Understanding economic theories

Ari A. Perdana, Cambridge, Mass.

"The power to hurt can be counted among the most impressive attributes of military power. ... To inflict suffering gains nothing and saves nothing directly; it can only make people behave to avoid it. ... War is always a bargaining process ... (and to win it before starting, one must maximize) the bargaining power that comes from the capacity to hurt ... (to cause) sheer pain and damage ... (because they are) the primary instruments of coercive warfare."

Those are the lines taken from a 1966 book Arms and Influence. The author of the book, Thomas Schelling, a former Harvard professor now teaching at the University of Maryland, just recently won the Nobel prize.

Not for peace -- for economics.

Schelling shared the prize with Hebrew University's Robert Aumann for their influential work in developing game theory -- a branch of applied mathematics that is used to analyze interactions among individuals, organizations and even states.

While both are economic theoreticians, the name Thomas Schelling is likely to be slightly more popular outside of academia. Most of Aumann's works are purely academic, while Shelling had written books that are more "readable" for a general audience. In addition to Arms and Influence, he also authored Micromotives and Microbehaviors (1978) and Choice and Consequences (1985).

Schelling introduced the concept of "focal point." What he meant was a condition where interacting parties can naturally achieve a mutual agreement, even without any formal communication or interaction taking place. He arrived in this concept after observing that in real life, when bargaining each player would rather make a concession than fail to reach any agreement at all. And there are a wide range of outcomes that would be preferable to both of them than no agreement at all.

This is where the concept of focal point play a role, because parties should have intuitively perceived mutual expectations, shared appreciations, preoccupations, obsessions, and sensitivities to suggestion. Because such a focal point exists, each party may be willing to give some concessions to achieve a better outcome. This might explain why the threat of nuclear war during the Cold War era never really came into reality.

Schelling also popularized the concept of "credible threat". Uncertain retaliation is more efficient than certain retaliation when bargaining, and the capability to retaliate is more useful than the ability to defend, he wrote. He used this concept when advising the Pentagon during the Vietnam War. He said that a massive bombing campaign should send a message to the Communist not to intervene with the South.

But he added, any campaign should not last than three weeks, because it will either succeed by then, or it would never succeed. Ironically, the bombing campaign that started in March 2, 1965 did not stop the behavior of the North. Either they did not read the message, or the message was not credible enough.

Schelling continued to be a prominent economist, although after the 1970s he did not write much about war and armed conflicts. But he used and developed the game theoretical analysis to explain why there are racial segregations in housing areas in the U.S. big cities. Also, the theory attempted to explain what makes people keep sending Christmas cards to each other. Or even why the first attendance in a seminar tends to choose the seat in the middle or back row.

The fact that this is not the first time the Nobel prize has been awarded to game theorists suggests the growing importance of game theory in economics. In 1994, the prize was awarded to John Harsanyi, John Nash and Reinhard Selten. Three of them were considered as pioneering the analysis of equilibrium concept in game theory. Economists and mathematicians are familiar with the "Nash equilibrium", a condition in which someone making an optimal decision based on the other's optimal decision.

Traditionally, economic analysis always assumes that one's decision is independent to another's. Game theoretical analysis and the Nash equilibrium concept allows economic analysis to capture the fact that an individual's decision-making often influences others, and what is optimal under an individualistic assumption may not be optimal in an interactive assumption.

It is not an overstatement that game theory has improved economic analysis because it fills the gray area in economics resulting from some extreme assumptions. For example, game theory provides a tool to explain producers' behavior in oligopolies -- a type of market where there are some producers whose decisions are influencing each other. Oligopoly lies in between two extreme market types: Perfect competition, in which there is an infinite number of producers, and pure monopoly.

Game theory also bridges analyses of individual and group behavior, and helps analyze the behavior of decision making in politics. Why do individuals behave differently when they are in groups than when they are alone? Why does government policy not always reflect society's preference? And so on.

Economics has always been one of the most fertile grounds for game theory to develop. While game theory is also a powerful analytical tool for strategic and military studies, diplomacy, and even natural science -- the competition for mating in many species, for example -- it is economics where the application of game theory is the fastest.

One possible reason for this is that in the past two decades, economists become more interested in studying individual behavior and decision making. Since Gary Becker won the Nobel Prize for economics in 1992 after his influential work on explaining a wide array of human behavior, at least seven Nobel prizes have been awarded to studies regarding this issue.

This also includes the award given to Akerloff and Spence Stigliz in 2001, for their work on how individuals make decisions under conditions of uncertainty and then for Daniel Kahneman in 2002 (shared with Vernon Smith) for his work on integrating psychological insights into economics.

The growing interest of economists to study individual behavior makes in inevitable that this analysis is broadened into non-economic issues. Becker's works, for example, included the issues of discrimination, crime, political competition, even theories of marriage and suicide.

Not everyone is pleased with these theories, however. Some experts from other social sciences are already complaining of economists' arrogance, intimating that they are overextending economic theories to dominate other disciplines. At the same time, economics has also been criticized for moving away from its nature as social science because of its heavy reliance on mathematical models to explain things.

To this, Becker has a reply: Economics has its powerful tools and methodologies, he says, while other social sciences have interesting questions. So let the cross-discipline synergy continue, rather than be discouraged by cross-discipline fanaticism.

The writer is a graduate student at the Kennedy School of Government, Harvard University. He is also a researcher at the Centre for Strategic and International Studies, Jakarta.