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Reconstructing normative economics on a foundation of mutual advantage

Periodic Reporting for period 3 - NormativeEconomics (Reconstructing normative economics on a foundation of mutual advantage)

Reporting period: 2019-01-01 to 2020-09-30

Economics has traditionally assumed that individuals seek to satisfy coherent and asocial preferences, and has used the satisfaction of those preferences as a normative criterion. This ‘neoclassical’ approach has supported a view of the market as an institution in which privately-motivated individual actions tend to produce socially beneficial consequences. These ideas have been called into question by recent developments in behavioural economics, which point to the cognitive limitations of economic agents, the instability of preferences, and the existence of pro-social motivations. A common inference is that traditional presumptions in favour of the market and against paternalism are invalidated. The objective of the project is to develop an approach to normative economics, and a corresponding understanding of the role of markets, which do not require neoclassical rationality assumptions but may still support those presumptions.

My approach is innovative in two ways. First, the criterion for normative analysis is opportunity, not preference satisfaction. Even if individuals lack coherent preferences, opportunities for mutually advantageous transactions can be defined in a normatively significant way, and competitive markets can be shown to be effective in providing such opportunities. Second, using a new version of the theory of ‘team reasoning’, the relationship between parties to a market transaction can be construed in terms of a joint intention to achieve mutual benefit. This motivation can support practices of trust and cooperation without disabling market incentives. Using the methods of theoretical and experimental economics and analytical philosophy, I aim to formalise and integrate these ideas and extend them to provide a new understanding of the role of government in the economy.

The work of the project is organised around two main themes. The first theme is the reconciliation of normative and behavioural economics, using opportunity as the primary normative criterion. There are five sub-themes: ‘The opportunity-based approach and market regulation’, ‘The opportunity-based approach and the compensation test’, ‘The opportunity-based approach and the distribution of income’, ‘Do individuals want to constrain themselves?’, and ‘Are well-being judgements context-dependent?’ The second theme is the theory of team of reasoning. There are three sub-themes: ‘Developing a new theory of team reasoning’, ‘Testing the new theory of team reasoning’, and ‘The influence of fairness considerations on market behaviour’.
1. Monograph

At the time I wrote my proposal, I was in the process of writing a monograph on the use of opportunity as a normative criterion. I said that, as part of my Horizon 2020 research, I would write a companion monograph on team reasoning. Both would be addressed to wider academic and quasi-academic audiences than are normal journal publications. Together, they would present my ideas about how normative economics can be reconstructed on a foundation of mutual advantage. Subsequently, I decided that it would be a better strategy to combine the two themes in a single, larger monograph. In the period from 1/1/16, I have completed the manuscript of this monograph. This involved a lot of theoretical work on both of the project’s themes (described in more detail below).

I submitted the first version of this manuscript to Cambridge University Press (CUP), Oxford University Press (OUP), and Princeton University Press (PUP) in the early summer of 2017. All three publishers sent the manuscript out to review, received highly favourable referees’ reports, and offered contracts. One anonymous reviewer wrote: ‘I believe that it is a quite major and enduring contribution, one that will greatly deepen the discussion of behavioral economics and liberalism. Sugden is a highly unusual and in some ways unique figure. He understands economics from the inside and he understands philosophy from the inside, and he is a major contributor to both…. Sugden has made a major contribution here, not least because he develops, more than anyone ever has, [John Stuart] Mill’s concept of a community of advantage, and shows that it can be seen as central to liberal thought and practice’. Another wrote: ‘The Community of Advantage is extremely ambitious, intelligent, and well-informed. It should cement Sugden’s reputation as a leading scholar – or perhaps the leading scholar working at the boundaries between economics and philosophy’.

I chose OUP as the publisher and spent a large part of summer and autumn 2017 refining the arguments of the book in the light of the comments I had received from all three publishers’ referees. The book is now in press and is expected to be published in July 2018:

-- Robert Sugden, The Community of Advantage: A Behavioural Economist’s Defence of the Market. Forthcoming from Oxford University Press. (Approximately 150,000 words.)

The book will be the subject of a session organised by the International Network for Economic Method at the American Economic Association meeting in January 2019.

2. Developing the theory of team reasoning

One of the main objectives of the project was to develop a new version of the theory of team reasoning in which team reasoners aim to play their respective parts in mutually beneficial practices (rather than, as in current versions of the theory, to play their respective parts in maximising some ‘team utility’ function). Working with Isoni, I have achieved this objective. We have found a way of defining a class of ‘voluntary interactions’ (essentially: games that are played if and only if all players so choose) which includes both ordinary market transactions and many forms of cooperation in civil life. For such interactions, we have been able to define ‘mutual benefit’ without making any assumptions about the preferences of the players. The essential idea is that if an individual chooses to enter a voluntary interaction, knowing what behaviour to expect from her co-participants, and if the interaction takes place as expected, she is treated as benefiting from the interaction. For any given type of voluntary interaction, a ‘practice’ is defined as a commonly-known set of expectations about behaviour within that interaction, by individuals who have chosen to enter it. An individual who uses team reasoning is motivated to conform to practices, provided that her co-participants conform too. Given this approach, the analysis of team reasoning is closely related to my work on using opportunity rather than preference-satisfaction as a normative criterion. The discovery of this relationship was one my main reasons for integrating the two planned monographs into one. The monograph contains the new version of the theory of team reasoning in a simple form, presented relatively informally. Isoni and I are now working on a more formal and more general presentation of the theory.

The first part of this work is a critique of the way that the conventional theory of social preferences explains practices of reciprocity (for example, trust and trustworthiness, and voluntary contributions to the provision of public goods). The conventional theory is based on the concepts of ‘kindness’ and ‘unkindness’; a person who is motivated by reciprocity wants to be kind (respectively, unkind) to people who are kind (unkind) to her. Isoni and I show that this theory leads to a ‘Paradox of Trust’: there cannot be an equilibrium in which trust and trustworthiness are both fully expected. (The paradox is that is that if trustworthiness was fully expected, trust would not be ‘kind’, and so would not induce reciprocation.) A theory in which individuals are motivated by intentions to achieve mutual benefit would not lead to this paradox. This analysis is presented in:

-- Andrea Isoni and Robert Sugden, ‘Reciprocity and the Paradox of Trust in psychological game theory’. Forthcoming in Journal of Economic Behavior and Organization.

The second part of this work is a formal statement of the new theory of team reasoning. Isoni and I are currently working on this, for submission to a leading journal.

I have also written two more philosophical papers on aspects of the theory of team reasoning. One paper discusses the view, shared by behavioural economists who write about intrinsic motivation and moral philosophers who present virtue-ethical critiques of the market, that the incentives of the market reward amoral, instrumental motivations. I argue that the market rewards people for participating in the creation of mutual benefit, and that the theory of team reasoning shows how behaviour in markets can be motivated by intentions for mutual benefit:

-- Robert Sugden, ‘Awards, incentives and mutual benefit’. Forthcoming in International Review of Economics. http://dx.doi.org/10.1007/s12232-017-0288-1.

In another paper, I revisit the work of James Buchanan. Writing before the era of behavioural economics, Buchanan argued that economics should be the study of exchange, understood as voluntary interaction, rather than of rational choice. I point to parallels between Buchanan’s approach and the theory of team reasoning:

--Robert Sugden, ‘What should economists do now?’ Forthcoming in Richard E. Wagner (ed.), James M. Buchanan: A Theorist of Political Economy and Social Philosophy (in Palgrave Macmillan series: Remaking Economics: Eminent Post-War Economists).

3. Testing a new theory of team reasoning

Isoni, Zheng and I have designed, programmed and run two major experiments to test a distinctive implication of our new theory of team reasoning. This implication is that people can be motivated to act contrary to immediate self-interest when conforming to ‘practices’ in voluntary interactions, even if they believe that their co-participants are acting in their self-interest (rather than acting out of ‘kindness’).

Our first experiment used a novel experimental game in which two individuals are each endowed with a good, and have the opportunity to exchange these goods. Each knows the value of both goods to himself, but not their value to the other player. Goods are represented to experimental subjects as two-sided ‘cards’. One side of each card describes its value to one player, the other side describes its value to the other. Each player can see only ‘her’ side of the two cards. The game takes place if and only if both players so decide; otherwise, each player simply earns the value to her of her card. (Thus, the game is a voluntary interaction in the sense of the new theory.) Exchange takes place in two stages. First, ‘Player A’ sends his card to ‘Player B’. B then chooses whether to complete the exchange by sending her card to A, or to keep both cards. A random process determines whether (as in a ‘trust game’), B is able to ‘cheat’ (keeping both cards and so gaining more than if she had completed the exchange) or whether (as in a typical market transaction when property rights are legally enforced) it is in her self-interest to complete the exchange. B knows whether cheating is possible before choosing whether to enter the game. The game is played repeatedly within small groups of subjects who sometimes play as A and sometimes as B.

In this set-up, it is possible for a practice of ‘honest trading’ to emerge, i.e. a practice in which B-players do not cheat, and each player chooses to enter the game if and only if he or she would benefit from a completed exchange. Such a practice requires B-players to act contrary to self-interest when they have an opportunity to cheat. However, if the probability that cheating is possible is sufficiently low, it is in A-players’ self-interest to send even if they expect B-players to cheat when they have the opportunity to do so. In this case, sending is not an act of ‘kindness’ in the sense of social preference theory, and so if B-players choose not to cheat, this is consistent with the theory of team reasoning but not with theories of reciprocal kindness.

The experiment produced surprising results. In contrast to the findings of previous experiments on trust games, a large majority of our participants consistently, and with considerable sophistication, acted on self-interest, i.e. taking advantage of virtually all opportunities to cheat and choosing to enter games whenever they could benefit by cheating. As a first step in understanding these results, we ran a further treatment in which there was transparency about opportunities to cheat: both players could ‘see’ both sides of the two cards, and both knew whether it was possible for B to cheat. Thus, games in which cheating was possible were formally similar to standard trust games. Again we found much more self-interested behaviour than is typically found in trust games.

These results are interesting in their own right, as evidence that motivations for trust and trustworthiness are not as robust as has previously been thought. However, it was not clear what features of the design were responsible for inducing self-interested behaviour. We conjectured that the description of the experimental task in terms of the values of ‘cards’ might have prompted subjects to think about the task as if it were a real-world card game in which players are expected to compete against one another, while the typical framing of a trust game experiment is more suggestive of real-world situations in which people cooperate for mutual benefit. We designed and ran a second experiment, in which the underlying game was similar to that of the first experiment, but was framed explicitly as a market exchange. (Player A owns a ‘painting’ that has a monetary value only to player B; the exchange requires A to pay a ‘delivery charge’ to send the painting to B, and requires B to send the ‘trade price’ to B.) We are currently analysing the data from this experiment. From a preliminary analysis, it is clear that the experiment induced overall degrees of trust and trustworthiness in early rounds of the game that were comparable to those found in standard trust games. As the game was repeated, behaviour became progressively more self-interested. Thus, practices of ‘honest trading’ were not self-sustaining. However, the behaviour of honest traders seems to show some patterns that are characteristic of team reasoning. We will write up these results as a paper for submission to a major journal.

Another strand of our work on testing our theory of team reasoning builds on an emerging consensus in the game-theoretic literature that some types of decision problem are more likely than others to prompt team reasoning. Experimental evidence shows that team reasoning is particularly likely to be used in Pure Coordination games (i.e. games in which the two players’ only objective is to coordinate their strategies, and in which the payoffs to the two players are always equal). It is less likely to be used in Battle of the Sexes games (i.e. games in which the players have a common interest in coordinating their strategies, but conflicting preferences between alternative ways of coordinating). Understanding why this is the case is important for the development of an empirically satisfactory theory of team reasoning. Isoni, Zheng and I have pursued three separate lines of enquiry into this issue.

Isoni, Zheng and I have noticed that the difference between behaviour in Pure Coordination and Battle of the Sexes games has two possible explanations: team reasoning might be inhibited either by conflict of interest or by inequality (in the Battle of the Sexes game, coordination always leads to unequal payoffs). If unavoidable inequality was a serious obstacle to the achievement of mutually beneficial cooperation, that would be bad news for liberal economists like myself who defend the market as an institution that provides opportunities for mutual benefit.

With two co-authors, Isoni and I have investigated whether the tendency for Battle of the Sexes games to inhibit team reasoning is less if (as is often the case in the real-world situations that this game is used to represent), players do not have full information about each other’s payoffs. During the period of the ERC award, we have analysed data generated by an earlier experiment, developing a new theoretical model for this purpose. We find that even imperfect information about the possibility of conflicts of interest inhibits team reasoning:

-- Andrea Isoni, Anders Poulsen, Robert Sugden and Kei Tsutsui). ‘Focal points and payoff information in tacit bargaining’. At ‘revise and resubmit’ stage at Games and Economic Behavior.

During the period of the ERC award, Isoni, Zheng and I have designed a new game, the ‘Pizza Night’ game, in which coordination always leads to unequal payoffs but there is no conflict of interest. We have run an experiment which allows us to compare behaviour in all three games. We find that team reasoning is inhibited much more by conflict of interest than by inequality. This experiment has been written up as:

-- Andrea Isoni, Robert Sugden and Jiwei Zheng, ‘The Pizza Night game: efficiency, conflict and inequality in tacit bargaining games with focal points’. Submitted to American Economic Journal: Microeconomics.

With a co-author, Zheng has compared coordination games in which the two ‘players’ are individuals with coordination games in which each ‘player’ is a pair of individuals who are required to agree about their strategy choices. The tendency for conflict of interest to inhibit team reasoning is less strong in the latter case. The implication is that when one member of a pair is initially inclined to use team reasoning but the other is not, agreement is more likely to be in favour of team reasoning:

-- Stefania Sitzia and Jiwei Zheng, ‘Group behaviour in tacit coordination games with focal points: an experimental investigation’. Submitted to Journal of Economic Behavior and Organization.

4. The opportunity-based approach and market regulation

I have proved an important extension to my previous work on the ‘Opportunity Criterion’. Previous work has proved a ‘Market Opportunity Theorem’ which establishes that, in every competitive equilibrium of an exchange economy (defined in a way that does not assume that
The 'summary of context and overall objectives' explains the importance and novelty of the project. The whole approach of basing normative economics on mutual advantage and using opportunity rather than preference-satisfaction as the normative criterion is beyond the current state of the art. The Community of Advantage provides an overview of this approach in a form that is accessible to a cross-disciplinary readership. I expect it to become a controversial and influential point of reference in discussions about the normative and policy implications of behavioural economics. The ‘new theory of team reasoning’ is radically different from existing theories of social preferences and also from existing theories of team reasoning. One particularly significant difference is that the new theory makes minimal assumptions about individuals’ rationality and about their knowledge about one another’s preferences, beliefs and intentions. In this respect, it is aligned with the recent trend towards explaining pro-social behaviour as driven by social norms; it can be interpreted as a model of a particular class of norms, namely norms about mutually beneficial cooperation. Another important difference is the emphasis on voluntariness. The ‘honest trading’ game (see the section ‘Testing a new theory of team reasoning’ above) uses a novel experimental design in which a trust game is played if and only if both potential players choose to participate.

The issues that the project will address are set out in ‘Summary of the context and overall objectives of the project’. As the work involves the development and testing of new theories, it is not possible to predict 'expected results' in detail. How far our experimental findings will give empirical confirmation to the theories of behaviour we have developed so far is outside our control. But in any case, my work is primarily a contribution to normative economics, based on the ‘contractarian’ approach of James Buchanan. Its aim is to produce recommendations that can be addressed, not directly to ‘social planners’, but to citizens, understood as potential parties to mutually beneficial agreements. Whatever the degree to which individuals actually act on a norm of mutual benefit, a specification of this norm and a demonstration that it works to everyone’s advantage would still be a significant contribution to normative economics and to public understanding of economics.