INTRODUCTION

This chapter pursues the key theoretical idea of this book: An institutional equilibrium can be destroyed or transformed by rapid belief changes in the population. The changes in electoral beliefs in the period prior to the election of Lincoln in 1860 and the commencement of the Civil War are examined in an attempt to understand the political transformation that occurred at that time, as well as its ramifications to the present day.

As observed in Chapter 2, Riker (1980) in his book, Liberalism against Populism, argued that Lincoln's success in the 1860 election was the culmination of a long progression of strategic attempts by the Whig coalition of commercial interests to defeat the “Jeffersonian–Jacksonian” Democratic coalition of agrarian populism. Riker adduced Lincoln's success to his “heresthetic” maneuver to force his competitor, Douglas, in the 1858 Illinois Senate race, to appear anti-slavery, thus splitting the Democratic Party in 1860. Riker also suggested that electoral preferences in 1860 exhibited an underlying “chaotic” preference cycle.

However, these accounts do not explain why the slavery question became paramount from 1858 to 1860. I suggest in this chapter that U.S. politics, from 1800 to the 1840s, can be interpreted in terms of a single land—capital axis that sustained the preeminence of an agrarian coalition, first created by Jefferson, of both slave interests and free labor. Lincoln's strategy from 1858 to 1860 was to persuade free labor in the northern and western states that they were threatened by the consequences of the Dred Scott decision by the Supreme Court in 1857.

Four decades ago, William H. Riker published Federalism: Origin, Operation, Maintenance (1964). Riker's motivation in writing this book came from a question that he had raised in his earlier book, Democracy in the United States (1953) about the origins of Federalism in the United States. His argument was that only an outside threat could provide the motivation to politicians to give up power by joining the Federal apparatus. His later book, The Theory of Political Coalitions (1962), also attempted to answer the question why plurality rule in the U.S. electoral system seemed to be the reason for both minimal winning coalitions and the two-party system. A further book, Positive Political Theory (with Peter Ordeshook, 1973), attempted to develop the theory, available at that time, on two-party elections. The convergence result presented in that volume was later shown to depend on unrealistic assumptions about the dimension of the space of political decisions. Later, using the so-called “chaos theorems,” Riker returned to the historical questions that had earlier intrigued him and suggested that manipulability and contingency were features of democratic systems (Riker, 1982, 1986, 1996).

Riker's work provides the motivation for this book and for a companion volume (Schofield and Sened, 2006). The formal theory of elections and coalitions, together with empirical analyses of elections in Britain, the United States, Israel, the Netherlands, and Italy, makes up that coauthored volume. This present volume addresses many of the historical questions raised by Riker, using as a conceptual basis the formal electoral model presented in the companion book.

THE RATIFICATION OF THE CONSTITUTION

A constitution is almost a living entity, but it also incorporates institutional features, “the rules of the game in a society, or more formally the humanly devised constraints that shape human interaction” (North, 1990: 3). Much more important than the rules themselves is the conceptual basis for the acceptance of these rules. To use the terminology of game theory, the beliefs that underpin the constitution must themselves generally be in equilibrium. That is, under “normal” circumstances, the rules of the constitution are grounded in what I have called a core belief. This is not to assert that the core belief remains unchanged during normal times; if change does occur it will be gradual. In extraordinary times, however, the core belief is fractured in some fashion, typically because of the realization that the society is faced with a deep “quandary.” Such a quandary may be due to an inconsistency, internal to the logical structure of the core beliefs, or to a disjunction between the core belief and some external aspect of social reality. When society faces a deep quandary, then mutually incompatible beliefs may population the society; very often a new equilibrium is attained only in the aftermath of war.

The core belief will generally consist of a number of components, and if one of these is called into question in a profound fashion, then the belief in the relevance of the entire constitution may fail. For example, as Chapter 7 observes, the events of the Depression during the 1930s cast doubt on the belief in the compatibility of the free-market system and democracy.

INTRODUCTION

A constitution is a system of rules and beliefs that governs the behavior of a society or family of societies. The heart of a constitution incorporates the fundamental core belief, or a set of beliefs essential to the constitution. The “Atlantic Constitution” is the family of constitutions (both written and implicit) of the member states of the “Atlantic Coalition” together with those rules and understandings that govern interstate behavior. A quandary for a constitution is a situation where the core belief is destroyed, either because of an empirical disjunction or because of a philosophical or theoretical inconsistency. The key episodes in British and U.S. history (circa 1668, 1776, 1787, 1860 and 1964) discussed in this book can be seen as quandaries for their respective constitutions.

I contend that the periods leading up to 1944 and 1982 were also associated with constitutional quandaries. The quandary of 1944 was generated by the incompatibility of the economic equilibrium theorem and the events of the Depression. I suggest that the key insight of Keynes' The General Theory of Employment, Interest and Money (1936) was his denial of the relevance of the equilibrium theorem for asset markets. This insight allowed Keynes to conceive of a new core belief, involving a reconfiguration of both citizen rights and economic efficiency.

The post-1944 “Keynesian synthesis” may have perverted Keynes' insight. This macroeconomic synthesis led to a retreat to an economic equilibrium perspective that proved, by the 1970s, to be invalid.

INTRODUCTION

One way to understand the logic of the Declaration of Independence is to attempt an estimate of the costs and benefits and plausible subjective probabilities associated with various outcomes that could follow from the Declaration. While it is true that a general belief that “taxation without representation is tyranny” gained ground in the colonies in the period after the end of the Seven Years War in 1763, the studies that have been carried out do not appear to give a realistic account of the motivations of the British and American decision makers. In particular, in declaring independence, the members of the Continental Congress expressed a willingness to accept the great costs of war. To simplify greatly, each member of Congress should rationally compute the expected costs of war after such a declaration (say qC, where q is the subjective probability of war, and C the subjective cost) against the expected costs of the status quo (involving the probability that the British intended tyranny, T being the cost of this tyranny). I give a more precise form of this calculation below. Presented in this fashion, it is evident that unless the magnitude of T is very high, then an “expected utility maximizer” would not choose independence. An alternative way of interpreting this decision problem under risk is to regard the absolute value of T as some prize to be gained by the Colonies through a successful prosecution of a Revolutionary War. I argue that avoidance of taxation is simply inadequate as a sufficient prize.

This chapter investigates incentives in firms. We explore the hidden action problems of a modern corporation. Section 1 compares firms in several leading industrialized countries. Section 2 examines the relationship between two senior executives who share the firm's profits and is followed by a brief look at the relationship between the owner and employees in an owner-managed firm (Section 3). The rest of the chapter is devoted to the hidden action problem confronting a widely dispersed group of shareholders whose objective is to have the firm that they jointly own maximize the value of their shares. Can they rely on the board of directors to provide the appropriate incentives to the company's management team, even though it is extremely costly for the shareholders to monitor the management and the board members themselves?

A BRIEF TOUR OF SEVERAL COUNTRIES

We are primarily concerned with the attempt of a firm's owners to obtain a satisfactory return on the capital they supply to the firm. The owners provide financing through the purchase of shares in the firm and also when the firm uses retained earnings for replacement of, or addition to, the capital equipment. Firms also borrow financial capital, and in many industrialized countries bank loans are a much more important source of finance than in the United States. All of the firm's suppliers of finance wish to ensure that management runs the firm in a way that brings them a high return. We refer to this as the agency problem.

A successful institution, whether large or small, must coordinate the activities of its individual members. In this book, I examine the incentives at work in a wide range of institutions, to see how—and how well—coordination is achieved by informing and motivating individual decision makers. Incentives work well when they result in a high level of individual welfare generally. This is problematic because each individual acts to maximize his or her individual payoff, regardless of the implications for the welfare of others. In other words, we examine incentives to determine the extent to which they prevent the pursuit of self-interest from being self-defeating. We look at an entire economy, as well as a single firm in that economy. Even two-person institutions receive attention: a car owner and a mechanic hired to repair the car, for instance. In all cases, a satisfactory outcome requires coordination among the participants, and coordination requires information transmission and motiv ation, as shown in Table 1.1.

The individual members of the institution cannot do their part unless they receive information telling them what their roles are. In the case of a market economy, much of the vital information is transmitted by prices. In a wide range of situations, the consumer's budget constraint and the firm's profit motive give the respective decision maker the incentive to use the information embodied in prices in a way that enhances the welfare of all households.

This and the remaining chapters investigate hidden characteristic problems, from voting to used-car markets to kidney exchanges. We see that market forces have spawned contracts and other devices that induce agents to reveal their hidden characteristics. This does not mean that the equilibrium outcome is efficient in each case, however. There are incentive schemes that do induce truthful revelation of the hidden information while at the same time bringing the system close to efficiency—the Vickrey auction of Chapter 6 for instance.

Markets are wonderfully creative in circumventing hidden information problems. Warranties on consumer durables provide a nice example of the market system generating its own solution to a hidden characteristic problem. The producer of a shoddy appliance cannot afford to offer a substantial warranty. The point of producing a low-quality item is to get more profit by keeping costs down, but if many appliances are being returned for refund or repair then costs will be high, not low. A producer who deliberately sets out to profit by misleading consumers about the quality of the product will not be able to offer the same kind of warranty as the producer of a high-quality product. The producer of the high-quality item is signaling high quality to the consumer by offering a substantial warranty. Reputable manufacturers often make good on a warranty even after it has expired, as long as the appliance is returned a month or less after the expiration date.

This chapter examines allocation problems for which the scarce resources are available only in discrete units, such as dormitory rooms, and each “consumer” wants one unit and only one unit. The objective is to match students with rooms, or available kidneys with the patients on a waiting list for a transplant, and so forth. The entire family of matching problems can be subdivided in two different ways. We can classify according to the nature of preferences. On one hand, suppose that an economics department has a given number of students (i.e., majors) and professors, and the objective is to assign each student a professor-advisor. In this case both sides of the match have preferences: Students like some professors better than others, and the professors also have preferences over the students. On the other hand, there are matching problems for which only one side of the match has preferences: Students have preferences for dormitory rooms, but the rooms don't have preferences for students. A matching problem for which only one side has preferences is referred to as an assignment problem. The objective is to assign students to rooms, for instance.

The other way to classify matching problems is according to whether we can have an outcome in which some agent is matched more than once. In the case of college admissions, each student will be matched with at most one college, but each college is matched with more than one student.

This chapter continues the exploration of hidden characteristic problems, with attention confined to the problem of preference revelation in the presence of a good that can be consumed jointly and simultaneously by the whole community—a fireworks display, for instance.

Agent A's action generates a positive spillover if some other agent B benefits as a result of that action. For example, if A removes weeds from A's own property, then neighbor B's grass will have fewer weeds because one source of seed has been eliminated. In this case, most of the benefit of A's effort is reaped by A, so we say that the spillover is incomplete. However, if C produces a fireworks display then everyone else in town will have just as good a view of it as C. The spillover is complete in that case. When the agent creating the spillover benefit is not compensated for the positive effect on the welfare of others, we refer to it as an externality. Important examples include the containment of a virulent disease by a health organization, the retardation of global warming or ozone depletion by international treaty, and publication of information concerning public safety.

Our aim is to provide the individual decision maker with incentive to consider the benefit that others derive from his or her actions. The decision maker can be a single individual or household, or a region within a country, or even a country itself.

This chapter examines decision making by a community (or any group) in a simple model: The community must choose from a finite set of mutually exclusive alternatives. (The next chapter endows the model with much more structure by specifying individual utility functions and a production function—and resource constraints. The utility functions will have classical economic properties.)

We look at situations in which a group must make a decision that will be binding on all of its members. For example, a class has to determine a time for a review session, a town has to decide whether to build a new school, a nation has to elect a legislature. The resulting choice will have no other implications for personal consumption—in this chapter. Think of the alternatives X, Y, Z, and so forth from which a choice is to be made as alternative ways of spending a fixed amount of government revenue, with the same individual tax burdens in each case. In this setting we can't rule out any ranking of the available options as a possible preference scheme for a member of the group. This makes it very difficult to induce truthful revelation of the hidden characteristic, which in this chapter and the next is the individual's true preference scheme. We want the individuals to reveal enough information about their preferences to enable the system to select the outcome that best reflects those individual preferences.

This chapter examines a hidden characteristic problem of great significance: We take an economy-wide perspective and ask if there is a mechanism that will elicit private information about individual preferences and firm production recipes in a way that allows an efficient allocation of private goods and services to be identified and implemented. We assume away all other hidden information problems. In particular, every consumer is assumed to know the quality of every firm's output, every employer knows the abilities of every prospective employee, every lender knows the probability of default of every creditor, and so on. Every manager can be relied on to maximize profit. In fact there is no shirking by anyone.

The economy still has an impressive challenge—to induce truthful revelation of the remaining hidden information, specifically the preferences and production functions. In fact, three of the five sections even assume away this hidden information problem, highlighting instead the transmission of information. Recall that an outcome is efficient if there is no other arrangement of production and consumption activities that makes one person better off without lowering the utility of anyone else. Identification of an efficient outcome would seem to require an enormous amount of information about all of the private characteristics. Therefore, even with most of the hidden information problems assumed away, identification of an efficient outcome by the market system is a remarkable accomplishment. Marginal social cost pricing is the key.

This chapter and the next investigate the extent to which an agent can be motivated to act in the principal's interest when the principal cannot determine whether the agent has in fact taken the appropriate action. Agents' behavior is problematic because their goal is to maximize their own utility. The next chapter is devoted to the specific hidden action problem of motivating workers and management in a firm, with the latter receiving most of our attention. This chapter examines a wide variety of other issues. In many of these the principal is a surrogate for society as a whole, and the principal's utility is maximized when the agents—the producers and consumers—are all motivated to do their part in contributing to an efficient outcome.

As with all hidden information problems, there are hidden characteristic elements as well as the hidden action element. In fact, some of the topics could have been presented as hidden characteristic problems. For instance, we could study resource allocation from the standpoint of inducing consumers to reveal their hidden preferences and firms to reveal their hidden production technologies so that an efficient outcome can be identified. However, the approach taken in the first section is that of inducing each individual to choose a bundle of goods and services at which his or her marginal rate of substitution equals that of the other consumers.

I am pleased to have this opportunity to express my appreciation to the following students and colleagues who assisted me at various stages: My former students Hanley Chiang, Ryan Mutter, and Sita Slavov discovered some glitches in the first edition and brought them to my attention. My current students David Hansen, Jonathan Kuzma, and Emma Murray helped me fill in many of the boxes that connect the theory to contemporary events, and Matthew Draper did some preliminary spadework for Chapter 9. I am grateful for the superb diagrams produced by Carrie Clingan, a student in the Masters in Public Policy program at William and Mary. Jerry Kelly of the Syracuse University Economics Department made copious comments on early drafts of Chapter 7. I have benefited from the insightful comments of Ed Nelson of the Tulane Economics Department, John Weymark of the Vanderbilt Economics Department, and David Ellerman of the World Bank. My colleague and coauthor for two undergraduate texts, Alfredo Pereira, taught me how to write textbooks. I express my deep gratitude to these people. I assume responsibility for any errors in the book.

It is a pleasure to acknowledge the support and encouragement of Scott Parris, the economics and finance editor at Cambridge University Press, and the diligence of his assistant, Brianne Millett. My readers will benefit significantly from the finishing touches of my copy editor, Nancy Hulan. Renee Redding, of TechBooks, did a first-class job of guiding me through the production process.

Auctions have been used for more than 2500 years to allocate a single indivisible asset. They are also used to sell multiple units of some commodities, such as rare wine or a new crop of tulip bulbs. There are many different types of auctions in use, and far more that have never been tried but could be employed if we felt that they served some purpose. The aim of this chapter is to determine which type of auction should be used in a particular situation. Accordingly, we need to determine which bidder would get the asset that is up for sale and then how much would be paid for it.

INTRODUCTION

When the government sells things at auction—treasury bills and oil-drilling rights, for instance—the appropriate criterion for determining which type of auction should be used is the maximization of general consumer welfare. Because the bidders are usually firms, we recommend the auction type that would put the asset in the hands of the firm that would use it to produce the highest level of consumer welfare. Fortunately, this is correlated with the value of the asset to a bidder: The more valuable the asset is to consumers when it is used by firm X, the more profit X anticipates from owning the asset, and thus the higher the value that X itself places on the asset. The individual firm reservation values are hidden characteristics.