Digressions Compilation 2 2025 PDF

Microeconomics Digressions Compilation 2025 1 Table of content Digression 1 (Increasing Means or Increasing Autonomy?)................................. 4 Digression 2 (Generosity for Nerds: Opportunity Costs and Donations).............. 5 Digression 3 (Homo Oeconomicus).................................................................. 7 Digression 4 (Transcending Reason)............................................................... 10 Digression 5 (Heckscher–Ohlin and the Losers of Globalization)...................... 11 Digression 6 (Exploitation and Lock-Ins in Unproductive Technologies)............ 15 Digression 7 (“Taming the Passions”).............................................................. 17 Digression 8 (What Is Ontology and Epistemology?)........................................ 19 Digression 9 (Property-Rights Enforcement).................................................... 20 Digression 10 (Self-Ownership)...................................................................... 21 Digression 11 (Money)................................................................................... 21 Digression 12 (What Is Capital?)..................................................................... 23 Digression 13 (Class Action).......................................................................... 25 Digression 14 (Externalities)........................................................................... 26 Digression 15 (Pollination Services)................................................................ 28 Digression 16 (Is There Someone to be Harmed?)........................................... 30 Digression 17 (The Role of Public Space in Democracy)................................... 31 Digression 18 (Cod)....................................................................................... 32 Digression 19 (A Tale About the Importance of Common Knowledge)............... 34 Digression 20 (Existence of a Nash Equilibrium).............................................. 35 Digression 21 (Cooperation Problems and Externalities).................................. 38 Digression 22 (The Cold War as a Game)......................................................... 39 Digression 23 (Backward-Induction Equilibria)................................................ 41 Digression 24 (Games as Structural Metaphors: Further Examples)................. 42 Digression 25 (Opportunity Costs and Maximization)...................................... 44 Digression 26 (Firms as Production Functions)............................................... 46 2 Digression 27 (The Limits of Proﬁt Maximizatio)............................................... 47 Digression 28 (Sunk Costs)............................................................................ 49 Digression 29 (The Ethics of Proﬁt Maximization)............................................. 51 Digression 30 (Measuring Willingness to Pay).................................................. 54 Digression 31 (What Factors Determine Price Elasticities?)............................. 55 Digression 32 (User Fees).............................................................................. 56 Digression 33 (Price Discrimination in the Digital Age)..................................... 57 Digression 34 (Pricing and Bounded Rationality)............................................. 59 Digression 35 (Parallel Imports in the EU)........................................................ 61 Digression 36 (The Stackelberg Model)........................................................... 62 Digression 37 (The Prisoner’s Dilemma and Frames of Reference)................... 66 Digression 38 (The Three Cs of Economics)..................................................... 67 Digression 39 (Additional Aspects)................................................................. 69 3 Digression 1 (Increasing Means or Increasing Autonomy?) Economics has no monopoly on scarcity as a starting point for the scientiﬁc endeavor. Philosophies like Buddhism start from a similar premise, although phrased in a di@erent terminology. The ﬁrst two of the so-called Four Noble Truths state that (1) dukkha exists and (2) that it arises from one’s attachment to desires. Dukkha is often translated as su@ering, but this blurs its meaning. It refers to misaligned desires and needs or, in other words, scarcity. It is interesting to see, however, that the impulse that resulted from this same premise points in opposite directions. Most “Western” economists try to ﬁnd out how scarcity can be alleviated by increasing means (through technological progress, growth, etc.). The intuitive reaction to the phenomenon of scarcity points outward: increasing the means to fulﬁll the given wants. This impulse is even reﬂected in the idea of individual freedom that is, by and large, conceptualized in the Western tradition as political freedom: as the absence of external compulsion. On the contrary, the reaction to scarcity in Buddhism points inwards: overcoming the wants to make them match the means. To see this, consider the two other noble truths: (3) su@ering ceases when attachment to desire ceases and (4) freedom from su@ering is possible by practicing the Eightfold Path. Freedom, according to this view, is interior freedom: autonomy from the “dictatorship” of desires. One sees the same starting point, but two completely di@erent conclusions. 4 Digression 2 (Generosity for Nerds: Opportunity Costs and Donations) The concept of opportunity costs is helpful when considering the conse- quences of any kind of behavior. To illustrate this point, I would like to focus on a recent trend called e2ective altruism, sometimes ironically called “generosity for nerds.” E@ective altruism seeks to maximize the good from one’s charitable donations. Here is an example that illustrates the problem. Assume that one graduates and wants to make a great di@erence in the world by devoting one’s career to doing something good. A lot of students with this type of motivation consider careers at Oxfam or some other charity. However, this may not be the smartest idea. Assume that one would earn CHF 50,000 with a job at a charity and that one could be replaced by some other graduate student, who does an equally good job. Now, assume that one considers a career at a major bank, where one would earn CHF 120,000 instead and then gives CHF 70,000 away to charity. This decision creates CHF 70,000 that can be used for doing good. In fact, it ﬁnances the position at Oxfam and still leaves CHF 20,000 for other charitable purposes. If the person replacing one at Oxfam does not have this career option, it is better if one works for the bank, even if it seems to contradict one’s intention of devoting one’s life to doing good. (But please make sure to actually donate the money.) The importance of this example is not the career advice that it provides, but the principle that can be elicited from it. Consider a simple version of this problem in which one wants to donate a certain amount of money and wants to make sure that it does 5 as much good as possible. E@ective altruism makes the point that one should think in terms of opportunity costs when one makes one’s decision: what are the alternative uses for one’s money and how much good could be done with the di@erent uses? One should then spend one’s next Swiss Franc in a way that would maximize the additional good that the money can create. This idea of donations may look like economics on steroids, but, in fact, it is an important regulative idea to alleviate su@ering. There is a lot of evidence, for example, that donations are highly irrational. Disaster relief following earthquakes and tsunamis is a good example. These events are horrible and create a lot of human su@ering. However, media attention often creates “superstar e@ects,” where people want to help and thereby crowd out other needs. In the end, earthquake relief programs end up with more money than they can usefully spend to alleviate the su@ering from the earthquake. To illustrate, if everyone spends a ﬁxed amount of money on charitable projects, then one additional Swiss Franc for earthquake relief reduces the money that is available for less prominent (but equally urgent) projects. Some charities are aware of this problem and want to use part of the earmarked donations for other projects, but they are often criticized for doing so, because the people want to make sure that their money is spent “in the right way.” On the other hand, what is the right way to spend their money? If saving an additional life in the earthquake region is expected to cost CHF 50,000 and it will likely cost CHF 10,000, if the money is spent on malaria prevention in some low-key project, then it may make sense to apply economic principles to save as many lives as possible. Thinking in terms of 6 opportunity cost allows for a more rational allocation of scarce resources from a utilitarian perspective. Digression 3 (Homo Oeconomicus) Economics is infamous for a character that populates most of its tales: the homo oeconomicus. Any theory that explains social phenomena as a result of individual behavior needs a decision theory that allows for the making of predictions. The term homo oeconomicus summarizes a number of assumptions about the way individuals make the decisions that are used in mainstream economics to make predictions about behavior. Di@erent economists use the term di@erently, but there is a broad consen- sus that the minimum requirements are as follows: ﬁrst, economists usually do not use the concept to explain the motivations that drive behavior in an exclusively descriptive way. This approach goes back to Vilfredo Pareto, John Hicks, Roy Allen, and Paul Samuelson, who eliminated psychological concepts from economics and based economic theory on principles of rational choice. The idea is that all one can observe are individual choices, but not the mental processes that motivate or cause behavior. All one has to know is that people make decisions in a structured way that allows one to infer a so-called preference relation from the observed behavior of the individuals. This is the revealed-preference approach in economics, which makes the point that, if behavior follows certain consistency assump- tions, then the individual behaves as if he/she maximizes his/her preferences or his/her utility function. Note that the 7 formulation says “as if,” which implies that the theory does not claim that individuals have preferences or utility functions somewhere in their heads. Pareto justiﬁed this approach in a letter from Pareto (1897): “It is an empirical fact that the natural sciences have progressed only when they have taken secondary principles as their point of departure, instead of trying to discover the essence of things. [... ] Pure political economy has therefore a great interest in relying as little as possible on the domain of psychology.” The consistency assumptions, which guarantee that an individual behaves as if he/she maximizes preferences, are as follows: he/she can rank the alternatives from which he/she can choose according to some relation repre- senting his/her preferences (if I have the choice between broccoli and potato chips, then I prefer broccoli to potato chips). This ranking is unique and stable over a su@iciently long period of time. Furthermore, the ranking is complete (I can rank any two alternatives) and transitive (if I prefer broccoli to potato chips and potato chips to ice cream, then I also prefer broccoli to ice cream). Such preferences are called an ordering. Last but not least, it is assumed that individuals always choose the best alternative that is available to them (maximization). The maximization of a preference ordering is the core of the rational-choice paradigm, which is integral to the concept of homo oeconomicus. Please note that this view on rationality is purely instrumental: it refers to the consistency of a ranking and the relationship between ranking and behavior. (If preferences are inferred from behavior, then there is no concep- tional gap between behavior and preferences; the latter are a workaround to 8 systemize choices.) It can be discussed whether completeness and transitivity capture the idea of rationality and if individuals always choose an alternative that is best for them, but both assumptions are considered indispensable for rational decision-making. The concept has been further reﬁned to be able to cover choice situations under conditions of risk and uncertainty; see Chaps. 7, 8, and 10 for details. It is a widespread misunderstanding that homo oeconomicus is concep- tualized as a selﬁsh actor. Given that the above concept wants to eliminate any deliberations about motives for action from the theory, it cannot, in its purest form, say anything about selﬁshness, altruism, or fairness concerns, because these concepts refer to the individual’s motives for taking action. Admittedly, a lot of scientists added assumptions about the structure of a preference ordering that can be interpreted as selﬁshness to the theory, but it should be noted that selﬁshness is not an integral part of what economists conceptualize as rationality. A detailed discussion of the concept of homo oeconomicus is beyond the scope of an introductory chapter, but some remarks are important. The di@erent aspects of the concept have been subject to critique. Psychologists and behavioral economists have shown that preferences need not be transitive and that individuals do not consistently choose alternatives that are best for them (a statement that cannot even be made within the revealed-preference paradigm). Furthermore, people do not act selﬁshly in a number of situations; see Chaps. 8 and 10 for details. Despite these empirical anomalies, the concept is popular in economics. From a methodological point of view, it is important as a regulative idea that helps 9 one to better understand the structure of limited rationality and non-selﬁsh behavior, even if everyone agrees that real people often deviate from the ideal of rational decision- making. Boundedly rational behavior follows patterns and it is easier to explore these patterns with reference to the standard of full rationality. In addition, as it will become clear throughout this chapter, good theories do not rely on “realistic” assumptions in a naïve understanding of the word. The predictive power of a theory that, for example, explains the behavior of prices in markets can be high, even if the underlying assumptions abstract from a lot of factors that may be important in reality Digression 4 (Transcending Reason) The necessity of a dogmatic starting point of any scientiﬁc research project points towards the limits of language in expressing reality. Some spiritual traditions even claim that some truths can and must be assessed by means other than scientiﬁc reasoning—for example, an act of revelation—and that reason is not a means of perceiving the truth but an obstacle on the way. This thought is most clearly expressed in Zen Buddhism, where the practice of meditation leads to a state of pure consciousness in which one sees the world “as it really is.” In order to get closer to this state, students are expected to work on k¯ oans, which, from the point of view of a Western understanding, are unanswerable questions or meaningless statements. The goal is the evocation of an existential crisis of rational thinking, which then transcends itself in the moment of satori. A distance is created between 10 the conventions of everyday thinking and the immediately perceived world, whereby the convention becomes recognizable as such. Digression 5 (Heckscher–Ohlin and the Losers of Globalization) The above example illustrates the possible distributional e@ects of sequential integration. To get a deeper understanding, we need to look “behind” the production- possibility frontier to see how resources, production technologies, and goods are interconnected and how the conditions for production di@er between countries. A full formal analysis is beyond the scope of this chapter, but we can at least develop some basic ideas. The standard model for analyzing distributional e@ects of globalization is the Heckscher–Ohlin model, which assumes that two countries produce two goods using two factors (such as capital and labor). The model abstracts from factor mobility between countries, i.e., foreign direct investment and migration. Specialization and trade do not take place in a vacuum in this model, but by means of markets with perfect competition (see Chaps. 3, 4, and 12 for a deﬁnition and analysis of this type of market). The main implication of perfect competition for our purposes is that market prices before and after a trade agreement determine the distribution of income and thus access to goods. Comparing autarky with trade reveals the comparative advantage of countries: “Countries tend to export goods whose production is intensive in factors with which the countries are richly endowed.” (Krugman et al. 11 2018). Moreover, trade tends to equalize prices, leading to the following conclusions regarding the distributional e@ects of integration: “Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors lose.” (Krugman et al 2018). Thus, factors of production that are speciﬁc to the industry facing new competition from foreign imports, being it capital or labor, are negatively a@ected. What are the conclusions of this general ﬁnding? Compared to the rest of the world, Western Europe and the United States have a relative abundance of high-skilled labor and a relative shortage of low-skilled labor. Therefore, trade tends to hurt low-skilled workers in these countries. Part of the problem may be temporary because, while skills may not change in the short run, incentives exist to acquire better skills in the long run. But part of the problem is also structural if not all people can acquire the skills necessary to be employed in the (high-skilled) export sector. This is one of the reasons for the domestic problems that are a consequence of globalization. Theoretically, these problems could be addressed because trade expands the two countries’ joint production (and thus consumption) possibilities. The redistributive e@ects are, thus, a result of the speciﬁc institutions, competitive markets in this case, that guide integration in the Heckscher–Ohlin model. The art and craft of good distributional policy, then, would be to intervene in market processes in such a way that (a) incentives to specialize remain unchanged and (b) potential gains from trade are distributed in a way that makes everyone better o@. In practice, however, this is rarely done. Do we ﬁnd e@ects like these in reality? The research service for the US Congress 12 found in a report on the development of the US income distribution from 2016 a sharp shift in the above mentioned trend (Donovan et al. 2016). From the mid-1970 to 2000, income inequality increased signiﬁcantly. However, incomes grew for households in all income quintiles (you cut the income distribution in ﬁve parts). This pattern changed between 2000 and 2015 when incomes rose modestly for the two top quintiles and fell for the three bottom quintiles, with a positive net e@ect. The authors identify technological change, decline in unionization, and globalization as the three (interdependent und mutually reinforcing) most important causes for this trend. These insights shed light on some of the political conﬂict lines in Western Europe and the United States of the last couple of years (you ﬁnd qualitatively similar trends in other Western countries as well). If one restricts attention to labor, high-skilled and typically urban workers are proﬁting and conse- quentially have a rather positive view about globalization and the awesome opportunities that come with it. On the other hand, somewhere: low skilled workers from and oftentimes rural workers feel like being left behind. This opposition played a role in the British (“Brexit”-) EU referendum, and David Goodhart in his book The Road to Somewhere: The Populist Revolt and the Future of Politics (2017) coined the names anywheres and somewheres to describe these two groups. Anywheres are well educated, urban elites who feel more like citizens of the global network of urban centers and who feel comfortable with diversity and immigration, whereas somewheres often live far from the metropolitan centers, feel left out and left behind, and are oftentimes more reluctant 13 towards immigration as the most visible aspect of globalization in their lives (whether immigration contributes to their relative economic decline or not). And this decline is not only economical but also cultural and symbolic: Goodhart argues that the self-absorbed lack of interest of the typical anywhere in the destiny of their fellow citizens and the search for self-respect of the typical somewhere make them tribes, not only groups, and these tribal us-versus-them identities are the seed for the “culture wars” that we can observe in many Western countries at the moment. Meanwhile, on the other side of the Atlantic, one of the reasons for the election of Donald Trump in the 2016 election was the voting behavior of the US equivalent of the British somewhere: workers from rural and formerly industrialized areas (like the rust belt) of the United States. Interestingly, the Trump administration started to roll back globalization by starting to impose tari@s on foreign imports, at least initially. The Heckscher–Ohlin model has been used to simulate the e@ects of a US–Chinese trade war on US-American wages. It turns out that one has to distinguish between two scenarios to understand the implications. In a hypothetical scenario where the US unilaterally imposes tari@s on Chinese imports, aggregate US consumption rises by a standard terms-of- trade e2ect. Fajgelbaum et al. (2019) quantify this e@ect to be about (a modest) $ 0.5 billion. The simulation shows that this overall gain is, however, unevenly distributed: workers in the exporting sector lose and workers in the importing sector gain. Hence, high- and low-skilled workers have opposing interests. However, China retaliated by imposing tari@s on US imports (“trade war”), the aggregate picture changes 14 because overall consumption falls as the economies move closer to autarky. Fajgelbaum et al. (2019) assess that the loss to US consumers and ﬁrms who buy imports was $51 billion, and the overall income loss for the US economy (accounting for tari@ revenue and gains to domestic producers) was $7.2 billion. The distributional consequences are, however, still qualitatively the same: It is no surprise that high-skilled labor is negatively a@ected. However, low- skilled labor can still proﬁt in the short run and is more or less una@ected in the long run. This explains why protectionism can ﬁnd political support irrespective of the threat of a trade war, even though the overall e@ects on the economy are negative. Yet, this is not what empirically happened according to Fajgelbaum et al. (2019). They conclude: “Import tari@s favored sectors concentrated in politically competitive counties, and the model implies that tradable- sector workers in heavily Republican counties were the most negatively a@ected due to the retaliatory tari@s.” This is in part a result of the fact that Chinese retaliations mainly targeted agricultural sectors, which tend to be concentrated in Republican-leaning counties. Digression 6 (Exploitation and Lock-Ins in Unproductive Technologies) The traditional mathematical theories of comparative advantage are static in nature, which means that they take resource endowments, qualiﬁcations, and technologies as given. This assumption paints a picture of globalization that neglects the inter-temporal evolution of comparative 15 advantages that can be a result of changes in technology or education. The short-run comparative advantage of a country may in fact be given at any time, be it because of di@erences in resource endowments, be it because of di@erences in skills, and specialization in this direction will in fact increase income in this country. However, the long-run comparative advantage of a country can be determined and inﬂuenced by the investment in speciﬁc technologies and skills of the workforce. These dynamic changes in comparative advantages can be nicely illustrated by the development of China over the last decades. In the early stages of China’s opening up to the world economy, the country had a comparative advantage in low-skilled production. Take furniture as an example. The US and Western Europe had an absolute advantage in the production of furniture, which were reﬂected in huge di@erences in real wages between the countries. These di@erences resulted mainly from a better trained work force, a higher quantity of capital used to make things, and better infrastructure. From this point of view, lower wages in China were a result of disadvantages that can be transformed into an advantage by specializing in making, for example, furniture. Over time, however, qualiﬁcations, capital stock, and infrastructure improved, and the rapid growth of the Chinese economy changed its compar- ative advantage into the direction of high-tech sectors. If specialization creates some kind of path dependence (for example, because it is costly to switch from specialization in one sector to specialization in another sector), letting short- run market forces guide you towards a technological and skill structure that reﬂects your short-run comparative advantage 16 may be dangerous: If the sector will fall back in time in its relative economic performance, for example, because the potential for long- run technology-induced increases in productivity is limited, one may get stuck in a technology that is a dead end with respect to its potential to increase productivity. Whether this view is correct or not depends on the existence of the above- mentioned substantial path dependencies and the realistic alternatives of a country in this dynamic competition for productivity growth. A country that decides to not specialize according to its short-term comparative advantage but to invest in a way to change it needs the means to do so. The question whether one should leave the evolution of comparative advantages and the accompanying transformation processes to market forces is subject of intensive debate among economists. Believers in the e@iciency of markets tend to argue that government interference in this process tends to harm long- term e@icient development, whereas believers in what is called market failures see room for government interventions to shape this process e@iciently. Market failures are a special case of externalities that we will cover in Chap. 6. As we will see in Chaps. 14 and 15, they can also exist because of market power, i.e., because of oligopolistic or monopolistic concentration. Digression 7 (“Taming the Passions”) Early theorists of capitalism, like Charles Montesquieu, James Steuart, and Adam Smith, had a complex understanding of the interplay between individ- uals and 17 society. Hirschmann (1977), for example, pointed out that it was a widely shared conjecture among these philosophers that a major merit of an economic system, based on specialization and trade, is its ability to “tame” the passions of men: “Money making [was seen] as an ‘innocent’ pastime and outlet for men’s energies, as an institution that diverts men from the antagonistic competition for power to the somewhat ridiculous and distasteful, but essentially harmless accumulation of wealth.” This view on markets (as institutions) is fundamentally di@erent from the later view, held by twentieth century mainstream economics, which has almost exclusively focused on the ability of competitive markets to achieve e@iciency. It was reanimated in the twentieth century by Keynes (1936, p. 374), who argued that “[... ] dangerous human proclivities can be canalized into comparatively harmless channels by the existence of opportunities for money-making and private wealth, which, if they cannot be satisﬁed in this way, may ﬁnd their outlet in cruelty, the reckless pursuit of personal power and authority, and other forms of self- aggrandisement. It is better that a man should tyrannise over his bank balance than over his fellow-citizens; and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative.” Proﬁt-seeking behavior and competition deﬁned a vision of a better society where the darker passions of human beings are kept under control by the pursuit of proﬁt. With free trade, according to this view, one need not see an enemy in a stranger, but instead a potential trading partner. Free trade and competition present a form of moral education that brings about relatively 18 harmless bourgeois virtues and that suppresses the darker aspects of human nature. Competition, within the context of free markets, has an explicitly moral quality, because the alternatives are so much worse. This view found its expression in Milton Friedman’s famous example of discrimination in a competitive economy (Friedman, 1962, Ch. 7): “It is a striking historical fact that the development of capitalism has been accompanied by a major reduction in the extent to which particular religious, racial, or social groups have operated under special handicaps in respect of their economic activities; have, as the saying goes, been discriminated against. The substitution of contract arrangements for status arrangements was the ﬁrst step toward the freeing of the serfs in the Middle Ages. The preservation of Jews through the Middle Ages was possible because of the existence of a market sector in which they could operate and maintain themselves despite o@icial persecution.” McCloskey (2006) goes even further and makes the case that markets and capitalism lead to the development of a set of distinctively burgeois virtues. As a consequence, markets and capitalism breed their own capitalist personalities. Digression 8 (What Is Ontology and Epistemology?) In philosophy, ontology is the study of “what there is,” of the nature of being and reality. It studies problems concerning the entities that do exist and their properties. Examples of ontological questions include the following: What is existence?, What is the nature of existence?, and What 19 principles govern the properties of matter? Epistemology is the study of knowledge and justiﬁed belief. Questions that it addresses may include the following: What are the necessary and su2icient conditions of knowledge?, How does one separate true ideas from false ideas?, and How does one know what is true? Digression 9 (Property-Rights Enforcement) It is vital to distinguish between the mutual recognition and the enforcement of property rights. People are used to thinking of property-rights enforcement as a centralized activity delegated to “the state.” An important proponent of this view was Weber (1988/1919), who observed that the modern state has monopolized the legitimate use of force. According to this point of view, the state provides for public enforcement and, with a few exceptions like self-help, limits private enforcement of property rights. This has not always been the case. The private enforcement of rights has been of considerable importance historically, for example, in late medieval Europe. The devel- opment of the code of conduct called “Lex Mercatoria,” in the eleventh and twelfth century, is seen as one of the key factors for the economic success of Europe, which arched over into the Renaissance. This helped to overcome the limited possibilities of centralized law enforcement in a politically fragmented Europe. According to Berman (1983), “[t]his legal system’s rules were privately produced, privately adjudicated, and privately enforced.” The system became e@ective exactly because medieval Europe was plagued by a maze of fragmented states, whose rulers 20 more closely resembled self-interested elites. In certain respects, the situation in medieval Europe looks similar to the situation of the globalized economy of today, where multinational ﬁrms are confronted with nation states that lack a centralized agency, which enforces contracts. Digression 10 (Self-Ownership) An often bypassed constituent element of private property is self-ownership, which is an important virtue and achievement of modern bourgeois society. Self-ownership excludes serfdom and slavery and is a necessary prerequisite for ownership rights over objects in the outside world. It is also important for the establishment of transactions of services like, for example, the time and expertise a person o@ers on labor markets. Usually, a labor contract speciﬁes the duties of the employer as well as of the employee. Self- ownership makes these contracts possible and, at the same time, deﬁnes limits to contractual freedom, because it, for example, prohibits a person from voluntarily selling himself/herself into slavery. Digression 11 (Money) One of humanity’s major achievements has been the invention of an abstract medium of exchange for facilitating the exchange of goods or trade. This medium of exchange is called money. Money is traditionally regarded as having three functions: it acts as a medium of exchange, a unit of accounting, and a means of storing value. Given that most 21 people grew up in societies where money is almost as pervasive as the air we breathe, it is easy to oversee three really peculiar aspects of money. First, compared to a barter economy where transactions can only take place if the supply and demand of two individuals perfectly align (which is called the “double coincidence of want”), the use of money dramatically facilitates this exchange, because it no longer depends on this coincidence. Second, given that money has no intrinsic value and merely represents an abstract promise to be convertible into directly useful goods and services in the future, it is a convention in the sense of Searle, see Chap. 2. Thus, its invention relies on abstract thinking and trust (it most likely evolved from debt certiﬁcates) and the historic development of money shows people’s increasing ability of thinking in abstract ways about the use and nature of money. The step from gold and silver coins (used by Lydians around 500–600 BCE) to paper money (from the seventh century CE in China to the thirteenth century CE in Europe), and then from Banknotes backed by Gold (Bretton– Woods System) to unbacked money, and ﬁnally to a perfectly abstract unit of exchange in the digital age shows an increasingly abstract way of thinking. Third, in opposition to directly useful goods and services, the value of money results from a social convention. Money has value only insofar as people are willing to accept it as a medium of exchange. This explains why the value of money, and of currencies, is inherently fragile, because the value of banknotes and coins (and, even worse, of purely abstract forms of money) drops to almost zero (which is an extreme form of inﬂation) as soon as people lose faith in its future value and start rejecting it as a medium 22 of exchange, despite the fact that everyone would be better o@, if money was accepted. Digression 12 (What Is Capital?) Capital is a key concept in economics and the eponym of the economic system of capitalism. It, therefore, deserves some extra attention. The term goes back to the Latin word caput, “head,” which is also the origin of cattle. This is important, because it casts light on two basic properties a resource must have in order to count as capital: the stock of cattle is moveable (which distinguishes it from land) and reproduces. Therefore, capital is any resource that is potentially mobile and bears an interest, if it is not immediately consumed. Adam Smith deﬁned capital as “[t]hat part of a man’s stock which he expects to a@ord him revenue [... ].” The ﬁrst resources economists had in mind when they used the term capital were livestock, machines, and other tools. However, over time, the concept got more abstract, covering other “interest-bearing” phenomena, as well. On a very abstract level, capital consists of resources that enhance a person’s power when she uses her time to achieve her goals (Pierre Bourdieu, 1983). This idea is nicely exempliﬁed by the closely related German words “Kapital” (capital) and “Vermögen” (capability, which stems from the Latin word capabilis, “being able to grasp or hold”, but is translated as “assets” in the system of national accounts). One could say that capital is a resource that makes one capable of achieving a goal. (This idea is also reﬂected by the fact that wealth is counted as an asset, whereas capital is a liability, in the system of 23 national accounts.) Consequently, contemporary economists distinguish between three or four di@erent types of capital: physical, human, social, and symbolic. Physical capital corresponds to the traditional concept, including machines, tools, and so on. Human capital refers to the skills of a human being that make him or her more productive in manipulating physical capital. It is the stock of knowledge that allows an individual to use his or her labor in a productive way. Social capital refers to the network of friends that allows one to achieve one’s goals. It is the stock of social bonds and relationships that helps one succeeding with one’s plans and insures one against adverse events. For example, information disseminated in a network of friends may allow one to make better decisions, or one may proﬁt from cooperative and altruistic behavior among friends. This has its roots in the preferential treatment group members can expect from each other. Symbolic capital is a controversial concept, which is better established in sociology than in economics. It refers to the ability of an individual to achieve her goals because of honor, prestige, or recognition and it depends on the cultural norms and language games of a society. The concept allows one to better understand the role of cultural conventions and ideologies within societies and it, therefore, became important in gender studies. Here is an example why: cultural norms and language games impose categories of thought and perception upon individual social agents who, if they accept these categories unscrutinized, perceive the social order as legitimate. If women, for example, do not consider it appropriate to become CEOs of ﬁrms, they do not strive for these careers and, thereby, leave 24 them to their male counterparts. Sometimes, human, social, and symbolic capital are di@icult to di@erenti- ate, and some deﬁnitions have social and symbolic capital, as in special cases of human capital. Digression 13 (Class Action) A class action is an element of the U.S. legal system that allows a group to sue another party. It is a way to overcome the collective-action problem that exists, if many people are harmed by the actions of one party. The problem, in cases like these, is often that the small recoveries that can be expected by any individual do not provide an incentive to sue individually, despite the fact that the aggregate recoveries may be very high. Such a situation creates an incentive for parties to take disproportionately high risks, because the likelihood that they will be brought to court in case of harm is ine@iciently small without class action. This problem leads to externalities. Class action is a means to internalize these externalities. This argument has been explicitly used by the United States Court of Appeals. In Mace v. Van Ru Credit Corporation (1997), the court argued that “[t]he policy at the very core of the class action mechanism is to overcome the problem that small recoveries do not provide the incentive for any individual to bring a solo action prosecuting his or her rights. A class action solves this problem by aggregating the relatively paltry potential recoveries into something worth someone’s (usually an attorney’s) labor.” This point is also stated in the preamble to the Class Action Fairness Act of 2005: “Class-action lawsuits are an important and valuable 25 part of the legal system when they permit the fair and e@icient resolution of legitimate claims of numerous parties by allowing the claims to be aggregated into a single action against a defendant that has allegedly caused harm.” Swiss law, on the contrary, does not allow for class action. When the government proposed a new Federal Code of Civil Procedure in 2006, replacing the cantonal codes of civil procedure, it rejected the introduction of class actions. In the message to Parliament on the Swiss Code of Civil Procedure (Federal Journal 2006, p. 7221) it has been argued that “[it] is alien to European legal thought to allow somebody to exercise rights on the behalf of a large number of people if these do not participate as parties in the action.” Digression 14 (Externalities) In environmental law, the “polluter-pays principle” makes the party that produces pollution responsible for paying for the damage. It has support from the Organization for Economic Co-operation and Development (OECD) and the European Union, and it seems to make a lot of sense intuitively: in the above example, the baker is responsible for the pollution of the lake, so why not making him pay for cleaning up his mess? Before one rushes to this conclusion, however, it makes sense to hold on for a second. It is correct to say that the baker causes the pollution, but this does not mean that he also causes the externality. This claim seems odd at ﬁrst and it is one of the many counterintuitive insights from Ronald Coase to stress that externalities, necessarily, involve more than a single party. The externality exists only 26 because both, the baker and the ﬁsherman, are located on the same lake. If one of them would move away, the externality would cease to exist. In other words, externalities must be treated as a reciprocal problem. The polluter-pays principle ignores the fact that externalities are jointly caused by all involved parties: to avoid harm to a pollutee necessarily inﬂicts harm on the polluter. If one is still not convinced, because it is the baker who pollutes the lake, think about a situation where a dynasty of bakers has been living at the lake for generations. Then, from one day to the other, a ﬁsher decides to settle and set up his business. A few days later, he starts complaining about the pollution. Is it still so obvious that the baker causes the externality? The polluter-pays principle is one way to assign rights, because it implies that one party, and not the other has to pay and, with adequately set payments, the externality gets internalized. One has, however, also seen that the same type of solution can be reached if the baker has the right to pollute and the ﬁsherman pays for reductions in pollution. Such a “pollutee-pays principle” may be at odds with one’s intuitions of fairness but, from an e@iciency point of view, one has no reason to assume that it is better or worse than the polluter- pays principle. If one sticks with e@iciency as a normative principle, it makes sense to replace the principle with a “cheapest cost avoider principle”. The idea behind this principle is that it cannot be assumed, in general, that both assignments of rights are equally e@icient. With di@erences in transaction costs, however, it makes sense to assign the rights in a transaction-costs minimizing way. The above discussion was exclusively concerned with the normative 27 crite- rion of e@iciency, which is an example of an anthropocentric ethic. The reason why the normative problem of externalities vanishes, if the ﬁsherman moves away, is because there is no human being left to be harmed. Environmental ethics like “deep ecology” make the point that such an ethic is too narrow, because the lake, as an ecosystem, still gets harmed and the only way to solve this problem is to reduce pollution. If one includes considerations like this, the polluter-pays principle requires a di@erent interpretation, because it is the only one that respects the integrity of nature. From this perspective, it can be seen as a special case of the more general principle of minimal harm or ahimsa that is a fundamental moral position of Jainism, Hinduism, and Buddhism. A very popular proponent of the principle of ahimsa was Mahatma Gandhi, and it also shaped Albert Schweitzer’s principle of “reverence for life”. Digression 15 (Pollination Services) The ﬁrst reaction of a lot of people when they ﬁrst hear about pollination services is to discard them as a slightly idiosyncratic curiosity, without much economic relevance. The truth is that pollination services are the backbone of agriculture and are also a very important economic factor. Pollination makes a very signiﬁcant contribution to the agricultural produc- tion of fruits, vegetables, ﬁber crops, and nuts. Estimates show that pollination services contribute between US $6 and US $14 billion to the US economy per year (Southwick & Southwick, 1992; Morse & Calderone, 2000). The United Nations Environment Programme (UNEP, 2016) 28 estimated that pollination services are worth between US $235 billion and $577 billion globally. Given the economic importance of pollination services, it should not come as a surprise that commercial pollination services have emerged, mostly provided by honeybees through a long-standing and well-organized market. Californian Almonds are a good example to study the functioning of this market. Almonds are one of the most proﬁtable agricultural products. Recently, honeybee pests and other problems have reduced available bee supplies. At the same time, the high proﬁt margins led to an expansion of almond acreage. Standard supply and demand analysis predicts that this trend—shortage in supply and increase in demand for pollination services— leads to an increase in the price. Figure 6.3 shows that this has, in fact, been the case: the average price per colony almost tripled between 1995 and 2006. Pollination services are an example of what is called an ecosystem function, which is deﬁned as “the capacity of the ecosystem to provide goods and services that satisfy human needs, directly or indirectly” (De Groot, 1992). These services are not only provided by bees, but by a wide variety of insects, birds, and mammals (like bats). A study for the UK found that insect- pollinated crops have become increasingly important in UK crop agriculture and, as of 2007, accounted for 20% of UK cropland value. Bees account for only about 34% of pollination services, down from 70% in 1984 (Breeze et al., 2011). Unlike with bees, it is very di@icult to create markets for pollination services provided by other species, which leads to externalities. One of the consequences is that the conservation status of pollinating bird and mammal species is deteriorating. 29 Digression 16 (Is There Someone to be Harmed?) There is an aspect of the problem of intergenerational justice that makes it di@erent from standard allocation problems between contemporaries. There is a debate in practical philosophy about the normative status of unborn people that focuses on the question, of whether unborn people have the same rights as contemporaries and whether and in what sense contemporaries can harm unborn human beings (Parﬁt, 1984). One of the key obstacles is the so-called non- identity problem, which argues that apparently trivial changes in one’s plans are likely to change the identity of the future people (for example, because the egg is fertilized by a di@erent sperm). Thus, changes in the political environment are likely to have some inﬂuence on the identity of future generations but, if this is the case, it cannot be argued that anybody is worse o@ in the future because one is comparing di@erent people. A pragmatic view would accept this problem as it is and declare the speciﬁc identity of a future human being to be morally irrelevant. The only fact that counts, one could argue, is that future generations will come into existence and that they can proﬁt or can be harmed by present generations’ choices. Plausible as this approach may sound, it implies a major deviation from standard welfarism, which builds on the idea that the welfare of actual people is normatively relevant. 30 Digression 17 (The Role of Public Space in Democracy) Congestion charges or road prices not only have distributive consequences, which one might ﬁnd objectionable, but also have more profound e@ects on how one thinks about the societal role of public space. In a democracy, public spaces have an important role in the expression of political opinions, as locations for spontaneous gatherings and, more generally, places where a representative proﬁle of people comes together and has the right to do so. A public space is a site where democracy becomes possible. Henri Lefebvre (1974) made this point quite poignantly: “(Social) space is a (social) product [... ] the space thus produced also serves as a tool of thought and of action [... ] in addition to being a means of production it is also a means of control, and hence of domination, of power.” Charging high prices for the access to public space, which makes it more di@icult for speciﬁc groups to access them is, therefore, politically questionable. A narrow economic view, which focuses on e@iciency gains, easily loses sight of the bigger context in which the instruments are embedded. A good example for the relationship between democracy and public space is the Landsgemeinde (cantonal assembly). This is a Swiss institution where eligible citizens of the canton meet on a certain day in a public space and debate and decide on laws and public expenditures. Another example is the Speakers’ Corner, an area for unrestricted public speaking, debate and discussion, which became a symbol for the importance of unrestricted access to public space in a democracy. An interesting, yet unresolved, question is whether virtual public 31 space on the internet can take over the role of physical public space, thereby overcoming physical and legal boundaries. Digression 18 (Cod) One of the most “famous” examples for the overexploitation of marine resources is gadus morhua, or cod. Cod has been a very important commodity for about 600 years and dried cod (also called stockﬁsh or clipﬁsh) was an essential food for mariners. During the Middle Ages and the Age of Discovery, it was one of the most important commodities that made seafaring possible, because dried cod was one of the world’s ﬁrst non-perishable foods. It also became a popular food in Europe and, for about 250 years, 60% of all the ﬁsh eaten in Europe was cod. As early as 1620, cod ﬁshing was at the center of international conﬂict, because various nations attempted to monopolize rich ﬁshing grounds. Even the King of Spain married o@ his son to the royal house of Portugal, because of ﬁshing rights. By the late 1700s, codﬁsh made New England an international commercial power. For a very long time, it was beyond imagination that human activity could negatively impact the species, because it was famous for its reproduction rates. In the words of Alexandre Dumas (1873), “It has been calculated that if no accident prevented the hatching of the eggs and each egg reached maturity, it would take only three years to ﬁll the sea so that you could walk across the Atlantic dryshod on the backs of cod.” Human imagination proved to be too limited. Since the late 1950ies, technological advances, which have made ﬁshing more e@ective, have heralded the start of a period of 32 overﬁshing, which led to a ﬁrst partial collapse of Atlantic northwest cod ﬁshery in the 1970ies and a complete collapse in the 1990ies. In the summer of 1992, the Northern Cod biomass fell to 1% of its earlier level, see Fig. 6.8. Cod is only a very prominent example of the problem of overﬁshing: the Peruvian coastal anchovy ﬁsheries crashed in the 1970s after overﬁshing, the sole ﬁsheries in the Irish Sea and the west English Channel have become hopelessly overﬁshed and many deep-sea ﬁsh are at risk, as well as a number of species of tuna. A 2008 UN report asserts that the world’s ﬁshing ﬂeet could be halved with no change in catch. Even more fundamental is the impact on the whole marine biosystem. Scientiﬁc evidence regarding the impact of humans on marine life is nicely summarized in a recent paper by McCauley et al. (2015): “Three lessons emerge when comparing the marine and terrestrial defaunation experiences: (i) today’s low rates of marine extinction may be the prelude to a major extinction pulse, similar to that observed on land during the industrial revolution, as the footprint of human ocean use widens; (ii) e@ectively slowing ocean defaunation requires both protected areas and careful management of the intervening ocean matrix; and (iii) the terrestrial experience and current trends in ocean use suggest that habitat destruction is likely to become an increasingly dominant threat to ocean wildlife over the next 150 years. [... ] Human dependency on marine wildlife and the linked fate of marine and terrestrial fauna necessitate that we act quickly to slow the advance of marine defaunation. 33 Digression 19 (A Tale About the Importance of Common Knowledge) On an island, there live 100 blue-eyed persons. The rest have a di@erent eye color. They are perfect logicians and never talk about eye color. An old custom, to which all citizens adhere, demands that, as soon as a citizen knows that he or she has blue eyes, he or she will leave the island during the subsequent night. However, because the citizens never talk about their eye color and because there is no reﬂecting surface on the island, no one knows his or her eye color. Consequently, no one ever leaves the island. One day, an outsider comes to the island. She is allowed to stay and soon acquires a reputation for being completely trustworthy. After a while, a ship lands and the outsider leaves the island again. At the time of her departure, all citizens gather at the harbor and the last thing the outsider tells the citizens is: “By the way, there is at least one blue-eyed person on the island!” What happens during the subsequent nights? Additionally, what does all this have to do with the concept of common knowledge? The answer is that, during the 100th night after the announcement, all the blue-eyed people will leave the island. Why does the announcement of the outsider make a di@erence? Before his announcement, each islander knew that there are blue-eyed persons on the island, but she did not know that the other islanders knew it as well, knew that she knows it, etc. Thus, the knowledge that there are blue- eyed islanders was not common knowledge. This changed with the announcement by the outsider. From that moment on, the existence of blue-eyed persons became common 34 knowledge. Why does it make a di@erence? To see this, one can use an inductive argument. If there is exactly one person with blue eyes, that person knows that there is no other person with blue eyes on the island. Before the announcement of the outsider, it was a possibility that there is no one with blue eyes on the island, so there was no need to leave. However, given the information by the outsider, the blue-eyed person learns that she must have blue eyes, so she leaves at night one. Next, assume that there are two persons with blue eyes. There is no need for any of them to leave during the ﬁrst night, because there is a possibility that there is only one person with blue eyes and that it is the other person. Thus, both will still be around the next day. However, given that both are still around the next morning, they have to realize that both of them must have seen another person with blue eyes. Given that there is no one else around, it must be herself. Therefore, both will leave during night two. The same argument holds if there are n blue-eyed persons: induction states that no one will leave during the ﬁrst n− 1 nights. However, given that everyone is still around after night n−1, each blue-eyed person has to conclude that there are n persons with blue eyes in total, one of them being him- or herself. Thus, the rather innocuous-sounding announcement by the outsider allows the islanders to eventually ﬁgure out the color of their eyes. Digression 20 (Existence of a Nash Equilibrium) As we have seen when we have analyzed the game in Table 9.3, it is often not easy to predict the outcome of a game 35 because there may be multiple equilibria. Another problem, which is at least as fundamental as the multiplicity, is the (non-)existence of Nash equilibria, a potential problem one already knows from the subchapter covering dominant strategies. Is it possible that a game has no Nash equilibrium? If so, then what would be a good prediction of the game’s outcome? An example for a game in which no Nash equilibrium exists is RPS. A matrix representation of the game can be found in Table 9.4. Whenever a player chooses a best response to the strategy of her opponent, the opponent must end up with a payo@ that is smaller than the one that could be achieved by a di@erent strategy, yielding her a utility of−1. Hence, there cannot be a proﬁle of strategies that are mutually best responses and, thus, no Nash equilibrium exists. A game that does not have an equilibrium is quite unsatisfactory, because this means one cannot make a prediction about the way people play it, which was why we started with game theory in the ﬁrst place. Consequently, researchers started searching for a way out of this problem and found one in the idea of “mixed strategies.” The idea is quite simple: put yourself in the position of a player in RPS. It is immediately clear that you want to avoid the other player knowing what you will do, because she could then exploit this knowledge, which would guarantee you a payo@ of−1. Hence, how can you ensure that she does not know what you will do and is not able to predict it, either? One possibility is to delegate the strategy choice to a random generator that chooses each strategy with a given probability that you determine at the beginning. This is precisely the idea underlying mixed strategies. A mixed strategy is a probability 36 distribution over the (as they will be called from now on) pure strategies at your disposal. If one allows players to choose probability distributions over pure strategies, then one increases the set of possible strategies, because each probability distribution over pure strategies also becomes a strategy—a mixed strategy. A Nash equilibrium, in which at least one player uses a mixed strategy, is called a mixed strategy Nash equilibrium. However, what is the point of this exercise? In games like RPS, no Nash equilibrium exists in pure, but only in mixed strategies. In RPS, the equilibrium is easy to ﬁnd: Each player chooses a pure strategy with the probability of 1/3. For example, if player 1 chooses a pure strategy with that probability, then player 2 receives the following expected utility from each of her pure strategies: Player 1’s mixed strategy makes player 2 indi@erent between all of her pure strategies and, thus, each of her pure strategies is a best response. This is, in turn, the precondition for her to be willing to randomize herself. If she randomizes herself with the same probabilities, then player 2 is also indi@erent between all her pure strategies and each pure strategy, as well as the mixed strategy, is a best response. Therefore, it is a Nash equilibrium in mixed strategies, if both players randomize and choose each pure strategy with a probability of 1/3. As the example shows, one can come up with a clear prediction of the game’s outcome, if one allows for a more comprehensive concept of a strategy. It was one of John Nash’s seminal contributions to show that such an equilibrium exists under very general conditions. Every game with a ﬁnite number of players and a ﬁnite number of pure strategies has at least one Nash equilibrium in mixed 37 strategies. This result of Nash’s theorem is of fundamental importance, because it guarantees that a prediction about the outcome of a game, based on the concept of a Nash equilibrium, is possible under very general conditions. I omit the proof of the theorem, because it involves advanced mathematical methods. Another example of a game in which no Nash equilibrium exists in pure strategies is the penalty kick in soccer. The goalkeeper decides which part of the goal to defend, while the kicker simultaneously decides where to place the shot. If the goalkeeper conjectures the kicker’s strategy correctly, then she successfully defends the shot; otherwise the kicker is successful. In order to be able to analyze this situation one can simplify and assume that each player has the pure strategies “left,” “middle,” and “right.” The game has a Nash equilibrium in mixed strategies, in which each player randomizes by choosing among the pure strategies with a probability of 1/3. Economists studied the behavior of goalkeepers and kickers based on data from the Italian and French professional soccer leagues. They found that the observed behavior was consistent with theoretical predictions. Digression 21 (Cooperation Problems and Externalities) This is a good point to hint at an important link between di@erent concepts that have been discussed in this book. I discussed the concept of externalities in Chap. 6. An externality exists, if the acts of an individual, A, have an impact on the well-being of another individual, B, that A does not take into consideration: It is a non-internalized 38 interdependency. Looking at cooperation problems, like the prisoner’s dilemma, one sees that it is exactly an externality that is at the heart of the problem: The rational behavior of one individual makes the other individual worse o@, but the individuals do not ﬁnd a way to internalize this e@ect. Hence, cooperation problems are metaphors for situations with mutual externalities, like anthropogenic climate change. Digression 22 (The Cold War as a Game) Deterrence is the art of producing in the mind of the enemy the fear to attack. (Stanley Kubrick, Dr. Strangelove) During the Cold War, the USA and the Soviet Union were in a nuclear stand- o@. Thus, the RAND Corporation (a major US think tank) hired some of the world’s top game theorists to study the situation. At the time, both nations had the same policy, “If one side launched a ﬁrst strike, the other threatened to answer with a devastating counterstrike.” This became known as Mutually Assured Destruction, or MAD, for short. Game theorists got worried about the rationality and, thereby, the credibility of MAD. The argument goes like this, “Suppose the USSR launches a ﬁrst strike against the USA. At that point, the American President ﬁnds his country already destroyed. He doesn’t bring it back to life by now blowing up the world, so he has no incentive to carry out his original threat to retaliate, which has now manifestly failed to achieve its point. Since the Russians can anticipate this, they should ignore the threat to retaliate and strike ﬁrst. Of course, the Americans are in an exactly symmetric position, so they too should strike ﬁrst. Each power will recognize this incentive on the part of 39 the other, and so will anticipate an attack if they don’t rush to preempt it. What we should therefore expect is a race between the two powers to be the ﬁrst to attack.” (Don Ross, 2016) This analysis led the RAND Corporation to recommend that the USA take actions designed to show their commitment to MAD. One strategy was to ensure that “second-strike capability” existed. A second strategy was to make leaders appear irrational. The CIA portrayed President Nixon as either insane or a drunk. The KGB, which appears to have come to the same conclusion as RAND, responded by fabricating medical records to show that General Secretary Brezhnev was senile. Another strategy was to introduce uncertainty about the ability to stop a counterstrike, for example by building more nuclear missiles and storing them in numerous locations (which made it less likely that the President could stop all of them from being launched in the event of a Soviet attack). A third strategy was to make MAD credible by creating “doomsday machines”: technologies that carry out a counterstrike automatically, without the ability of human beings to interfere. The USSR went so far as to create Perimeter, or Dead Head, which was the closest thing this world has ever seen to such a doomsday machine. It was able to automatically trigger the launch of intercontinental ballistic missiles, if a nuclear strike is detected by seismic, light, radioactivity, and overpressure sensors. It is commonplace to suggest that the strategic situation during the Cold War was a case of the prisoner’s dilemma. However, it is far from obvious that the leaderships in either country in fact attached the necessary payo@s in their utility functions—preferring the destruction of the world 40 to their own unique destruction—that would have been required for their situation to actually have been a prisoner’s dilemma. Digression 23 (Backward-Induction Equilibria) One of the ﬁrst formal game-theoretic studies was Ernst Zermelo’s analysis of the game of chess. Chess can be interpreted as an extensive-form game between two players, but the game’s complexity makes it impossible to write down the players’ strategies, to draw a game tree, or to solve it (at least with today’s means). However, Zermelo was able to show that there is an optimal, deterministic way to play chess. This result also illustrates why backward- induction equilibria must exist, if each player has a ﬁnite number of strategies. Certain rules in chess guarantee that it cannot go on forever (see Article 5.2 of the o@icial Fide chess rules) and, thus, every player has ﬁnitely many strategies. The conditions that Zermelo found to be necessary in his proof are hence met and it is, therefore, proven that either white has a winning strategy, or that black has a winning strategy, or that both can force at least a draw. Until now, nobody has been able to ﬁnd out whether white or black has a winning strategy or whether each player can force a draw. Therefore, of course, nobody knows the optimal strategy to play chess. Zermelo’s result is, in this respect, a rather strange mathematical theorem: One knows that there is an optimal way to play chess, but one does not know what the optimal strategies are. Fortunately, one might say, because this is why the game of chess remains interesting. Zermelo’s theorem has important 41 implication for other games, as well. First, it reveals that, under quite general conditions, a pure strategy equilib- rium exists when players move sequentially. Furthermore, it shows that this equilibrium is not based on empty threats. These two points are of importance for the ability to predict the outcomes of extensive-form games. Digression 24 (Games as Structural Metaphors: Further Examples) This chapter has already clariﬁed that game theory is a method and that games with speciﬁc sequences of moves and payo@ structures are problem structures, which are not tied to speciﬁc interpretations, but that can be used as metaphors for a wide array of social phenomena. This versatility is one of game theory’s strengths, because it allows one to understand the strategic similarities between, apparently, very di@erent social spheres. Here are some examples for social phenomena that have aspects of the chainstore game: Military conﬂicts: Situations that are very similar in their logic to the market-entry problem can be found in many military conﬂicts. Often, one party in a conﬂict threatens to attack another party, should that party continue with some provocative action. However, if there were an actual attack, both parties would be worse o@. Bailouts: The state has an interest in ensuring that its major banks are managed in a way that makes situations of serious ﬁnancial 42 stress unlikely. However, if a major bank gets into ﬁnancial trouble, the economic consequences for the rest of the country are so severe that the state bails it out. If banks anticipate this incentive, they know that they are at least partially insured against failure and so they have an incentive to invest in riskier strategies, which increases the likelihood that a bailout will become necessary. The major challenge for a state is, therefore, to make a no-bailout strategy credible. This is, of course, the exact situation that Switzerland, the USA, and other European countries faced during the ﬁnancial crises that started in 2007, and it also illustrates some of the EU’s problems regarding institutional reforms in some of its member states. Legalization of illegal immigrants: Countries want to restrict and control illegal immigration. Therefore, it is in their best interest to signal a tough policy towards potential illegal immigrants in order to prevent them from attempting to migrate. It is in light of this background that the debate about the legalization of illegal immigrants in the USA can be understood. The Obama administration was largely in favor of legalizing this group of people. President Barack Obama said in a press conference on September 06th, 2014 that, although his “preference is to see Congress act,” he intended to take unilateral action in order to give illegal aliens “some path” to “be legal,” if Congress did not enact the sort of immigration legislation he wanted (at that time congress was being controlled by a Republican majority that was mostly against legalization). Advocates of the pro- legalization camp typically use two types of arguments to support their views: humanitarian and economic (illegal immigrants are, for example, an important part of the 43 Californian agricultural industry). Opponents often argue that legalization sends the wrong signals, because it encourages immigration. Touchiness can pay o@: Now, it is time to get to the really important stu@. Think of a typical situation in a partnership. You can stay home for the night with TV and crackers (your partnership has reached a mature stage) or you can go out with friends, but without your signiﬁcant other. You think the latter alternative is much more fun, but only if your signiﬁcant other does not create a scene the next morning. Your partner would be jealous if you go out without him or her, but he or she also shies away from making a scene. Thus, if you actually went he or she would give in and make the best out of the evening. However, he or she would proﬁt from a reputation of being touchy. The art and craft of a social scientist is to boil complex social phenomena down to their essential strategic structures. This is not always easy, as the discussion of the Cold War as a prisoner’s dilemma game has shown, and a reconstruction of the above situations as chainstore games may be wrong or misleading in a given situation. Everyone is well aware that, if one has a hammer, everything looks like a nail and it is the same with game theory: If one has, for example, the prisoner’s dilemma as a device for making sense of things, then suddenly everything looks like a cooperation problem. Digression 25 (Opportunity Costs and Maximization) The idea that rational decisions are based on the correct identiﬁcation, evaluation, and comparison of opportunity costs is closely related to the idea of maximization. An 44 individual is a maximizer, if he/she consistently chooses the best (according to his/her subjective standard) alternative among the available alternatives. There is a lot of evidence that people are rarely maximizers in this sense. One is seldom in a position to know and precisely evaluate all the alternatives, because of uncertainties regarding the relevant probabilities and cognitive limitations. Hence, a lot of people are not aiming for the best, but for a good enough alternative. Think of your decision to meet a friend for dinner. Most people browse their directory and call the ﬁrst friend with whom it seems su@iciently interesting to spend the evening with. Simon (1957) called this type of behavior satisﬁcing. The idea is that individuals have certain aspiration levels and choose the ﬁrst alternative that meets these standards. Because of that, the resulting choices are, in general, less than optimal. There may have been friends in your directory with whom you could have spent an even better evening. At ﬁrst glance, satisﬁcing seems to contradict the idea of maximization and thereby the concept that one should start by identifying and evaluating all opportunity costs. However, advocates of the maximization approach have argued that the opposite is the case: satisﬁcing is optimization where all opportunity costs, including the costs of processing information and optimization, are considered. Looking for the best friend to spend the evening with may be so complicated and time consuming that, in the end, one has dinner alone. It is disputed, however, whether this is a legitimate defense of the idea of maximization. It brings the whole concept close to a tautology, because it comes with the risk of explaining every type of behavior by identifying arbitrary and non-falsiﬁable 45 opportunity costs. What studies with monozygotic and dizygotic twins have shown is that the tendency to satisﬁce or to maximize has a strong genetic component and that people can be categorized into “maximizers” and “satisﬁcers.” Interestingly, maximizers tend to make better decisions than satisﬁcers but are less happy with them. One explanation for this apparent paradox is that even maximizers tend to fail to identify the best alternative in complex environments but are more aware of the fact that they may have failed to achieve their goals. Hence, they often feel regretful when they evaluate their choices. Therefore, in the end, the satisﬁcer goes to the ﬁrst ok-looking restaurant with the ﬁrst ok-looking friend and spends a happy evening, whereas the maximizer continuously questions whether sushi with Sasha would have been better than pizza with Paul. Digression 26 (Firms as Production Functions) At this point, it is important to scrutinize the basic assumption that a point along the production function can actually be reached. Underlying this assumption is the view that ﬁrms are able to organize economic activities within the ﬁrm in a perfectly e@icient way. Historically, economists were not particularly interested in the management structures of ﬁrms and treated the ﬁrm as a black box that entered their analysis as a production function. This simpliﬁcation might be useful, if the primary focus of the analysis is the interaction of supply and demand on markets. As one knows from the short introduction into the philosophy of science (Chap. 1), every scientiﬁc theory has to make simplifying 46 assumptions; the question is if the simpliﬁcations are useful. The ﬁrm-as-production-function view was challenged when economists started to realize that they cannot explain the existence of ﬁrms as subsets of transactions that replace decentralized market transactions with more centralized forms of governance. Since then, a large body of literature on the internal organization of ﬁrms and the boundaries between ﬁrms and markets has emerged that allows one to better understand under what conditions and with what kind of organizational structure companies can get to or close to the production function. This issue boils down to understanding if ﬁrms can organize economic activities in a way that all interdependencies, which are internal to the ﬁrm, are internalized (i.e., no ﬁrm-internal externalities exist). The strands of the literature that focus on these problems are called principal- agent theory, contract theory, or merely theory of the ﬁrm. The important point is that one has to conceptually distinguish between the production function and the relationship between inputs and outputs, which exists given the (possibly imperfect) way economic activities are organized within a ﬁrm. Digression 27 (The Limits of Proﬁt Maximizatio) The idea that income-maximizing owners would like to make sure that the managers of the ﬁrm maximize proﬁts is simple and powerful. However, it is the source of a lot of controversy for both normative and positive reasons. From the positive point of view, it is sometimes argued that ﬁrms do not, in fact, maximize their proﬁts. Deviations from this objective may 47 have several reasons. They can be a result of imperfect information about costs and revenues. Limited information is deﬁnitely a relevant problem and it may lead to decisions that are apparently not in line with proﬁt maximization. Nevertheless, it does not falsify the objective per se. As previous chapters have shown, it is the purpose of managerial accounting to provide information to support decisions. If the information is bad, the decisions are bad, and the ﬁrst impulse should be to develop a better accounting system, not to abandon proﬁt maximization. Another important reason for deviations from proﬁt maximization results from the fact that ﬁrms are usually complex networks of individuals with their own objectives. The key question then becomes whether it is possible to align the interests of the owners with the interests of the workers. Take the CEO of a ﬁrm that is not managed by the owner, and assume further that both, the owner and the manager, want to maximize their incomes. The income of the manager depends on the contract, so it becomes a problem of contract design whether the owner’s and the manager’s income maximizations coincide. (One can think of such a contract as an incentive mechanism. An optimal contract is one that creates no externalities between manager and owner.) The key question is, therefore, how such a contract has to be designed to make sure that the manager internalizes the interests of the owner. If the contract is ill- designed, the manager will use her discretionary power to maximize her own income, which is not compatible with the owner’s income maximization and, therefore, is in conﬂict with proﬁt maximization. An example might be a contract 48 with bonus payments that incentivizes short-term proﬁts, despite the fact that they are in conﬂict with the long-term interests of the ﬁrm. Digression 28 (Sunk Costs) It appears that deviations from the sunk-cost principle are always bad. However, if this were the case, one may wonder why human brains evolved in a way that makes us vulnerable to the sunk-cost fallacy. Recent research in evolutionary biology challenges the theory that such behavior is necessarily bad. Take the so-called ultimatum game as an example. In this game, two players have to decide how to divide a sum of money. The ﬁrst player can propose how to split the sum between the two players and the other player can then accept or reject the o@er. If she accepts, the money will be split according to the proposal; if she rejects, neither player receives anything. According to the sunk-cost principle, the second player should accept any positive amount, because the proposal of the ﬁrst player is in the past and cannot be inﬂuenced. Nevertheless, with this logic, a selﬁsh player 1 should o@er the minimum amount possible. Hence, the sunk-cost principle guarantees that player 2 gets almost nothing. This prediction has been consistently tested and falsiﬁed in the laboratory. It turns out that subjects in the role of player 2 very often reject small o@ers, because they ﬁnd them unfair or even outrageous. However, rejecting positive o@ers violates the sunk-cost principle. In the end, one walks home without any money when one could at least have had some. From an evolutionary point of view, however, 49 the apparently dysfunctional emotions of anger, frustration, or rage that lead one to turn down ﬂimsy o@ers may play a very functional role. Within a community, reputation takes on a vital role in human interaction, because it is not unlikely for one to be in a position to do business with the same person more than once or with people who have heard about one’s previous business dealings. Thus, player 2 would like to commit to a strategy that turns down bad o@ers because, if player 1 knows that bad o@ers will be turned down, he has an incentive to make better ones. The problem is, of course, how to make such an announcement credible. An important role emotions seem to be playing in regulating human interactions is exactly this: to make credible commitments possible. Assume player 2 reacts with anger and frustration to bad o@ers, so that he happily rejects them and player 1 knows this (either by introspection or because he knows player 2). This knowledge would motivate player 1 to make a better o@er, with the consequence that the resulting allocation is more egalitarian, which gives an “emotional” player 2 a ﬁtness advantage over a purely “rational” player 2. What this example shows is that one’s behavioral dispositions and emotional reactions evolved over a long period of time and that they are usually functional adaptations to certain environments. In di@erent environments, however, they may become dysfunctional. This is why it would be completely premature to classify the sunk-cost principle as the only rational way to make decisions; it all depends on the context. 50 Digression 29 (The Ethics of Proﬁt Maximization) Proﬁt is useful if it serves as a means towards an end that provides a sense both of how to produce it and how to make good use of it. Once proﬁt becomes the exclusive goal, if it is produced by improper means and without the common good as its ultimate end, it risks destroying wealth and creating poverty. (Benedict XVI 2009, Caritas in Veritate) One of the most intensely scrutinized assumptions of mainstream economics is proﬁt maximization. Most people ﬁnd it unethical, or even morally o@en- sive, and claim that proﬁt maximization is a major source of the problems of capitalist societies. The idea of corporate social responsibility (CSR) is seen as an alternative to proﬁt maximization, which helps ﬁrms to better align their behavior with society’s interests. The debate about ethical and moral standards in business is probably as old as business itself. One of the oldest deciphered writings of signiﬁcant length in the world, the Code of Hammurabi (1700s B.C.), lays down the rules of commerce and prescribes prices and tari@s, as well as penalties for noncompliance. According to the 2001 Greenbook by the European Union, CSR is a “concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis.” In addition, since 2011, the European Union deﬁnes CSR as “the responsibility of enterprises for their impacts on society.” This concept goes far beyond the narrow idea of proﬁt maximization, which was put forward by Milton Friedman (1970): “In [a free economy] there is one and only one social responsibility of business— to use its resources and engage in activities designed to 51 increase its proﬁts so long as it stays within the rules of the game.” This quote nicely expresses the mainstream view that normative concerns should, and can be, addressed at the level of the foundational institutions of society: the “rules of the game.” One has seen examples for this approach in the preceding chapters: externalities should be internalized by the design of property rights, contract law, taxes, regulations, and so on, but not by appealing to ﬁrms to voluntarily internalize them by non-proﬁt- maximizing business practices. Given these opposing views, is it possible to bridge them? For starters, one gets a lot of support for the so-called Friedman doctrine from the model of ﬁrm behavior under perfect competition, which was developed in this chapter. First, note that the existence of a complete set of competitive markets implies an ideal institutional framework, which, in the language of Milton Friedman, could be understood as the perfect rules of the game. This is expressed in the First Theorem of Welfare Economics. Second, with free entry and exit, competition has the tendency to drive proﬁts to zero. However, if proﬁts are zero at the maximum, ﬁrms do not have much choice but to maximize them. Paying higher wages to employees or selling at lower prices simply drives ﬁrms out of business. The only exceptions to this rule are short-run proﬁts, or a situation where entry and exit are restricted, such that proﬁts are positive even in the long run. However, in this case, advocates of free markets would argue that one should ﬁrst try to reduce the entry and exit barriers to the largest extent possible, in this case. Like it or not, under perfect competition, there is not much room for anything but proﬁt maximization. A lot of ﬁrms voluntarily choose ethically 52 sound business practices. One has to be careful to judge these practices correctly, though. Their existence does not necessarily imply that ﬁrms incorporate other objectives than simply proﬁts into their business models. There are a number of cases where a more comprehensive understanding of the factors that inﬂuence the adoption of these practices is necessary. For example, there are apparently cases in which ethical practices are proﬁt maximizing in a long time horizon. Paying decent wages may motivate employees to work harder and to be loyal to the ﬁrm, thereby increasing proﬁts. Sustainability standards may lead to higher prices, if consumers have a willingness to pay for sustainable production, and so on. In fact, a lot of proponents of CSR reduce the concept to this “enlightened self-interest” of the ﬁrm, the argument being that a lot of potential conﬂicts of interest between the owners and managers of ﬁrms (“shareholders”) and other groups in society (“stakeholders”) result from a too-narrow perspective of the shareholders. This view implicitly accepts the proﬁt motive but aligns it with social interests by declaring them compatible. The approach could also be called responsible proﬁt maximization. However, this is not the end of the story. One has seen that perfect competition depends on technological prerequisites, which are not always fulﬁlled, and that externalities may make an equilibrium ine@icient. In situations like these, there is room for discussion about the adequate way to address ine@iciencies and problems of sustainability, as well as distributive justice on the ﬁrm level. Here is an example: one of the major challenges of globalization is exactly the lack of a consistent global 53 regulatory framework— the rules of the game—that create a perfectly level playing ﬁeld, and institutions like the WTO or OECD are too weak to ﬁll the holes and gaps in the playground. (Nevertheless, CSR goes beyond the problems imposed by globalization.) Nation states even enter into race- to-the-bottom types of international competition, where they reduce taxes and social standards to attract internationally mobile capital. This type of competition can, in principle, be beneﬁcial, if it is primarily utilized as a disciplinary device for nation states to provide public services more e@iciently, but it often drives standards below the e@icient level. Especially large multinational corporations can proﬁt from these developments, and, for the foreseeable future, there is no other institutional actor able to address the ethical issues that result from these developments other than the corporations themselves. Again, like it or not, if they do not care, no one will. Digression 30 (Measuring Willingness to Pay) This chapter’s analysis shows that an understanding of the likely responses of potential buyers to price changes is of considerable importance for ﬁrms. Despite this fact and despite the advances in pricing research, many ﬁrms price and develop products without an adequate knowledge of their customers’ willingness to pay. Research has shown that only 8–15% of all companies use pricing strategies that are based on empirical assessments of buyer responses (Monroe and Cox, 2001), despite the fact that there is empirical evidence that even minor changes in prices can 54 have important e@ects on proﬁts (Marn et al., 2003). A lot of ﬁrms would rather use a strategy that may be dubbed “intuitive” pricing. Marketing research o@ers a large variety of di@erent techniques for mea- suring the willingness to pay. Broadly speaking, they fall into two di@erent categories: “revealed” and “stated” preference models. Revealed- preference techniques infer a customer’s willingness to pay from observed data. This can be market data, data that is generated while browsing the internet or data generated in experiments. Stated-preference techniques are based on surveys that are designed to elicit information about the willingness to pay. Examples of these include, among others, expert or customer surveys, and conjoint analysis. Conjoint analysis is a statistical technique where a product is partitioned into di@erent attributes that together generate value for the customer (in the case of a car, these attributes might be mobility, versatility, status, etc.). Customers are then asked to rank or rate di@erent bundles of these attributes. The results are used for the design and pricing of future products. The di@erent techniques to measure one’s willingness to pay have their own strengths and weaknesses, and it depends on the speciﬁc product and the available budget of the market-research department which method is applied. Digression 31 (What Factors Determine Price Elasticities?) There are two factors that determine the price elasticity of demand: The customer’s purchasing power (when the good becomes more expensive, customers can ceteris paribus 55 a@ord less of it) and the willingness and Monopoly Without Price Discrimination 409 p MC(y) MR(y) P(x) * p PS DWL MC(y) MR(y) Fig. 14.1 * * x =y The supply of a monopolist without price discrimination x,y possibility to substitute the good with another one. This second determinant makes the model applicable to markets with close but imperfect substitutes, e.g., di@erent brands of jeans. The model’s implication for markets with close substitutes is that markups have to be relatively moderate. The markup rule also gives one a ﬁrst clue about how ﬁrms should invest in advertising and public relations: Cost-plus pricing indicates that the markup in a market is negatively related to the price elasticity of demand. A marketing campaign should hence aim at making demand less elastic. In order to determine the optimal advertising budget, the ﬁrm needs to know the marginal revenues and marginal costs of advertising. The marginal revenues are determined by the change of the price elasticity of demand that is induced by another unit of advertising. Digression 32 (User Fees) One could argue that an aggressive placement of ads on platforms reduces user experience, so a user-fee-based business model with ad-free service (and no data collection) could be a viable alternative. And some platforms like Spotify do indeed o@er so-called premium services as an option. Whether this strategy can work depends on the speciﬁc services the platform o@ers. Facebook, at least so far, has always insisted on o@ering a free service for its users. An interesting thought experiment is to ask what user fee 56 Facebook would have to charge to be indi@erent between its current business model and a user fee-based alternative. In 2017, Facebook’s average revenue per user in North America was 84.41 U.S. dollars. To replace that revenue with an ad- free service, Facebook would need to charge each user at least that amount. A recent survey of US Facebook users found that less than 10% would be willing to pay such a user fee for an ad-free service. Taking this ﬁgure at face value, the community would collapse dramatically. This would have two negative e@ects for the remaining users. First, due to the importance of network externalities, they would perceive Facebook as less attractive. And second, maintaining Facebook’s revenue would mean that user fees would also have to increase dramatically, which would likely drive away even more users. Digression 33 (Price Discrimination in the Digital Age) Compared to second- and third-degree price discrimination, ﬁrst-degree price discrimination has long been seen as a theoretical benchmark without much practical relevance, because the need for customer-speciﬁc information that is necessary to charge personalized prices was considered too extensive. On the other hand, moving in the direction of perfect price discrimination is extremely tempting for ﬁrms, because of its obvious consequences for proﬁts. It should therefore not come as a surprise that e-commerce sites experiment heavily with pricing strategies that are based on the tracks people leave while browsing the internet. A Executive O@ice President of the United States (2015) report 57 for the attention of the President of the USA concludes that “the combination of di@erential pricing and big data raises concerns that some customers can be made worse o@, and have very little knowledge why. [... ] [M]any companies already use big data for targeted marketing, and some are experimenting with personalized pricing, though examples of personalized pricing remain fairly limited. [... ] [P]roviding consumers with increased transparency into how companies use and trade their data would promote more competition and better informed consumer choice.” Hannak (2014) analyzed the search results of 300 people who visited 16 online retailers and travel agencies from the USA. They found that customers were shown di@erent prices or di@erent results for the same searches on nine of these 16 sites. For example, the online-travel company Expedia discriminates prices according to the browsing history stored on the customers’ computers. It is unclear, however, which type of browsing history triggers high prices. Another travel-agency, Travelocity, o@ered hotel rooms that were $15 a night cheaper if viewed from an iPhone or iPad. Home Depot displays higher prices and pricier products for smartphone users than for customers using desktops. In 2012, Wall Street Journal found that Staples discriminated prices according to the location of the device, and Orbitz discriminated prices between Mac and PC users, because data analysis revealed that Mac users are willing to pay higher prices for hotels. These attempts to discriminate prices are still relatively crude, but the availability of more information and better algorithms may soon change the picture. Calo (2013) concludes that big data and better algorithms will enable 58 companies to proﬁle customers and deliver advertisements in a much more personalized way, also making use of the limited rationality of individuals. For example, Apple and Microsoft have ﬁled patents for the so-called mood- based advertising, and Amazon is developing algorithms that tell them what the customers are likely to want before they place an order. This information is crucial for price discrimination, because it allows them to adjust prices or tweak choices while the customer is still searching. Google, for example, is ﬁling a patent for an algorithm that can decide if a customer is likely to buy something and then to display a high price, while lowering the price for customers who have a low likelihood of buying. Shiller (2014) studies the e@ects of including more information into pricing strategies on proﬁts in the case of Netﬂix. He found that, compared to standard second-degree price discrimination, using the full set of information about web-browsing behavior increases variable proﬁts by 1.39%, compared to 0.15% if pricing strategies are based on demographics alone. This may not sound like much but, compared to net proﬁt margins of 2.34% in the US online retail industry, it makes a big di@erence. Digression 34 (Pricing and Bounded Ratio

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