Adam Smith and Robert Shiller help us make models useful

<Adam Smith>

He intends only his own security, and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain. And he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention...By pursuing his own interest he frequently promotes that of the society more effectively than when he really intends to promote it.

<Robert Shiller - an exerpt from Animal Spirits>

Economic experiments offer another demonstration of the role of fairness. There are many, many different experiments, but our very favorites are those of Ernst Fehr and Simon Gachter. They made an innovation to a game commonly played in experimental laboratories to test subjects' cooperation and trust of one another. In the plain vanilla version of this game subjects have the opportunity to put some money into a “pot,” which will be augmented and then shared with the rest of the group. If everyone acts cooperatively the returns for the whole group are the greatest. But at the same time there is an incentive to act selfishly: I achieve the best outcome for myself if everyone else puts his money in the pot – to be augmented and shared – but I act selfishly.

<Steak>

The premise of this experiment seems to fly in the face of Adam Smith's invisible hand. In his framework everybody acting in their own self interest leads to a sum-greater-than-parts result that improves the lot of everyone. A situation where the optimal result is derived from all contributing to a collective pot would sound very much like socialism to any self-proclaimed capitalist. What if one member of the group could produce more than all other contributions combined, would that not be stifled if they had to contribute to the communal pot?

The answer to that question comes again from Smith, who described his day's version of an assembly line. He observes that ten men on an assembly line increase their productivity an order of magnitude as compared to working individually. In what he describes below, “if everyone acts cooperatively the returns for the whole group are the greatest.”

<Adam Smith>

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades.

...Though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

<Steak>

The rewards and productivity achieved by those ten men can be modeled with minor adjustments to the experiment delineated above. Consider that if they are earning a wage then they contribute labor and get an augmented sum in return. At the same time someone on an assembly line is working slow or not at all but still earning a wage, it is analogous to the person who does not contribute to the pot but still gets paid. At their core, the experiment above and the assembly line both require collaboration with others to achieve an augmented result greater than the sum of contributions. Therefore this experiment does provide an accurate and relevant framework for us to explore human behavior in a capitalistic economy.

<Shiller>

If everyone acts cooperatively the returns for the whole group are the greatest. But at the same time there is an incentive to act selfishly: I achieve the best outcome for myself if everyone else puts his money in the pot – to be augmented and shared – but I act selfishly. There is a standard wisdom about the outcomes of such games: experimental subjects initially play such games with some degree of cooperation, but if the games are repeated they first learn some other players are defectors and then they themselves increasingly defect. After many repetitions of the game all players are playing selfishly. The behavior pattern is very basic: it has been documented in monkeys as well as humans.

<Steak>

The two key elements introduced in this paragraph are the concepts of fairness in a collaborative endeavor and a biological component of social behavior. The fact that this behavior is also observed in monkeys says that our responses in this experiment are naturally evolved to lead us to cooperative behavior that benefits the whole. If pressed we always have the instinct to protect oneself first, which is why everyone drops out the game when it turns unfair.

So far Schiller has set up the model and turned it on but has not told us how to get it to run smoothly. As we see, even though collaboration can be a complicated and fragile endeavor, we have a defense mechanism to keep the augmented benefits of cooperation accruing smoothly.

<Shiller>

But Fehr and Gachter had an idea. They made a slight modification to the game to determine what would happen if players could punish those who played non-cooperatively. They conjectured that subjects would punish even if they had to pay to do so. This is exactly what they found: subjects were willing to pay to punish those who acted selfishly, even though there was an individual cost to inflicting such punishments. Interestingly they also found that the possibility of punishment greatly reduced selfish behavior. Even after numerous repeated games, many players were still putting money into the pot.

Of course payments for the opportunity to punish indicate that subjects care about fairness. They are angry when other subjects are selfish. With another set of co-authors Fehr asked subjects to play similar games while their brains were being PET scanned. Engaging in such punishment appears to make subjects happy: it activates an area of the brain, the dorsal striatum, that “lights up” in anticipation of many different types of rewards.

* Fehr also pointed out that – since the dorsal striatum is activated in anticipation of both getting water, if one is thirsty, and getting revenge, if one is angry – people can literally be “thirsty for revenge.”

<Steak>

In the final explanation of the experiment Schiller notes that this experiment tells us we cannot cooperate in a system that cannot punish free riders (and other ne'er do wells). If participants believe their collaborative effort has been adequately purged, then the system runs smoothly by achieving the optimal gain for the group as a whole.

What is critical here is that we have an experiment that is very conducive to being modeled in the manner of Duncan Watts' Model for Global Cascades. Indeed the knowledge about the free riders and the group decision to abandon the game spreads as a cascade. We also have the benefit of knowing how to prevent a global cascade: prosecute the criminals.

Keynesian economics could not conceive of someone accepting short-term loss for what is essentially the satisfaction of revenge. Yet we all have these urges embedded in our DNA. If we know how to model the behavior in question we can test various questions about how to most efficiently get the cooperative system working again. In a networked model we could see if high profile prosecutions (a highly connected node) was more effective than prosecuting as many nodes as possible. The results could then be tested by performing the experiment with those modifications.

Actually doing all this is a ways off, but the potential is obvious. Economic models have willfully dismissed the human element for too long and we are now stuck with output gap / natural employment rate theory that sucks beyond words at describing the world as is.

The spirit animal for this post is the termite

The theme song for this post is the instrumental of Jay-Z Lost One:

http://www.youtube.com/watch?v=ke9Xy3TzKgw