Social Interactions and the Need for Institutions

Introduction

The classical constitutional conundrum begs the question: how can social interactions be structured so that people are free to choose their own actions while avoiding outcomes that none would have chosen? In other words, how can Pareto-efficient outcomes be ensured? The problem with policy designed to address this conundrum lies in the difficulty in ranking outcomes, especially when Pareto-inefficient outcomes are sometimes preferred. Rules governing interactions are needed to account for externalities, or the unintended consequences of actions taken by self-interested individuals. Adam Smith's argues that given appropriate institutional conditions, an invisible hand will influence self-interested individuals to create socially desirable outcomes.

Coordination and Conflict

In contrast to Smith is the believe that individuals cannot or do not take into consideration the effects their actions have on others. This concept of the tragedy of the commons, developed by Garrett Hardin, occurs when individuals pursue their own interests to the point where it becomes disastrous for all involved, including themselves.

Tragedy of the Commons

An example to illustrate a tragedy of the commons involves two fishers, Jay and Eye, who have exclusive access to a lake. Each must decide how much time to spend fishing, which directly correlates to how much fish they will catch. Fishing longer hours will result in more fish caught for that person but less for the other. Without an agreement or contract each will fish for 8 hours per day and the benefits will be equal to the next best alternative to fishing. If each would fish less, they would be better off since the increased leisure time would more than offset the smaller catch.

Table 1.1 shows the payoffs each would receive based on fishing either 6 or 8 hours per day.

• u represents the total benefits if they each fished 8 hours, which is equal to the alternative.
• u > 0
• alpha > 0
• 1 > u

The best solution would be for them to agree to each fish 6 hours. But there is difficulty in making this happen for two reasons:

1. It is too difficult to enforce an agreement or know if it has been violated.

• This is the problem of asymmetric information and it would be difficult to prove in court just how much the other person was fishing.

2. An agreement must be made on the allocation of the resources and the distribution of the benefits.

• The two individuals must decide on how many hours to fish in total and also how to divide those hours (eg. 6 hours for each, 4 hours for Jay and 8 hours for Eye, etc.) Should they not divide the total hours equally they would need a way to divide to benefits to satisfy both parties.

This graph shows the "production possibilities" for the two fishers. Point C, representing each fisher working 6 hours, is the furthest point on the frontier where benefits are maximized.

Social Interaction

There are two general classes of interactions that individuals are involved in:

Cooperative and Noncooperative Games

• A cooperative games occurs when everything that is affected by the action of the players and is of concern to the players is subject to a binding agreement. For example, the transaction of a house puts the interests of the seller against that of the buyer, but an enforceable deal is reached that covers all aspects of the transfer.
• A noncooperative game involves a situation in which an aspect is not subject to a binding agreement. An example of this is wage bargaining between employer and employee. The contract reached between these two parties will not include things such as how hard the employee will work what the employer will do with the profit.

Common Interest and Conflict Games

• A pure common interest game refers to a case where there is one outcome that all players prefer to any other, ie. one outcome is Pareto Optimal. No traffic is an outcome that all travelers would prefer to the alternatives of having some or heavy traffic.
• A pure conflict game occurs when all possible outcomes are Pareto optimal. The dollar Division Game, developed by Schelling (1960), illustrates pure conflict. A dollar is to be divided between two people. Without communication each submits a claim for any amount of the dollar. If the sum of the two claims is less than one, they are granted. If the sum is greater than one than each person gets nothing.

Need for Institutions

The suboptimal outcomes that result from the pursuit of individual interests can be categorized as coordination failures. Coordination failures can be defined as occurring when the noncooperative interaction of two or more individuals leads to a result that is not Pareto optimal.

The ability of an institution to prevent a Pareto-inferior outcome can be illustrated by looking at the Indian village of Palanpur. The small, 200-family village remains perennially poor, even by Indian standards. Part of the reason can be attributed to the fact that Palanpur farmers plant their crops several weeks after the date that would yield the greatest returns. The farmers are fully aware of this yet continue this practice because the first farmer to plant his seeds has them eaten by birds. As a result, a waiting game takes place with no one wanting to be first. When asked why the farmers had not agreed to all plant on the same day to minimize the loss each would suffer, a farmer replied "If we knew how to do that, we would not be poor."

The table above shows a simplified version of this situation with two farmers. The ideal result would have both farmers plant early as this would maximize the return and it would be the same for both. The problem is that a Nash equilibrium also occurs if both plant late since neither has an incentive to plant early unless the other does. An institution, such as a law, could be used to ensure both farmers plant on the same date and this would result in the Pareto optimal outcome.

Why Don't Institutions Always Work?

• Coordination failures among a few individuals are easy to address. When hundreds or thousands become involved, noncooperation and asymmetric information make the result difficult to optimize.
• Skepticism exists regarding the ability of the government to coordinate efficient outcomes.

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Source

Bowles, Samuel. Microeconomics: Behavior, Institutions, and Evolution. New Jersey: Princeton University Press, 2004.

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