An updated and revised draft of the paper on the game theoretic analysis of consent in network formation with Subhadip Chakrabarti and Sudipta Sarangi is now available at the network formation page.
I just posted a new paper on multilateral matching in network economies on the game theory page. This paper is co-authored with Emiliya Lazarova (University of Birmingham) and Pieter Ruys (Tilburg University).
This paper investigates a network economy in which economic agents are connected within a structure of value-generating relationships. Agents are assumed to be able to participate in three types of economic activities: autarkic self-provision; binary matching interactions; and multi-person cooperative collaborations. We introduce two concepts of stability and provide sufficient and necessary conditions on the prevailing network structure for the existence of stable assignments, both in the absence of externalities from cooperation as well as in the presence of size-based externalities. We show that institutional elements such as the emergence of socioeconomic roles and hierarchical leadership structures are necessary for establishing stability and as such support and promote stable economic development.
It seems to me there is a lack of game-theoretic modelling of network formation under mutual consent in the relationship building process. To model such a process of mutual consent is rather difficult. The simplest model from the literature is Myerson’s network formation game in which all individuals announce which links they want to build. Subsequently only those links that are supported by both parties are actually formed.
The main problem with this static approach is that the class of networks supported through Nash equilibria in this game is very large. In particular, the empty network (without any links whatsoever) is very strongly supported in this model; it is a strict Nash equilibrium if building links is costly, which is usually the case. My paper with Chakrabarti and Sarangi (2011) reports an exact description of the properties of the equilibrium networks in Myerson’s model under arbitrary cost structures in the link formation process.
In my (now published) paper with Sarangi (2010) we introduce a concept that pulls us away from the conclusion that the empty network is always a strict equilibrium. This alternative concept is founded on modelling a form of trusting behaviour or “confidence” in the brain of the individuals in the link building process. The result is a much smaller class of stable networks, usually not including the empty network. This actually shows that we can support the idea that trust builds meaningful social networks.
The referred papers on network formation under consent are posted on the network formation page at this web site. In particular, this post addresses the material covered in the first two papers posted there.
Together with Zhengzheng Pan I am working on how naive economic decision makers operate in complex, multi-layer network structures. In the updated paper that I posted on the game theory research page, we consider how decision makers interact in a network and at the same time observe other decision makers in a separate, but correlated interaction structure. Our main result is that behavioral islands form and that in each of those islands there emerge local conventions. If we add stubborn or persistent individuals, they have an extraordinary large effect on the local conventions that emerge in the behavioral islands that they are member of. All in all, rather interesting insights from a straightforward model that is founded on boundedly rational behavior rather than fully rational optimization.
This week news emerged that senior managers at large corporations (FTSE100) gave themselves an average pay rise of 55%. (Today there was a response by an executive that this pay rise was “only” 23%…) This followed earlier news that investment bankers have increased their bonuses to record levels as they face record profits. These tremendous increases of salary sums occur in a depressed economy in which both capital providers and regular workers do not get any returns; instead they are squeezed in the current economic climate with little real pay increases and no returns on (pension) investments during the last decade. It is a phenomenon that has emerged within the last 20 years and has resulted into an income distribution that is more unequal and skewed than anytime during the last 90 years. So, what are we looking at?
I believe that during the last thirty years there has emerged a brand new form of economy, the network or managerial economy. Capitalism that emerged after the industrial revolution got its name from the fact that capital providers and entrepreneurs were the most powerful class in the economy. Capitalism matured through the hardships of the first half of the 20th century into a more balanced and cooperative form. It was as if we learned to control and regulate excessive market power exercised by capital providers. This control was most signified by the absence of any serious financial panics between 1929 and 2008.
But since 1980 we are witnessing another revolution, namely the emergence of a new form of economy founded on network infrastructures. It is mainly based on the rise of the financial sector as universal middlemen of all economic interaction; it is an age of managers, positioning themselves in crucial structural middleman positions in the complex networks that have emerged in the global economy. Managers act as the emperors of these networks and reap excessive from these positions, resulting into huge profits. And as in classical 19th century capitalism it results into stark inequalities and unfairness.
The financial panic of 2008 was the first crisis of the new network economy and signifies the trouble ahead. We need to learn to control and regulate these new networks before we can ease the situation again and move to a more functional and fair economy. This might take a while, in particular since we do not truly understand the network economy yet.
Yesterday, news broke that the SEC is accusing Goldman-Sachs of exploiting its middleman position for fraudulent purposes. This case is a striking example of what failures the relational or network structure of the global economy can cause without proper regulation and governance. In fact, this case has several important implications for our understanding of the global economy.
First, by now it should be very clear that we do not live at all in a “market economy”, but rather in a network or relational economy. So, lets just burn those silly principles of economics textbook that are used in introductory economics courses and write some new texts that actually center on this insight. Over the past decades the banking sector has (again) become an all-powerful middleman industry. It is even more profound than that: banking has actually replaced the monetary system itself. Instead of using government or bank issued money, we now use credit and debit cards and, as such, the banking system is mediating nearly all transactions that we make. (It also collects a nice fee for every transaction that we make with these monetary instruments; a guaranteed income stream therefore results for the banking sector.) As such, there is no “money” as a commodity anymore; instead we rely on a completely virtual system. The implications are profound for our understanding of for the 21st century global economy. Namely, any financial crisis would result in a much larger, even unprecedented trust crisis, exactly as is the case for the financial panic of 2008.
Goldman-Sachs is one of the main middlemen in the financial network that governs our global economy; it is very good at exploiting this position. Profits over 2009 and even 2008 show that middlemen as Goldman-Sachs usually do not have to fear any crisis; they make money hand over fist regardless of what happens around them in the rest of the economy. Only stupidity, such as shown in the behavior by Lehmann Brothers in the run-up to the financial panic and now in the alleged behavior of Goldman-Sachs, would actually result in substantial financial losses.
Second, middleman power is fundamentally corrupting. It leads to more and more exploitation, which in turn undermines the network. And as a result these networks will collapse on a regular basis, following the rhythm of an economic cycle. A well-functioning network results in large gains from positional power for the middleman, which triggers over-extended greed and a collapse follows. After a period of rebuilding, a new cycle begins. The greed cycle in the financial networks was very clear throughout the 19th century. This was a period of complete deregulation; only self-governance and self-regulation actually supported the functioning of these networks. The 19th century financial cycle resulted in an average of one collapse per decade. Over time these crises became worse, ultimately resulting in the Long Depression of the 1890s and the Great Depression of the 1930s. After that, government intervention through regulation, stabilized the financial networks considerably; the worst excesses were prevented until the financial panic of 2008. This occurred after a decade of considerable deregulation.
The only forces that counter such a middleman exploitation cycle are those of positional contestability of middleman positions and the proper regulation of such networks. Contestability works very well in the regular commodity networks in our economy. Shops are great examples of well-contested middlemen that cause very little disruption in the economy. (In the misplaced and confusing language of regular neo-classical economics, this phenomenon is called “market competition”, although these shops operate primarily in network environments rather than markets.) Banking is much less subject to contestability and as such should be regulated much more forcefully. Self-regulation is clearly insufficient, as shown in the economic history of the 19th century and currently the Goldman-Sachs case.
Third, the Goldman-Sachs case shows moreover that the functioning of these networks is closely founded on very high levels of trust. Goldman-Sachs was trusted blindly by its client-investors, who followed its advice; even its institutional clients invested in these fraudulent products that Goldman-Sachs peddled. This trust was completely exploited through the alleged behavior in the case brought by the SEC. This case has major repercussions for the financial sector in general; they now have to purge themselves to rebuild this trust. This ideally implies the re-regulation of these networks and the punishment of certain parties. But this re-regulation has to be done with care; we do not want to have another major financial panic emanating from greedy behavior by financial middlemen in the next decade.
Recently there has been a small surge in the economics literature addressing the role of trust in the economy. Experiments have shown that trust is extremely important for understanding economic processes. Trust does not fit very well with the traditional concept of “homo economicus”: Rational behavior is not trusting. The building and confirmation of trust usually requires sacrifices of resources, contradicting the utility and profit maximizing hypotheses of the homo economicus.
The Scientific American recently posted an article that looks at the evidence for trusting behavior from behavioral economics, in particular trust experiments and brain scan evidence from neuro-economic experiments.
I want to add my own two cents worth to this. First, trust building is directly related to the functioning of socio-economic networks. The better the functioning of these networks and the denser these networks, the better the development and building of trust. This in turn forms the foundation for a better functioning economy. (A neglected aspect in traditional neo-classical economics.)
On the other hand, network building is firmly founded on the presence of trust and behavioral norms of trusting behavior. The higher the level of trust in the society, the better one is able to build and maintain social networks.
This two-way street between trust building and network building lies at the foundation of my research on networks. It now seems that more and more evidence confirms the justification of these and similar theories of network formation. Here I also refer to the recent work of Markus Mobius and his co-authors.