5. Economics and the Ethics of Greed

If (a) the most important mission of economists in the world is to alleviate poverty, and (b) the Development as Virtue theory is even partly true, and an important cause of poverty is the lack of trust to facilitate exchange, then economists might have a duty to preach morality, and persuade people to be honest and generous, so that the economy might grow, and the needs of the poor met. But that goes against the grain, for economists have a long tradition of doing almost the opposite, of tolerating, taking for granted, even at times encouraging, widespread selfish greed.

The tradition can be traced in part to Adam Smith, and it is most famously expressed in this passage from The Wealth of Nations:

Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

Was Adam Smith right? Certainly the last sentence, if taken literally, is false. If I go to the meat counter in the supermarket, I tell the person behind the counter what I need, not what’s in it for them if they provide it. But I do pay, of course, and from what I and others like me pay, they get their wages. However, it does not follow that “it is not from the benevolence of the butcher” that I expect my dinner. Just because he is paid, and has to be paid if he is to cover his costs and stay in business, does not mean he is not sincerely benevolent, and motivated by a desire for his customers to eat well. One can’t really know, from the mere fact that he provides meat and gets paid, what his motives are. He might want to get paid, and providing meat is just a means to that end. Or he might want to provide meat, and getting paid is just a means to that end. He may be equally motivated to provide meat and to get paid.

If money for meat is a fully transparent spot transaction, or if reputational or legal incentives are sufficiently strong to motivate appropriate quality controls purely for commercial advantage, I may not need to rely on the butcher’s benevolence towards me, even if it might be, for all I know, present in a high degree. Let him love me or be indifferent, he will sell me meat in the same way. But if I cannot easily ascertain the quality of the meat that I am buying, and if he, with his superior knowledge, could hand me lower quality meat than I’m paying for without my knowing it, the butcher’s benevolence might matter a good deal. I might be able to eat a really delicious steak, on Christmas Day for example, or on my birthday, only because the discerning eye of my benevolent butcher secured for me meat of a quality I could never have found for myself.

Still, Adam Smith had a point, even if he overstated it. The invisible hand of the market does induce people to serve one another in ways that they don’t understand or intend. And sometimes the market operates so efficiently that it’s actually counter-productive to let virtuous impulses interfere with it. There are times when greed is good, or at least, when rational selfishness by all parties leads to the best feasible outcome.

It would be easy to multiply examples too obvious to be interesting. People sitting around a well-laden dinner table may eat their fill as selfishly as they like. People caught in the rain, but all carrying umbrellas, may freely indulge their greed for keeping dry. But there are more counter-intuitive examples, where the insight of the economist can really come in handy by dispelling unhelpful scruples.

Let my first example be called the Gas Price Parable.

Once upon a time, gas prices had long hovered around $2/gallon, when a surging economy in China, a weak dollar, and a war in the Middle East suddenly drove them up to $5/gallon. Cash-strapped consumers resented “gouging” by oil companies, and pleaded eloquently for relief. The conscience-stricken oil companies yielded to public pressure, and with many grandiloquent speeches about “community” and “responsibility” and “patriotism,” they announced, to general applause, their determination not to let arbitrary market conditions tempt them away from charging the “fair price” of $2/gallon that they have been charging for years.

The result is shown in Figure 1:

Figure 1

The result of the “fair price” was a large shortage of gasoline, and long queues at the pumps. The “deadweight loss” resulting from the self-imposed price cap set by the oil companies was equal in value to regions C+E in the chart. Furthermore, since the willingness-to-pay of the marginal consumer was now well above the equilibrium price of $5, the time they were willing to waste in queues, so as to make them indifferent being buying and not buying more gas, had a value equal to regions A+B in the chart. Alas, not only would the oil companies have earned higher profits by charging what the market will bear, but even consumers, the intended beneficiaries of the “fair price,” were harmed by getting less gas, and effectively paying more for it, with the cost in wasted time far exceeding the money savings.

The moral of this story seems to be: BE GREEDY. Forget generosity and fairness. Ignore the outcry of public opinion. Don’t worry about fairness. Just maximize profits, rationally, a little ruthlessly, and let the chips fall where they may. The market will sort it all out. You’ll actually make things worse by trying to be virtuous. Virtue just muddles things and wreaks havoc. Greed makes the world a better place.

But now consider my second example, which I’ll call the Team Production Parable.

Once upon a time, there was a small manufacturer called Middlevale Widgets. It shut down every summer to save on air conditioning, but for the other nine months, it was a busy place from 9AM to 11PM every day, and half the town had worked on its assembly lines at one time or another, to earn money for college, for example, or to save up for a down payment on a home. Wages are mediocre, and the work is dull, so turnover is high, but everyone is glad the factory is there.

Over and above the twenty or thirty comparatively transient floor employees are five long-term staff who stick around even in the summer, getting ready for the next season, and who have regular meetings to make Middlevale Widgets’ decisions. All of them are indispensable if the factory is to operate. They are shown in Table 1.

Table 1

Person	Function	Salary	Outside Option Pay	Replacement Pay
Alex	Machinist, repairman	$62,000	$31,000	$107,000
Bill	Computers, databases	$57,000	$26,000	$81,000
Cindy	Accounting, finance, and HR	$44,000	$42,000	$135,000
Dan	Marketing and product development	$109,000	$77,000	$183,000
Eleanor	Supply chain and logistics	$92,000	$38,000	$99,000
Total		$364,000	$214,000	$605,000

In addition to function and salary, Table 1 shows the “outside option pay” for each of the core staffers, i.e., what they could earn at some other job if they didn’t work for Middlevale Widgets, and the “replacement pay,” which is the salary Middlevale Widgets would have to offer to recruit someone else with the same skills.

Middlevale Widgets sells about $3 million of product each year, and pays out $2.5 million for floor employee wages, raw materials, utilities, replacement of depreciated capital, debt service, and a few other, smaller, necessary costs of doing business. Out of the remaining $500,000, the five long-term staffers’ salaries are paid, and whatever is left is distributed to shareholders.

Note the following:

1. All five core staffers are paid more than their outside option. They benefit from Middlevale Widgets being in operation.
2. The salaries of the five core staffers are rather random. The pay differences seem inexplicable and without pattern. The amounts of “producer surplus,” so to speak, that the five staffers get by being at Middlevale Widgets rather than somewhere else, vary wildly, from Cindy’s $2,000 to Eleanor’s $54,000.
3. Any of the core staffers might demand a raise, on the reasonable ground that he or she is being paid less than it would cost to replace them. As long as the salary demanded was less than the replacement pay, it would be in the immediate interest of the others to concede to the demand.
4. But Middlevale Widgets cannot afford to pay all the core staffers their replacement pay. If they all insist on large raises, the factory will go broke.

By the way, the Team Production Parable is, I think, channeling an argument made by Bengt Holmstrom in his 1982 paper, “Moral Hazard in Teams.” Cue the sycophantic academic blather: “seminal contribution,” etc., etc. I haven’t read the paper and I don’t intend to. I heard the argument second-hand and immediately understood it, so why read the paper? But Google Scholar shows 358 citations, so probably somewhere in subscriber-only journals there are exchanges of ideas somewhat parallel to the thoughts I’m jotting down now. Forgive the digression. Back to the argument.

The moral of the Team Production Parable is very hard to discern, if we first tie our hands by the supposing, in the silly-clever fashion characteristic of economic theorists, that Alex, Bill, Cindy, Dan, and Eleanor are possessed by a spirit of myopic greed, blindly indifferent to the welfare of everyone around them. At first, it seems that each should demand a large raise. Then it seems that each will demand a large raise, so the factory is doomed. But since that’s disastrous for everyone, they might try to hit on some cooperative-greedy compromise whereby the raises are somehow shared out while staying within the budget constraint. But can that be managed? And suddenly the factory becomes a strategic problem, and more details are needed about how they make the joint decisions, and what each expects the others to do, and how much they care about the future vs. the present, and it’s all very complex and difficult. The prisoner’s dilemma stands as a proof of concept that there might be no way for self-interested people to avoid a breakdown in cooperation. I have made the story complex and vague enough to give it a flavor of realism. I could not describe the rules of decision-making, or the goals and states of mind of the players, with sufficient detail to satisfy a game theorist, without in the process destroying the realism of the example, for it is part of the nature of life to be a game in which we do not know all the rules. Yet if I did describe them, it would probably result in a game with many Nash equilibria (I’ll explain what that means in a later post) and all would still be uncertain.

But here’s the real point. If we assume that Alex, Bill, Cindy, Dan, and Eleanor are normal, sensible people, who care somewhat about one another, somewhat about the work of the factory for its own sake, somewhat about being well-liked and respected, somewhat about the floor employees and the town, and a little even about Middlevale Widgets’ customers and shareholders, then the moral of the Team Production Parable is: DON’T BE GREEDY. Don’t encourage, or condone, greed in others. Cry “shame!” whenever you hear a rumor of it. Greed is a wrecking ball that destroys, that impoverishes everyone. Cling to anything, any custom, any arbitrary rule or protocol or tradition, any ritual or polite nothing or taboo, that might restrain greed and keep if off the table. Better for everyone to be irrational and stupid, than to let greed in the door. Just be thankful for what you have, and keep on working.

The moral of both these scenarios, together, is that sometimes economic reasoning can show, contra intuition, if not why greed is good, at least why certain scruples that restrain it are misguided, while at other times, it lucidly confirms and reinforces the popular prejudice that greed is bad, and underlines how urgently it needs to be contained.

Now, what I want to suggest, perhaps quixotically, is that it is a kind of negligence to look at the Team Production Parable and not praise virtue and denounce greed. It is like doing an incomplete sum, carrying the 1s and jotting down a couple of digits, then shrugging and walking away. The argument demands to be carried through to that conclusion.

Economists practice a curious double standard, whereby they love to search for policies, that is, public policies to be adopted by governments, that are “Pareto-improving,” that is, that make everyone better off, and then exhort governments to adopt those policies, yet they do not engage in a similar search for moral rules, that is, private policies to be adopted by individuals, that are Pareto-improving, that is, that would, if widely adopted, make everyone better off, and then exhort individuals to adopt those moral rules. Economists are quite bold in advocating free trade or condemning rent and price controls. They are much less vocal in advocating honest dealing or denouncing opportunistic greed. I don’t really see how the practice can be defended, but I'll hazard a few guesses as to how the practice came to be current.

First, I think economists understand the Gas Price Parable and its moral very well, while they either don’t know about, or don’t understand, the Team Production Parable and its moral, or else they think it is less important and general. I think it is more so. Some version of the Team Production Parable is usually relevant in any organization, and most of us spend more of our time working in organizations than trading in markets.

Second, I think economists don’t see moral exhortation as their forte, their turf. Perhaps there’s an intellectual division of labor, and it is the economist’s business to explain the team production problem, and the moral philosopher’s business to discern whether, finding themselves in such a scenario, people ought to eschew opportunistic greed. Yet that won’t quite do. Economists know how to borrow from other fields. They’ll happily consult a lawyer to understand whether a certain contract is legally feasible, or an engineer to understand how much a trebling of capacity lowers the unit costs of a ship or a building. Why don’t they just ask the moral philosophers what Alex, Bill, Cindy, Dan, and Eleanor ought to do, and then finish the team production parable by saying, “... and several moral philosophers have reported to us that a person ought not to demand a pay raise in circumstances like these?” Probably one reason is that whereas lawyers and engineers usually agree, moral philosophy has gotten on the wrong track and been stuck in a quagmire of interminable arguments for centuries, to echo the dour diagnosis of Alasdair MacIntyre, so economists can’t defer to the authority of moral philosophy because it lacks a united voice.

Yet I think the inhibition here is not so much that economists don’t want to try to be moral philosophers, as that they don’t want to try to be pastors. When an economics professor denounces protectionist trade policies, he is denouncing politicians, who are probably not sitting in his classroom. But if an economics professor denounced dishonest dealing or opportunistic greed, he would be denouncing some, or most, of his students. That might make him unpopular. However, priests and pastors have been denouncing the sins of their congregations for centuries, and yet have retained a substantial popular following. How do they manage it? They do that by hating the sin while loving the sinner, and by provoking men not only to feel shame at their sins, but also to hope in God’s mercy and the promise of paradise. An economist might follow suit after his own fashion, by inspiring his class with rosy visions of the prosperous world that would arise if everyone were virtuous, even as he made students painfully aware of how they impoverished their fellow men through their own laziness or dishonesty or greed. But that’s not how they’ve been trained. It goes against the grain.

A third factor, I think, is political correctness. The Development as Virtue theory which I suggested in the last post may have much or little truth in it, but that aside, it is very politically incorrect. It blames the poor for their poverty, not necessary as individuals-- an important clarification-- but certainly as nations. It suggests that Indians, Chinese, and Africans are less virtuous, on average, than Westerners. This will strike many modern, generous, morally relativist people as intolerably judgmental. It’s much better to argue inoffensively that the wealth of the West arises from education, or democracy, or climate, or well-designed laws.

A fourth factor may be that economists want to be seen as “scientists,” and to that end, try to create an aura of scientific detachment in the way they talk, which they feel to be incompatible with moral exhortation.

Finally, economists may be in a subtle, usually unconscious rivalry with the Christian churches, whereby they are led, as if by an invisible hand, to win popularity precisely among those who are tired of being preached at and told to be good. Let’s think again about the students in that economics class. Who are they? Why are they there? For many different reasons, of course, but they are probably a bit less likely to be there if they aspire to the ministry or the priesthood, and probably a bit more likely to be there if they want to make a lot of money. They’ve probably heard, moreover, or got the impression somehow at second hand, that economists are rather tolerant of greed and self-interest, and are not particularly preachy or puritanical, but tend to have a rather irreverent and worldly ethos. That’s what they want. So if an economics professor were to begin denouncing greed, he might feel a kind of chill emanating from the seats of the classroom. That’s not what we came for, professor, he would feel his students silently saying. Let’s talk about money.

To think through all these biases only makes me more convinced that economists tend to neglect the moralistic conclusions that a properly conducted science of economics, starting from sociobiology and game theory and continuing on to markets without embracing the fiction of “perfect competition,” would constantly point to. Virtue makes the world a better place, and economists are well-equipped to remind people of that, and show them why, and how.

Let me conclude by raising an ethical question, somewhat remote from most people’s experience, yet really of quite sweeping importance. Should corporations maximize shareholder value?

Economic theory tends to assume that companies do “maximize profits,” a principle which, if translated into an intertemporal problem in the context of large, liquid financial markets, becomes shareholder value maximization. How to actually make corporations maximize shareholder value is a tricky problem, since it is characteristic of corporations to separate ownership (by the shareholders) from control (by the board and the CEO). Some kind of separation of ownership from control is necessary if the resources of many savers is to be pooled to finance large commercial ventures enjoying economies of scale, while allocating risk to those who can bear it, and taking advantage of the benefits of financial diversification, and at the same time giving the commercial venture a sufficiently centralized and rapid decision-making structure to operate effectively. But it creates principal-agent problems, and it’s very hard, in fact it’s impossible, to align incentives so that shareholders can fully trust the corporate manager they hire to run their company to serve their interests rather than his own. And so, while the mantra that a corporation’s goal is to “maximize shareholder value” is often seen as epitomizing an ideology of corporate greed, it is a kind of ethical ideal. It involves a chief executive solemnly promising to keep his own greed in check, and faithfully serve the greed of the shareholders, whose greed may often seem justified, if the shareholders are middle-class workers saving for retirement, or universities and charitable foundations who need a steady stream of income to pursue their lofty and altruistic goals.

While acknowledging that this argument has a certain strength, I nonetheless dissent. It might be convincing in a world of complete market efficiency, as envisioned by a certain style of pure economic theory, but the real world diverges quite far from that vision in many, many ways, and the result is that a corporation that maximized shareholder value would probably, among other things, miss many opportunities to do good, for which there doesn’t happen to be a way to recover the corporation’s costs. Is there a way to avoid missing these opportunities to do good? Is a world possible in which corporations served the greater good of mankind, even when it doesn’t happen to coincide with the lesser goods of their shareholders?

Let me explore the question by means of a third example, which I’ll call the Tale of Johnny Upright.

Once upon a time, the Fabridor Corporation, a vast multinational empire of manufacturing plants linked by cutting-edge logistics, was looking for a new CEO. One of the candidates, named Johnny Upright, came before the board, and after a long presentation describing, with dazzling acuity and vision, the corporation’s organizational strengths and weaknesses, its assets, its opportunities, and how they can best be marshaled to do better what they’re doing while acquiring new capabilities and penetrating new markets, he concludes with this manifesto:

“Friends, if you hire me, I will not make it a priority to maximize shareholder value. I will run the Fabridor Corporation in the broad interests of mankind, seizing as many opportunities to do great good as I can, within the limits of what is financially and operationally feasible for us to accomplish. I will also try to increase the financial and operational capacities of the Fabridor Corporation, so that it will be able to accomplish even more good in the future. Any cash that we don’t have a good, practical use for, I will return to the legal shareholders, and may they use it to serve their fellow men to the best of their ability. I think it quite likely that the Fabridor Corporation’s share price will do well under my leadership, as a side-effect of my accumulating money and building capacity for the purpose of doing good, but I don’t really care if it does or not, and you shouldn’t either. In a higher moral sense, in the truest sense, every man, woman, and child on Earth will be a shareholder of the Fabridor Corporation, for through our work, we will serve them all, every one, to the best of our ability, without partiality.”

Should the board hire Johnny Upright? Is the board likely to hire Johnny Upright?

In its deliberations, board members raise several points. On the one hand, while not pure greed machines, they are somewhat greedier, in their own right or on behalf of the shareholders, than Johnny Upright. They actually do care about the company’s share price, and they would prefer for the Fabridor Corporation’s CEO to be at least somewhat partial to the interests of the Fabridor Corporation’s shareholders, and to attach a bit more importance to the welfare of that part of mankind that owns Fabridor stock, than the welfare of the part of mankind that doesn’t. On the other hand, they have no doubt that Johnny Upright’s sheer managerial talent is far superior to that of the rival candidates. They’re quite sure that he won’t steal the company’s assets through Swiss bank accounts or corrupt insider dealing, and his lofty, altruistic vision promises to be a wonderful PR asset, helpful in getting favorable treatment from politicians, and in recruiting bright, young, idealistic talent to consider a career at Fabridor. If, as seems possible, Johnny Upright decides to play Robin Hood and give the company’s assets to charity little by little, shareholders might blame the board for hiring a CEO after such a manifesto. Yet they think the odds are good that an audacious mastermind like Johnny Upright will happen to bring in enormous profits as he accomplishes his visionary and transformative goals, and send the share price soaring.

I’ll end the tale there, since one ending (the board hires Johnny) would be cloying, and the other (it doesn’t) tragic. But note that it matters what the competition offers, not only in terms of talent, but in terms of objectives. Corporate boards might choose less talented, but also less idealistic, candidates, but they can only do so if such candidates are available. What if no one offered to maximize shareholder value? What if all the people remotely qualified to run big corporations insisted that to be asked to set aside the interests of the rest of mankind in favor of those of the shareholders was ethically unacceptable? Maybe such an ethical revolution in corporate leadership would reduce share prices across the board. Then again, maybe each corporation’s altruistic behavior would create positive spillovers that would boost the productivity of other corporations, and there would still be just as much money to return to shareholders, and share prices might be just as high as they are today. We might end up with as many, and as thriving, corporations as we have today, or even more.

I think there could be a world in which shareholder value maximization, like slavery, was transcended by moral progress. I think, tentatively, that it would be a better place.

4. Game Theory, Exchange, and Trust

I started this blog in medias res, with markets, yet markets are not really a proper starting place. A novelist might begin with a crisis, to get the reader interested, then fill in the backstory afterwards. So here. A market, as represented by a supply-and-demand chart, is already a rather complex and advanced institution. A lot of assumptions are cooked into it. There must be a system of property rights, else suppliers have nothing to sell, nor customers, to pay with. Property rights must be transferable. There must be some kind of money in place, to facilitate the transaction, and to have units in which to denominate prices. The classic supply-and-demand chart is not a model of barter trade. There must be some kind of standardization of goods, for it to make sense that the quantity axis is a continuous variable.

Game theory is a method that enables economists to study simpler, more primitive and fundamental situations. It has applications far beyond economics, for example in international relations and evolutionary biology. Unfortunately, it is most often used in economics to model competition among firms. The Cournot model and the Bertrand model are the oldest and most venerable of this type. I don’t think game theory is very useful in understanding competition among firms. It starts by simplifying to the point of surreality, then, when it starts the long road back to realism, immediately sinks into a swamp of intractability. It can deliver a few basic concepts, e.g., what collusion is, but it can't get you very far. I think I have a better approach to understanding competition among firms, which is a key starting point for my reinvention of economics. I'll get to that later. But game theory still has an important role.

Game theory starts with players, rules, and outcomes, then analyzes the strategies by which rational players will try to achieve their goals, usually concluding with predictions about what will occur if scenarios resembling the game arise in the real world. In common parlance, the word “game” usually refers to things like checkers or chess, which are too complex to be solved. Game theorists deal in games vastly simpler than that. For example, consider the TRANSACTION GAME shown below:

Here's what every economist or good econ undergrad knows about diagrams like that shown above. (Begin review) The above graph is called the “extensive form” of a game. The game flows from top (the beginning) to bottom (the end). Each of the nodes (the blue circles) represents a scenario that might arise in the course of play, in which one of the players can move. Each of the lines branching out from a node represents a move that is available to the player in question in that scenario. The text boxes next to the nodes say whose move it is, or at the end, says “payoffs” to indicate that the game is over and it’s time to count the gains and losses. The payoffs refer to the overall benefit or loss that the players enjoy as a result of the game. They are denominated in dollars and listed in the order that the players moved, i.e., ($customer payoff, $seller payoff). I’ve numbered the decision nodes to facilitate analysis. (End review)

The narrative behind this game is as follows. A seller has something that a customer values at $15, but which is only worth $10 to the seller. They’ve discussed a price of $12 and found it mutually agreeable. But someone has to move first, and the assumption here is that it’s the customer. The customer either pays, or does not pay. Then the seller either provides the good, or does not provide the good. If no transaction occurs, no gain to either results, i.e., each gets a payoff of $0. If the customer pays, but the seller does not deliver, the customer loses his $12, the seller gains it. In the unlikely event that the seller provides even though the customer didn’t pay, the customer gets the full $15 value, and the seller suffers the full $10 cost. Finally, if the transaction goes through smoothly, with the customer paying and the seller providing, both gain, with $3 of benefit going to the customer ($15 value minus $12 price) and $2 of benefit going to the seller ($12 price minus $10 value).

So, what will happen?

To “solve” the game, we use backward induction. If we arrive at decision node 3, the seller’s best option is not to supply the good. Supplying it gives him a payoff of -$10, which is much worse than his payoff, $0, for doing nothing. That’s a good place to begin the analysis, because the game is then over, so there’s nothing more for the seller to consider. So we can make a confident prediction. If the seller is rational, he’ll decline to provide the good to the non-paying customer.

But now look at decision node 2. Even though the customer paid, it’s still in the seller’s interest not to supply the good! After all, if he supplies the good, he only gets $2 of benefit. But if he declines to supply it, he gets the full $12 the customer paid as benefit. So we predict that a rational seller will just take the customer’s money. Now we can go back to decision node 1. The customer, having analyzed the seller’s optimal strategies at nodes 2 and 3, predicts that “pay” will give him a payoff of -$12, “don’t pay,” a payoff of $0. He doesn’t pay, and the seller doesn’t provide. We’ve solved the game.

But wait a minute. That can't be right! Our conclusion seems to be that buyers and sellers face an insurmountable barrier of mistrust that makes it impossible for them to transact. In the real world, buyers and sellers transact all the time. What's the use of this model?

First, it's useful for theory to draw attention to a solved problem, because we might forget that it's there. Sellers could be “opportunistic” and “defect” from the cooperative game that is a commercial transaction. Buyers could preempt this and not transact in the first place. Why doesn’t this happen?  

Here are four important reasons:

• Law: People may transact honestly because they fear punishment by the government if they don't.
• Virtue: People may transact honestly because that is one of the moral principles by which they regulate their own conduct.
• Reputation: People may transact honestly because they want to foster a reputation for honest dealings, so that they will get more opportunities for profitable transactions in the future.
• Habit: People may transact honestly because it doesn't occur to them to do anything else.

Now, of these four, virtue stands out as particularly desirable and excellent. It's generally good to have as many reasons to transact honestly in play as possible, but law, reputation, and habit all fail in predictable ways and/or are expensive to sustain.

If social trust is based on reputation, young people and newcomers start out in a kind of catch-22. Can't transact unless trusted, can't earn trust except by transacting. Moreover, when a major change makes future transactions unlikely-- during certain disasters, or when one is about to move out of town-- reputation may suddenly lose value and cease to be worth investing in, so one walks away from unpaid bills when one is moving.

If social trust is based on law and fear of the government, the prevalence of honesty will be proportional to the efficiency of the police. Whenever people think the police aren’t watching and can’t easily be called in, they’ll start cheating each other. Moreover, law and government give rise to a “who guards the guards?” problem. If the police have enough power to prevent people from cheating each other, they have enough power to rob people blind.

If social trust is based on mere habit, it can be disrupted by simply putting bad ideas in people’s heads. If a wicked novel is circulated that glorifies cheaters and liars, people might start imitating it. And people are always reasoning and imagining, so if there’s an opportunity to benefit by dishonest dealing, it will probably at least occur to people as a possibility sooner or later. 

But if people are virtuous, they will transact honestly regardless of the incentives they face. That makes social cooperation easier to establish, and less vulnerable to disruption.

Perhaps the transaction game won’t be taken as proof of the economic importance of virtue, because the problem to which it draws attention, and to which virtue is offered as a solution, seems so trivial to solve in practice. But it’s not. In physical marketplaces and stores, when both the buyer and the seller are simultaneously present in person, and the good in question is tangible and portable, and its valuable properties are readily ascertainable, the transaction process is easy. But when the transaction is remote, executed by mail or online, or when the good in question is intangible, like intellectual property rights in a book or a piece of music, or not portable, like real estate, or many of its useful properties are hard to ascertain, or the good or service is to be delivered in the future or on an ongoing basis over a period of time, trust is often an important problem, and many mutually beneficial transactions fail to take place because the potential transactors cannot establish sufficient trust.

One nifty feature of game theory is that a game with the same structure can be adapted to describe many different situations. Consider an Employment Game:

In this Employment Game, the employee can do something for the employer that is worth $1500 to him, while the employee values at $1000 the leisure he would sacrifice by taking the job. There are, therefore, potential gains from trade. The employer considers hiring the employee for $1200. However, he will not be able to supervise the employee effectively, perhaps because the work involves the use of some discretion or special skills, or because the employer is too busy to be present while the job is being done. Moreover, he has to pay the employee even if the work is not done, maybe because the employee can always credibly claim that he was prevented from accomplishing the task by flawed instructions or inadequate materials, or maybe because the employer will only be able to ascertain the quality of the work sometime after the fact, well after the wages are due to be paid. So the employer uses backward induction. If he doesn’t hire the employee, the employee presumably won’t do the work, so he gets a payoff of $0. But if he does hire the employee, the employee is still better off if he doesn’t do the work, since he still gets paid and can do what he likes instead of working.

The only unrealistic thing about the Employment Game is that the employer is completely unable to supervise the employee and make him work, or to withhold payment if he doesn’t. Usually, employers have some ability to monitor employees and punish shirkers. But it’s quite common for an employer not to know what a reasonable pace of work is, and/or not to be able to observe an employee all the time. Employers typically won't know, even when they are observing, whether employees are exerting himself to the best of his ability. And while it’s hard to quantity the exact extent of the phenomenon, it seems certain that many employment arrangements that would be mutually beneficial fail to occur because the potential employer doesn’t sufficiently trust the potential employee. This has little to do with unemployment, by the way. A fully employed economy may nonetheless be full of unrealized employment opportunities, which if realized, would crowd out existing, less valuable jobs. Mistrust causes, not unemployment, but weak labor demand and low wages, as employers forego creating high-value but trust-requiring jobs, in favor of low-value jobs amenable to close supervision and performance monitoring.

The structure of the Employment Game is exactly the same as that of the Transaction Game, and the lessons are the same, namely, that a trust problem will prevent mutually beneficial exchange from occurring, unless it can be solved by forces such as law, habit, reputation, or above all, virtue. In this case, the virtue needed is a “work ethic” on the part of the employee, who, once hired, will hopefully feel honor bound to serve the employer to the best of his ability for the duration of the job.

A third example, the Investment Game, will highlight the generality of the model, and is interesting in itself.

In the Investment Game, an entrepreneur has a bright business idea, but lacks the money to execute it. He needs $1 million, but can-- if he works hard-- earn $1.5 million (over and above the opportunity cost of his labor) over two years. The investor considers lending him $1 million, to be returned plus $200,000 interest after two years. The investor will make $200,000, and the entrepreneur will make $300,000.

I modified the game somewhat since the entrepreneur can’t implement his business plans unless the investor invests. But it is essentially the same. The investor foresees that while it’s advantageous for the entrepreneur to invest and make a profit, it’s even more advantageous for him to get the money and abscond, $1.2 million richer than he was before. So the investor does not invest. Of course, rather than abscond, the entrepreneur might live off the investment capital, then declare his business bankrupt. As before, the trust problem will prevent a mutually beneficial exchange, unless it’s solved through law, reputation, habit, or virtue. If it fails to occur, the entrepreneurial opportunity fails to be exploited. If such entrepreneurial opportunities fail to be exploited, returns to capital fall, and economic growth slows.

Now, it is quite difficult to make a game-theoretic model that sheds a realistic light on competition among firms, which is full of complicating factors like imperfect information and decisions being made continuously and simultaneously. But it is very easy to use game theory to elucidate ethics, and to show why justice and generosity make the world a better place. Indeed, it’s difficult to make game-theoretic models at all, without constantly bumping up against the conclusion that fairness, gratitude, altruism, pity, and so on make it much more likely that game-like scenarios will end in favorable outcomes.

So let me jump to conclusions. No, just kidding: not to conclusions, but to a hypothesis. It’s not the sort of hypothesis that would appear in a textbook, in part because textbook authors are reluctant to entrust undergraduates, who are apt to believe everything they hear, with tentative hypotheses, which their young minds will turn into facts and dogmas. I am genuinely tentative. I merely suggest. The following is only a hypothesis.

Call it the theory of Development as Virtue. The Transaction Game, the Employment Game, and the Investment Game, between them, shed light on why some nations are so rich, and others so poor. It’s because people in rich countries are more virtuous. They are less inclined to cheat each other when exchanging goods and services. They are endowed with a stronger work ethic so that they perform well on the job without close supervision. They are more inclined to fulfill their fiduciary duties to investors when entrusted with the leadership of companies. These virtues facilitate mutually beneficial exchange in markets for goods and services, labor, and capital, resulting in far more productive economic activity than in poorer, less virtuous countries.

Rich countries also benefit from having better-designed laws and more honest governments, widespread good habits, and effective reputation systems that motivate people and companies to do right for the sake of a good name, which is the key to getting continued opportunities. But they owe all these things to a more fundamental factor, namely, virtue. Good laws arise from the agitation of honest, engaged citizens and the labor of relatively non-corrupt legislators striving to serve the public interest. Honest government results from cops and judges and bureaucrats refusing bribes, and being content to live on their salaries, and avoiding conflicts of interests and favoritism too. Good habits become widespread and stable when virtue has so thoroughly banished certain vices and sins that people stop even thinking of them as possibilities. Reputations are more accurate and worth investing in if, when people talk to each other about other people, they try hard to be just in what they say.

It’s only a theory, to enter the lists against other theories as we move forward. But it’s plausible enough to add urgency to the question of how economics relates to ETHICS.