Searching for Economic Solutions in Game Theory

by | Feb 9, 2023

Searching for Economic Solutions in Game Theory

by | Feb 9, 2023

decision making

The left and right-wings of economic thought spend much of their energy trying to refute each other, but an integration of both perspectives might be worth considering. The right-wing of economic thought has conclusively demonstrated that the value creating ability of capitalist economics cannot be matched by any left-wing economic model. However, the left-wing has highlighted consistent, major flaws in the capitalist system which include the inevitability of collusion between industry and government, and the need to create regulations which try to impose a uniform pattern of life. Ironically, the Stalinist economic regimes of the twentieth century exemplified the extremes of both criticisms; maybe this was the left’s caricature of industrial capitalism in their attempt to compete against it.

Resolving the differences between left and right would require identifying what lends capitalism its ability to create value and then why this leads to social problems. In a previous essay, I discussed the economics behind capitalism’s value creation machine. When these mechanics are considered in the competitive social context, using game theory, the riddle of capitalism can be solved.

Conventional game theory deals with competition between players each seeking to maximize value, but where their success is checked by the efforts of other players seeking the same thing. Game theory asks players not only to consider their own path, but also to put themselves in the shoes of other players who are doing the same thing. The solution to non-cooperative game theory problems involves assuming that everyone will choose their least bad option, rather than their best option. A “best” option is the value you could realize if nobody else was competing. If everyone goes for that, as in a game of chicken, there’s a chance everyone could lose. In markets, this could be a price war, a race to the bottom that wipes everyone out. A “least bad” option makes particular sense in economics, where even limited profits are infinitely preferable to bankruptcy.

In twentieth century industrial capitalism, markets tended to structure into segments, which were divided up by semi-cartels of industry rivals. Competitive barriers, including government interference, permitted stability. The existence of competitive pressure led to invention and growth, but barriers limited total value creation. Leftist economists frequently highlight this problem, calling it economic rent. While this idea is cynical and misleading, servicing their political aims, they do correctly identify that market barriers create waste, but are also necessary for modern capitalism to work. They do not offer a realistic alternative. A better treatment of this problem attributes it to the consequences of game theory. Reliance on competitive barriers is a “least bad” solution to market competition.

In addition to non-cooperative game theory, there is also a branch of game theory which deals with cooperation. This theory assumes that people will be drawn to cooperate if doing so will produce more value than what they can accomplish alone. Cooperative game theory discusses what conditions are necessary to keep people from going their own way. The first assumption is that the group will produce more value cooperatively than as individuals. This could be a result of efficiency applied at scale, or division of labor. It can also be the result of forgoing the wasteful “least bad” options driven by competition. If cooperation will produce more value, then it’s still necessary for each individual participant to individually earn more from cooperating. The market might produce more value if a monopolist makes room for others, but the monopolist certainly won’t.

The silver bullet of cooperative game theory says that the winners of competitive environments will only cooperate if they are compensated by the group. A monopolist will give up their monopoly if the entire coalition pays them out as if they still had monopoly control and then some. The group can afford to do this because cooperation creates more overall value than competitive “chicken.” Well-structured pay-out schemes are essential to make cooperation work.

Cooperation usually requires rules. In a division of labor, value is optimized as individuals are assigned to tasks which provide comparative advantage. If they don’t stick to their task, or make purchasing decisions which disrupt predicted market prices, the coalition can’t produce the amount of value they expected, and the cooperation could fall apart.

There are plenty of examples of real-world market cooperation. Business alliances are a good example, where airlines heavily cooperate on sales and prices. There are also industrial coalitions, which cooperate over standards, or engage in collective bargaining for raw materials. Companies are coalition game solutions. The profits of the company are pooled, and the firm’s salary structure distributes it to employees in a way that balances the value of different kinds of labor with sufficient incentives. Management matches talent to task in an economical way. In business theory, the concept of cooperative game theory has been heavily studied particularly for distribution or logistics networks where even rivals can benefit from the joint optimization of efficiency. Trucking firms can make more money carrying the cargo of rivals when they have spare capacity, if the cooperation scheme is well designed.

Since a firm is a coalition game solution, it should be easy to see how a value-added supply chain has the potential to integrate into a coalition as well. Not everyone will be paid equally and not everything can be pre-planned, but substantial coordination could create more value than a more competitive environment. Likewise, firms can integrate horizontally to achieve maximum efficiency through scale and scope in an industrial sector.

Looking at it the other way, a centrally planned economy is the ultimate scheme of cooperation, and the inefficiencies and waste of central economic planning are well demonstrated. There is an obvious limit to cooperation, so when can it occur?

Generally, firms should compete and markets should be free. However, out of the competitive milieu, there is room for cooperation at almost any level so long as the conditions for cooperation are met. These are as follows:

  1. There is a point of value realization. The cooperative activity, which has costs, must result in a transaction in the marketplace by which those costs can be compensated. You can’t cooperate half of the way through production. This is because cooperation should be responsive to price signals and incentives, and not a political mandate.
  2. The coalition can achieve an optimal configuration of labor and assets. The team needs to be able to produce more value than the competitive alternative, in practice.
  3. The payout structure needs to compensate the winners of the competitive alternative.
  4. There is a means of rule enforcement. This enables point #2. The enforcement ought to be through economic incentives if possible (penalties), in light of point #1.

A basic firm fulfills all these requirements.

In theory, if an industrial sector is experiencing economic waste due to competitive barriers, then that waste is a strong economic incentive to try and build a scheme of cooperation so long as the above rubric’s conditions are achievable.

Why haven’t businesses cooperated if there’s money to be made? First, there are many industries which already use cooperation and alliances to great success. However, it is probably the interference of government during the twentieth century, including the creation of central banking, which prevented markets from realizing the need for cooperation. Instead, central banking funded the wastefulness of non-cooperation. In my opinion, if it weren’t for central banking, the market would have driven businesses to understand the importance of cooperation within competition much sooner.

The theory of cooperation within competition still leaves certain questions of practice unanswered. Determining whether cooperation makes sense or not is a difficult task. Obviously, central planning is a bad idea. Even the mergers and acquisitions movement of the nineteenth century quickly discovered the limits of too much consolidation.

Contemporary business theory addresses this question with the concept of mixed games. These assume that there are many layers of cooperation and competition which are heavily interwoven in an efficient and productive game. Implicitly, any asset, laborer, or economic sub-unit needs the ability to shift between cooperative and competitive modes with agility. The first step in facilitating practical cooperation is to design the legal and financial structure of assets to become more modular, to enter into and leave coalitions while keeping track of value and ownership. This wouldn’t be so hard to design if the market incentive and opportunity existed.

A more meaningful question is how to know when modular assets should be given up into cooperation. The rubric of cooperation provides the answer to that question, but with a caveat. Implicit to the rubric of cooperation is an acknowledgment that the players involved are confident that the cooperation will be profitable. They already know what prices to expect, and they are already aware of best practices and the division of labor which will make the cooperation valuable. In other words, cooperation would be a phenomenon of mature, stable markets.

In contrast, competition would be a feature of emerging sectors or disruptive events. Competition is the ruthless taskmaster by which the engine of capitalism discovers knowledge and value. However, once that process matures, there should be a shift to cooperation. Cooperation will never be equal, in fact the results of competition help signal where inequalities of distribution make sense. There is also meta-cooperation where the long-term social health of an economy is recognized as an important foundation to the game, and the modularity of assets which switch between cooperation and competition includes negotiated stabilizing factors which acknowledge the need to protect the core benefits of cooperative environments from competitive phases, while also leaving them subject to disruption if economically necessary.

Real world examples of the cooperation within competition model nevertheless fail to convey a pure example of it in action. The pure model might exist within a blockchain-driven, mostly decentralized supply chain of the future. Some middle ground between these poles might have been what the free market would have produced in the absence of central banking. Less politically charged workers’ syndicates, which are more economically sensitive. These labor cooperatives wouldn’t have necessarily crowded out the middle class, but there would have likely been a more diverse, locally idiosyncratic set of middle classes without progressive regulation interfering.

The cooperation within competition model is the missing piece of the puzzle which solves certain problems for both the right and the left. The left has never found an economic model that works, because its prioritization of politics is antithetical to healthy economics. The right has difficulty admitting the degree to which the apparent freedom of progressive capitalism is made possible by profound government intervention, although it does a good job of critiquing the harms caused by government. The middle ground is worth considering. It’s technical, economic, and avoids politics completely.

About Zack Sorenson

Zachary Sorenson was a captain in the United States Air Force before quitting because of a principled opposition to war. He received a MBA from Waseda University in Tokyo, Japan as class valedictorian. He also has a BA in Economics and a BS in Computer Science.

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