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 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.

INSERT TABLE

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 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.