Darwin vs. Smith

From Economist's View:

"Trumped by Darwin?"

Robert Frank returns to the point he made in Alpha Markets, i.e. that Charles Darwin provides the "true intellectual foundation" for economics. Though the example this time is male elk rather than bull elephant seals, the central point - and it's one worth giving more thought to - is that "Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance." In these situations, which occur frequently in economic and social relationships, the assumption in neoclassical economic models that the maximization of self-interest is consistent with the maximization of social interest does not hold, and failure to recognize this has " undermined regulatory efforts ... causing considerable harm to us all":

The Invisible Hand, Trumped by Darwin?, by Robert Frank, Commentary, NY Times: If asked to identify the intellectual founder of their discipline, most economists today would probably cite Adam Smith. But that will change. ... Charles Darwin ... tracks economic reality much more closely. ...

Smith’s basic idea was that business owners ... have powerful incentives to introduce improved product designs and cost-saving innovations. These moves bolster innovators’ profits in the short term. But rivals respond by adopting the same innovations, and the resulting competition gradually drives down prices and profits. In the end, Smith argued, consumers reap all the gains.

The central theme of Darwin’s narrative was that competition favors traits and behavior according to how they affect the success of individuals, not species or other groups. As in Smith’s account, traits that enhance individual fitness sometimes promote group interests. For example, a mutation for keener eyesight in hawks benefits not only any individual hawk that bears it, but also makes hawks more likely to prosper as a species.

In other cases, however, traits that help individuals are harmful to larger groups. For instance, a mutation for larger antlers served the reproductive interests of an individual male elk, because it helped him prevail in battles ... for access to mates. But as this mutation spread, it started an arms race that made life more hazardous for male elk over all. The antlers of male elk can now span five feet or more. And despite their utility in battle, they often become a fatal handicap when predators pursue males into dense woods.

In Darwin’s framework, then,... [c]ompetition, to be sure, sometimes guides individual behavior in ways that benefit society as a whole. But not always.

Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance, as in the antlers arms race. In the marketplace, such reward structures are the rule, not the exception. The income of investment managers, for example, depends mainly on the amount of money they manage, which in turn depends largely on their funds’ relative performance. Relative performance affects many other rewards in contemporary life. ...

In cases like these, relative incentive structures undermine the invisible hand. To make their funds more attractive to investors, money managers create complex securities that impose serious, if often well-camouflaged, risks on society. But when all managers take such steps, they are mutually offsetting. No one benefits, yet the risk of financial crises rises sharply. ...

It’s the same with athletes who take anabolic steroids. ...

If male elk could vote to scale back their antlers by half, they would have compelling reasons for doing so, because only relative antler size matters. Of course, they have no means to enact such regulations.

But humans can and do. ... Darwin has identified the rationale for much of the regulation we observe in modern societies — including steroid bans in sports, safety and hours regulation in the workplace, product safety standards and the myriad restrictions typically imposed on the financial sector.

Ideas have consequences. The uncritical celebration of the invisible hand by Smith’s disciples has undermined regulatory efforts to reconcile conflicts between individual and collective interests in recent decades, causing considerable harm to us all. ...

[And, again, for those who might be interested, see also Paul Krugman's: What Economists Can Learn from Evolutionary Theorists Synopsis.]

The first thing that comes to mind when reading this is the game theory behind the mutual scaling back of antler size by the elk. If they could all decide together to scale back the size of their antlers, they would choose to do so. However, there would also be incentive for some to cheat because then you still have small enough antlers to avoid predators but you also have bigger antlers which benefits finding a mate. This compares directly the discussion of cartels where firms decide to scale back production together in order to raise the price, but there is incentive to cheat and produce more to increase the benefits of the higher price.

The second thing is how this may or may not refute the invisible hand. It seems to me that following the theory of evolution, the size of the elk's antlers probably has reached a happy medium or at least is along the path towards that, two of the elk's primary evolutionary goals being survival and to mate. If the size of the elk's antlers became to large to be able to run away from predators, the ones with the smaller antlers would be those that survive and go on to mate, thus "regulating" antler size.

Thus it should happen in the economic world. There is a balance that needs to be made between maximizing profits and survival. As we've seen, the incentive structure in the financial world was severely misaligned, and so now we're seeing the correction. Those that are able to properly evolve in this environment will be better and stronger companies as we come out of the recession. Along the same metaphor of evolution, when recently reading White Fang the allusion of a recession to a famine stuck out to me. In the wild, during a famine, those animals that are strongest and best equipped to survive difficult times are the one's that live on to reproduce and continue on the species. Sometimes there's luck involved and sometimes animals that maybe shouldn't have died, die. But overall, it is the strongest of the species that live on. The problem that we're seeing now is that the government is keeping alive even the very weakest of the companies, making the god-like decision of who is deserving to carry on the species (whether it be bank, car, small business, etc...).

And if it was a faulty incentive structure that was the downfall of the banking industry, what incentive structure can the government be expected to be held by?