, the prisoner's dilemma, and the logic of collective action. She then contrasts two theoretical approaches to managing a commons: The 'Leviathan' Approach in which a strong central authority limits use of the commons to what is sustainable, and the 'Privatization' approach, in which the commons is replaced by a system of private property rights (e.g. every fisherman is given ownership over a particular piece of ocean or a particular group of fish).

Ostrom, after conducting extensive fieldwork around the world on what she calls common pool resources (small scale situations where a group of people manage a renewable but not inexhaustible resource - e.g. inland fisheries, pastures, irrigation systems, etc.) ends up rejecting both the Leviathan approach and the Privatization approach in favour of what she encountered in her research: locally managed and run collectives that are neither run directly by a central government (although support from the government is generally helpful) nor managed via a system of individual property rights (although granting of individual licenses of some sort is often part of the management approach).

Per wikipedia, Ostrom identifies eight requirements for insitutions that managed common pool resources to be successful:

"1. Clearly defined boundaries
2. Congruence between appropriation and provision rules and local conditions
3. Collective-choice arrangements allowing for the participation of most of the appropriators in the decision making process
4. Effective monitoring by monitors who are part of or accountable to the appropriators
5. Graduated sanctions for appropriators who do not respect community rules
6. Conflict-resolution mechanisms which are cheap and easy of access
7. Minimal recognition of rights to organize (e.g., by the government)
8. In case of larger CPRs: Organisation in the form of multiple layers of nested enterprises, with small, local CPRs at their bases."

Note how point 1, clearly defined boundaries, corresponds to the Guardian syndrome as representing territorial concerns. Points 4, 5 and 6 correspond to the Guardian value of taking vengeance as appropriate. Point 8 harkens back to the work of Mancur Olson (The Logic of Collective Action) which noted that the problems of motivating group-oriented (as opposed to self-oriented) behaviour in large groups could be mitigated by a hierarchical structure (as supported by the guardian values of obedience and respect for hierarchy).

The institutions that govern common pool resources, are clearly guardian-type institutions, managing a particular territory, based on taking rather than trading, seeking to optimize rather than maximize output, and requiring collective restraint rather than pursuit of self-interest. But at the same time, the participants who are extracting the resources are functioning to some extent as commercial operators - looking to make a living by trading what they extract, and pursuing innovation to the extent it helps them become better off.

A high standard of ethical behaviour is required of participants in the common pool management to be able to maintain a guardian based approach to management of the land on one point, while still retaining their commercial approach to trading the resource on the other hand. This may be why institutions for managing common pool resources failed in many (although by no means all) of the cases Ostrom studied.

I'm only scratching the surface of Ostrom's work in this post, and hopefully I'll have a chance to come back to it in more detail at a later date.

42. Cowboys on a Spaceship

I remember a cartoon I saw once, many many years ago during the debates over the cod fishery.

The left side of the panel showed a fisherman in the office of a banker, with the banker pointing at a graph with a steeply rising line, the implication being that the fisherman's revenue needed to grow at that rate for him to be able to borrow the money he needed from the bank. The right side of the panel had the fisherman at the water's edge, showing the same chart to a fish in the water, with the fish saying, "But I can't grow that fast!"

---
Imagine you were given stewardship over a vast forest, and the conditions were as follows:

* You receive a fixed amount of money for every tree you chop down and place in a pickup area.
* No matter how many trees you chop down, you could never make any kind of dent in the size of the massive forest.

Under these conditions, you might take on a set of values similar to the ones I classified under the 'moral conditions of economic maximization' earlier. You would be open to strangers and aliens, inviting anyone who was interested to come chop down trees, as long as you got a cut of their profits, of course. You would want everyone to be productive and industrious and to innovate for the sake of the task of chopping down more trees.

Now imagine you were given stewardship over a different forest, and the rules were as follows:
* You received a large profit from the first 10 trees you chopped down each week,
* But, you were not allowed to chop down any more than 10 per week, because the forest wouldn't regenerate otherwise.

Under these conditions, your values would be quite different. Openness to strangers and aliens would simply dilute your profits. Industriousness and productivity would do you no good. Innovativeness might help you chop down the 10 trees faster each week, but it's benefits would be limited. Rich use of leisure would keep people away from the temptation to chop down the forest too quickly.

This example highlights how, from an economic and moral perspective, everything changes once the concept of limits is introduced. It is this importance of limits which explains why notions such as the Club of Rome's 'Limits to Growth' or the notion of 'Peak Oil' have proven to be so controversial.

This leads me to the title of today's post. Back in 1966, economist Kenneth Boulding published a prescient essay titled, 'The Economics of the Coming Spaceship Earth'.

Boulding argued that,

"We are now in the middle of a long process of transition in the nature of the image which man has of himself and his environment. Primitive men, and to a large extent also men of the early civilizations, imagined themselves to be living on a virtually illimitable plane. There was almost always somewhere beyond the known limits of human habitation, and over a very large part of the time that man has been on earth, there has been something like a frontier. That is, there was always some place else to go when things got too difficult, either by reason of the deterioration of the natural environment or a deterioration of the social structure in places where people happened to live. The image of the frontier is probably one of the oldest images of mankind, and it is not surprising that we find it hard to get rid of.

Gradually, however, man has been accustoming himself to the notion of the spherical earth and a closed sphere of human activity."

The metaphor that Boulding used was that of moving from the mentality of a Cowboy, roaming a limitless plane, to a Spaceship where everything is in finite supply.

Much like my forest example above, Boulding noted that different principles would be required in these two worlds,

"The closed earth of the future requires economic principles which are somewhat different from those of the open earth of the past.

...

The difference between the two types of economy becomes most apparent in the attitude towards consumption. In the cowboy economy, consumption is regarded as a good thing and production likewise; and the success of the economy is measured by the amount of tile throughput from the "factors of production," a part of which, at any rate, is extracted from the reservoirs of raw materials and noneconomic objects, and another part of which is output into the reservoirs of pollution. If there are infinite reservoirs from which material can be obtained and into which effluvia can be deposited, then the throughput is at least a plausible measure of the success of the economy. The gross national product is a rough measure of this total throughput. It should be possible, however, to distinguish that part of the GNP which is derived from exhaustible and that which is derived from reproducible resources, as well as that part of consumption which represents effluvia and that which represents input into the productive system again. Nobody, as far as I know, has ever attempted to break down the GNP in this way, although it Would be an interesting and extremely important exercise, which is unfortunately beyond the scope of this paper.

By contrast, in the spaceman economy, throughput is by no means a desideratum, and is indeed to be regarded as something to be minimized rather than maximized. The essential measure of the success of the economy is not production and consumption at all, but the nature, extent, quality, and complexity of the total capital stock, including in this the state of the human bodies and minds included in the system. In the spaceman economy, what we are primarily concerned with is stock maintenance, and any technological change which results in the maintenance of a given total stock with a lessened throughput (that is, less production and consumption) is clearly a gain. This idea that both production and consumption are bad things rather than good things is very strange to economists, who have been obsessed with tile income-flow concepts to the exclusion, almost, of capital-stock concepts."

I find Boulding's notion of moving from the 'income statement' approach to the 'balance sheet' approach fascinating, although I'm not really sure what more to make of it, at the moment.

Another point worth noting is that the spaceship model requires restraint from all participants in order to work. If 9 out of 10 people refrain from consuming a finite resource, but this just means that more is left over for the 10th person who is taking as much as they can, this is ineffective. Only unanimous (or monopoly) restraint will be effective.

In his essay Boulding seems to believe that the spaceship world is something that we will only encounter in the distant future, but it seems a little more present now in a world of global warming, a hole in the ozone layer and peak oil.

Of course there's one critical economic ingredient that we largely ran out of hundreds of years ago, but isn't mentioned by Boulding even though his choice of metaphorical Cowboys and Spaceships shows how it must have lurked in his subconscious - what am I referring to? Land, of course, they aren't making any more as any real estate agent will tell you. We hit peak land a long time ago (the last time we had an open frontier was the Cowboy era), but more on that another time.