Positive Political Economy: Freedom and Rational Choice Theory

1. Positive Political Economy: Freedom and Rational Choice Theory Can the liberal model be used to explain social interaction? But why do policy-makers often diverge from the liberal model? What explains actual policy? Why doesn’t the market always rule? What other institutions affect economic choices?

2. Today’s session we will • Discuss some of the origins of rational choice theory—using the methods of liberal theory • Discuss assumptions of rat choice theory • Show how the theory works in life: strategic interaction and prisoners dilemma • Argue that cooperation is best for all but it’s hard to get: the problem of collective action • Argue that Institutions and governments are necessary to ensure cooperation---ensure competition and more • Argue that governments are often clunky and that problems of cooperation can be solved through the market mechanism: Coase Theorem

3. Answers come from building blocks of the liberal economic model! • Economics seems to be the most successful of the social sciences • Assumed that people are motivated by the drive for wealth • Success led other social scientists to cast an envious eye in its direction • They thought: “If we follow the methods of economics, maybe we can achieve similar success!” • So they began to build theories around the concept that people are rational.

4. And they came up with rational choice theory • Assumptions the same as liberal theory • Production, distribution, consumption of goods and services organized through the market • Market mechanisms can explain human action around other resources, e.g. time, information, prestige, etc.

5. Assumption: Individuals are self interested • Individuals are at the center of all social activity • self-interest is not the same as “selfishness” • self-interest in rational choice theory is premised on the idea that all • individuals have specific (“reasonable”) goals and that they behave in • way that best enables them to achieve those goals

6. Assumption: Individuals are Rational • Individuals are rational • They are motivated by goals that express their preferences • But you can’t always have what you want! • Goals are shaped by constraints like • Information (which is always imperfect)

7. And other Constraints shape calculations….. • About the costs and benefits of any action that might be taken to achieve a goal. • We sometimes call this the “strategic environment” • And in that environment we engage in “strategic interaction” • what you do may affect what I choose to do, and what I do may affect what you choose to do.

8. So our calculations are dependent on what others do

9. Life is just a Game! • These situations can be modeled as a game • Model: a simplified version of reality • Game: a model of strategic interaction defined by • Players (or actors) • Strategies: plans of actions for all players that set out what player i does under all possible contingencies • Payoffs

10. The Relationship Game

11. In the Game of Life, (Promise of) Rewards are “Benefits” (Threats of) Punishments are “costs” • “utility” • Constraints • incentives • Calculations of probabilities • Profit • utility maximization • Social interaction continues only as long as participants think they will make a profit—maximize their utility

12. We are all caught in a “prisoner’s dilemma”

13. Prisoners Dilemma: How the game is played

14. Strategic Interaction; imperfect information

15. How the Prisoners’ Dilemma explains Doping

16. Assumptions • you are earning your living through cycling, • your team had made performance-enhancing drugs part of its “medical program” • You’ll be cut if you’re not competitive. • You believe that your competitors are doping • Those who are tested rarely get caught • Rules are not clear and not enforced. • authorities look the other way, • creating a perfect environment for doping.

17. Probabilities for calculation of rewards and punishments • Game Assumptions: Current Competition • Value of winning the Tour de France: $10 million • Likelihood that a doping rider will win the Tour de France against nondoping competitors: 100% • Value of cycling professionally for a year, when the playing field is level: $1 million • Cost of getting caught cheating (penalties and lost income): $1 million • Likelihood of getting caught cheating: 10% • Cost of getting cut from a team (forgone earnings and loss of status): $1 million • Likelihood that a nondoping rider will get cut from a team for being noncompetitive: 50%

18. Why so much doping?

19. Cooperation is difficult but necessary

20. How is cooperation ever achieved? The Problem of Collective Action • Individuals can aggregate their preferences in groups, like trade unions, other interest groups, and political parties? • Why do rational individuals join groups? • Because the benefits outweigh the costs of membership. • Group membership is a constraint on freedom • And often individuals can get the same benefits without joining the group • They can achieve what they want on their own • Or they can “free ride” on the group

21. Game of Achieving what you want on your own: The Stag Hunt The Stag Hunt Chasing the Rabbit

22. Here is what the calculations look like: Cooperate Defect Me You Cooperate Defect

23. Why do people always arrive late to a party?

24. The problem of Trust • it is very hard to move from the low-trust situation, in which both prisoners confess, each hunter chases his own rabbits, --or everyone arrives late---to the more trusting situation, in which both team up to get a light sentence, to bring down the stag—or everyone arrives on time. Any move to the high-trust environment is going to require its own, possibly costly, attempt at coordination.

25. Back to doping…..can Lance create Trust?

26. Can only higher authorities change risk and reward calculations and create trust? • Trust reduces our “transaction costs” in groups • That’s why we have institutions to help create cooperation • institutions formalize trust and thus dramatically expand our ability to interact with those beyond our immediate neighbors. • That’s why we have laws and law enforcement • Back to political economy and the market….. • the U..S. government (an institution) decided to “bail out” the financial system when the market broke down • It is a way to bring back trust. • Markets sometimes “fail” at coordinating economic activity

27. Governments coordinate economic activity when uncoordinated markets “fail” • Prosperity • Transition • Trough • Recovery ? Governemt “bailout

28. Then there is the Problem of Free Riders

29. Rational Actors have no incentive to join in collective action

30. Social Costs complicate social interactions

31. Market failure and property rights • In groups Property rights need to encompass costs imposed on others • I have a right to play the piano, while my neighbor feels he has the right peace and quiet. • We could go to court over it…….

32. Governments don’t have good information and they make mistakes Brussels Sprouts Farm using pesticides Herb Farm that wants organic certification

33. Coase Theorem….back to the grand piano—Market solution

34. Property rights must include costs • as long as the initial property rights are clearly defined to include social costs and benefits, the Coase Bargaining Theorem results in a socially optimal outcome • A potential market failure is averted using a purely market-based tool, without relying on government or the legal system.

35. So are we really Free? • Our behavior is not free but determined • By rewards and punishments • We do things that lead to rewards and avoid whatever we are punished for. • Joining groups restricts freedom • Social costs restrict freedom • Isn’t that a kind of prison?

36. What is “rational” decision-making? knowing all information? No perfect calculation? No choices that are morally good? Not necessarily Different in small groups than in big groups? Yes

37. Rational Choice simplifies a very complex reality • Yes, people are self-interested • But their limited information, preferences, utility maximization, calculations and • strategic interaction makes “rational decision-making” more complex than it appears on the surface