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The Invisible Hand — Invisible Because It Does Not Exist?∗

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The Invisible Hand — Invisible Because It Does Not Exist?∗ The Invisible Hand | Invisible Because It Does Not Exist?∗ Adam Brandenburgery Harborne Stuartz Version 12/08/13 Abstract We argue that the application of game theory to economics leads to a serious challenge to the supposed benevolence of Adam Smith's Invisible Hand. The usual view in economics is that the Invisible Hand works, i.e., individualistic behavior leads to the largest economic pie, unless market imperfections or failures are present. Starting from a game-theoretic approach, all interdependencies are a priori present in an economic system, and to be sure that the Invisible Hand will work, one must be sure that various interdependencies are absent. This analytical reversal | from a question of presence to a question of absence | reverses the burden of proof. The presumption is now that the Invisible Hand does not work, unless it can be shown that interdependencies are limited in the appropriate way. We explain that, while game theory has long been applied to economics, this key insight has been obscured by the fact that it has been applied in a piecemeal rather than holistic fashion. We end with a brief reference to the biological view that members of our species have prosocial as well as self-interested tendencies | and to some additional issues this raises for an analysis of the Invisible Hand. 1 Game Theory vs. The Invisible Hand There is a well-known scene in the movie A Beautiful Mind 1 in which the young game theorist John Nash and his fellow male Princeton students are watching some women who have just entered the Princeton bar. Should they all compete for the attentions of the most attractive one? Nash's fellow students appear to think so. Indeed, proud of their erudition, they invoke Adam Smith's Invisible Hand to claim that it is even to the common good that they do so. Looking up suddenly from his pile of books, Nash strongly disagrees:2 ∗We owe this line to Ben Polak, who shared it with us some years ago. A seminar audience at the National University of Singapore Business School, students in the NYU class The Project, and Amar Bhide, Robert Frank, Jonathan Haidt, Jessy Hsieh, Geoffrey Miller, Stephen Miller, Aurelie Ouss, Alex Peysakhovich, Paul Romer, Clay Shirky, Richard Sylla, Natalya Vinokurova, Shellwyn Weston, and Bernie Yeung provided valuable input. As always, in thanking someone we do not mean to suggest that person necessarily shares the views we express here. Financial support from the NYU Stern School of Business is gratefully acknowledged. tih-12-08-13 yAddress: Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012, [email protected], http://www.stern.nyu.edu/%7Eabranden. zAddress: Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012, hstu- [email protected], http://www.stern.nyu.edu/%7Ehstuart. “Adam Smith said the best outcome for the group comes from everyone trying to do what's best for himself. Incorrect. The best outcome results from everyone trying to do what’s best for himself and the group.” Nash lays out an alternative | and, to his mind, superior | strategy for him and his colleagues to follow to gain the attentions of the women. This is, of course, a fictional account, so it provides no information about what the real John Nash might say about the Invisible Hand. But is the fictional Nash correct? Does game theory really tell us, in some general and profound way, that if everyone follows the prescription of doing the best for oneself, the result may well not be the best group or social outcome? If so, this would be a striking proposition. A belief that the Invisible Hand works much of the time underlies the presumption in favor of unfettered markets that is prevalent in economics today. In this essay, we will argue that in an interdependent world, game theory should seriously un- dermine confidence in the benevolence of the Invisible Hand. 2 Game Theory and the Pie If game theory really undermines the Invisible Hand, why is this fact not widely known?3 After all, game theory is a widely used mathematical tool | used extensively in modern economics, in particular. We will argue that while there is indeed a lot of game theory in economics nowadays, the way game theory has been used serves to obscure this fundamental issue. Do'not' confess' Confess' 1'Year' 0'Years' Do'not' confess' 1'Year' 20'Years' 20'Years' 5'Years' Confess' 0'Years' 5'Years' Figure 1 We start with the most famous game model of all, the Prisoner's Dilemma.4 See Figure 1. The story is well known. There is sufficient evidence to convict both suspects, Alice and Bob, of a minor crime (1-year sentence each), but insufficient evidence to convict the suspects of a more serious crime (5-year sentence each) unless at least one of them confesses. The police offer a carrot (no time served) and a stick (20-year sentence) in such a way that each suspect is better off confessing, regardless of what the other suspect decides to do. In this game, when each player makes the best individual choice (\Confess"5), they fail to arrive at the best joint outcome for them (which would be a 1-year sentence each). 2 All this is clear and is well known. What is not so clear is whether the outcome in which Alice and Bob both confess is good or bad under some appropriate measure of the overall worth of the game | what can be called the overall \pie." Perhaps, society is best off if Alice and Bob are each kept out of circulation for 5 years. Perhaps not, because they have families which depend on them. The point is that the Prisoner's Dilemma model does not provide enough information for us to decide. What is missing is a definition of the overall pie | and a way of saying how the players' actions in a game affect this pie. We need a game theory that talks about these concepts. Turning to economics, if we want to use game theory to understand whether or not the Invisible Hand works, we need to be able to pose within game theory the question: When players follow their individual interests, do the choices they make lead to the largest overall economic pie? We need a game theory that includes a definition of the overall economic pie and that also contains a principle that explains how players' actions affect the size of this pie. 3 A Patchwork of Models This is not the game theory that has, for the very large part, been used in economics. To see this, start where economics starts, which is with the so-called perfect market as depicted by the usual supply-and-demand diagram. The largest possible pie is the area between the supply and demand curves. This is precisely the pie that will result if the market price is the one that goes through the intersection of the two curves, and sellers and buyers transact at this price. In the language of economics, the outcome is efficient.6 The next step is to analyze markets which depart from this one, because of the presence of \imperfections" such as market power (monopoly, oligopoly, etc.), externalities (also termed \market failures"), or other features. This is the point at which game theory enters the picture. But, the way game theory enters is via a patchwork of models. For each feature, there is a large repertoire of purpose-built game models used to examine it. For example, for oligopoly, there is the Cournot model, the Bertrand model, and many others. Textbooks often contain literally dozens of different such models.7 For each specific model, we can analyze how that model works and answer the question of whether or not the outcome is economically efficient. But, this case-by-case approach does not allow us to answer the question: What are the general conditions under which economic efficiency does or does not result? An answer that says efficiency results in this model, but not in that model, and so on, is not very illuminating. What is needed is a general game model of the pie and of how the players’ actions affect the size of the pie. This model needs to be capable of describing a wide variety of markets. With such a model, we can hope to identify general factors that determine whether or not the Invisible Hand works. 3 4 Preview There is such a game model. It can be built by going back to the early days of game theory and looking at how John von Neumann (in his seminal 1928 Mathematische Annalen paper8) and then von Neumann together with Oskar Morgenstern (in their 1944 book Theory of Games and Economic Behavior 9) began to develop a theory of how \value" (i.e., the pie) is created by and divided among the players in a game. We will apply this general model (more precisely, a development of it) to the question of when is it true that players, following their individual interests, make choices that lead to the largest overall pie. Our answer is a complete reversal of the usual one. The usual answer is that the Invisible Hand works, unless various kinds of market imperfections or failures are present. This is the natural answer when one starts with the perfect market and works outwards from it, so to speak. But, when we start with the general game model, there is a striking reversal.
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