Waxing Theoretical: Social Capital and Markets

In principles level coverage in economics, we typically identify land, labor, capital and entrepreneurship as the productive resources an economy has to work with in order to produce output. Often we distinguish between skilled and unskilled labor and therefore include another type of capital - human capital (which reflects the augmenting of raw labor with education and on the job training, which improves the mental and physical performance of labor) - and in doing this we re-label the previous concept of capital as physical capital, in order to make the distinction among capital types clear.

Another resource that is arguably important, but overlooked in traditional economic theory, but which perhaps serves as a moderator of the excesses of markets in market economies, is what researchers call social capital. It is overlooked perhaps because it is not readily seen as a tangible resource or one that can be properly harnessed without having to make value judgments about right and wrong behavior.

In the context of markets, social capital reflects positive dynamics that exist between the human agents involved in production, which are not captured by market incentives, but which arguably has bearing on the production process.

More generally, social capital can be seen as an amalgam of several things that work together to ensure the continued agreement, by members of some civil society, with the social contracts that govern human interactions, and when maximally employed, allows society to meet the key objectives its institutions are designed to achieve, allocative and productive efficiency through markets being one of them.

In referencing social contracts one means the core agreement(s) that allow us to have whatever political and economic institutions we have in place. However, in institutions, especially in markets, because social capital is a fairly vague and intangible concept, existing only in the background as some nebulous process between the human agents involved in the production process it is not concretely accounted for and this creates the tension that societies tend to experience when workplace shirking is prevalent, income inequality increases, regulatory capture is rife, and social injustices seem to proliferate.

Social capital is not an economic resource that requires payment in the traditional sense, but it still has to be accounted for. As implied, it actually transcends markets by being relevant for all institutions, but it has to be provided for within each. Its nebulous nature makes it a resource that requires either prior policy mechanisms in place to ensure that it is provided for, or if those do not exist, some form of voluntary adjustments have to take place to reduce any perceptions of injustice if the institutions systematically create extreme outcomes not previously agreed to or envisaged under the social contract.

In market production relations, when employer and employee incomes/ earnings diverge considerably, perceptions of injustices come to the fore and are interpreted as a disregard for "humanity" implicit in the social contract. Failing to provide for social capital will tend to create distrust and destroy workplace relations, ultimately impede production, and lead to inefficiency in market outcomes.

To be clear, this is not an advocation for equality driven redistribution as, absent the underlying policy mechanisms that should provide for social capital, adjustments have to be voluntary and ideally should not reduce entrepreneurial incentives while at the same time it should boost worker productivity. It is somewhat akin to the payment of “efficiency wages” in traditional economic theory, but with the exception that such wages reflect a voluntary redistribution of profits to labor earnings and have no impact on prices or on entrepreneurial incentives toward creativity.

In economic theory efficiency wages are wages greater than the competitive value of the marginal contribution of the worker on the job. It is so called because it is a monetary incentive that is intended to raise worker productivity over what would normally obtain and reduce tendency to shirk on the job by making the job loss if caught shirking very costly to the worker. However in standard economic theory, the payment of such wages would generate unemployment, and result in higher product prices.

To motivate the relevance of social capital and the need for the adjustments it requires let us understand how the labor and entrepreneurial markets work.

In traditional theory we would expect workers wages to go up if they are able to raise their productivity or if the value of what they produce goes up. Usually in the case of the latter we would look at what is happening to the price of the product that is produced: If the price of that product goes up, then the value of what workers are producing also goes up. Business owners seeking to capitalize on that will therefore want to hire more workers in order to produce more. To do so they will have to pay higher wages to attract these workers, and because the workers have similar skills this will cause wages in general to go up.

Now switch gears to business owners' incomes or executive pay. In practice, especially with corporations, their value tends to go up when investors increase their demand for the stock of these companies (or when there is an increase in the purchase of their products, for all businesses in general). Focusing on corporations, such increased demand often follows reports of increased profits or expected higher earnings. Quite naturally the presumption here is that this reflects corporate choices or entrepreneurial innovation so that the rewards of this outcome tend to lead to higher executive pay (or dividend payouts to stock holders).

However this outcome, even if not reflected in their product prices going up, reflects some increase in the value of the corporation's product(s) and should therefore see an increase in workers wages, even though their marginal contribution on the job may not have changed. When this increase in workers wages fails to take place then we have a situation where social capital is not accounted for.

Now suppose you are still wondering if this is all contrived, think hard about this. Is it not interesting that when profits increase, the argument for the higher executive pay is their residual ownership of reward for assuming the risks involved in the corporation decisions that led to this outcome. Worker marginal productivity has not changed (and perhaps prices have also not changed), so there is no reason to raise workers wages. However when corporations suffer losses from same corporate choices, workers, whose marginal productivity has still not changed, lose their jobs as the corporation finds ways of mitigating the fallout from those wrong choices.

To the initiated, what it would look like I have described is not a new phenomenon in economics, and it is a well established concept - market failure. In the generalized illustration above we have the presence of market power preventing workers from being paid wages that reflect the correct valuation of their contribution. The difference though, and why I refer to this in the context of social capital instead, is that the price of the product may not have increased, so there is no overt market failure, however because the valuation of the output has actually increased, the other human agency involved in production - labor - should have resulting higher wages to reflect the upgraded value of their contribution.

The question then is since we cannot impose "voluntary" adjustments in incomes, how do we ensure that social capital is accounted for in practice? Some believe that having a minimum wage policy in place, and perhaps also capping executive compensation will be effective policies to achieve this. Are they right? No. Are there better options? Yes.

The economist is always going to be wary of price controls of any kind. Fundamentally they distort allocations by working against the price mechanism that in the world of economics is the greatest thing since sliced cheese. To think about how social capital arises to begin with, its nature, its contribution toward production, if at all any, we need to understand the concept clearly, and this is a nontrivial undertaking: social capital has been defined in many ways having roots in sociology, political science, and more recently in political economics that make it a very elusive concept to grasp and analyze.

Many of these definitions are similar or are attempts at getting at the same somewhat complex idea, and my goal will not be to necessarily reproduce any of these ideas or attempt to blend them but rather to provide my own sense of what this concept means so that we can assess its value for production purposes and determine how economies can contribute towards satisfying its contribution.

We have done the first part already, now let's work on the second.

Societal Organization

So, to proceed from how this idea has been conceived of in the paragraphs above, let’s think about how this concept arises. Labor and entrepreneurship are two fundamental resources that are embedded in human agents. In relationships among human agents, decisions have to be made, actions carried out, desirable group purposes accomplished. This, in most cases requires some leadership structure. Someone or group of people who assume that role of directing the course of action, assigning of responsibilities for different roles, and perhaps overseeing the activities and making decisions about changes in any of these in order to achieve those goals.

However it is also easy to see that in these settings the very nature of role delineation creates room for “power structures” to emerge. As with all institutions in which these types of structures are prone to emerge we tend to define good institutions as those which appear to have ways of addressing the possible conflict that could result as such conflict becomes an impediment in reaching the goals for which the institutions has been designed.

For example, in thinking about representative democracies as being good political institutions we often point to at least three assumedly important features: First, broad participation by the “ruled” in determining their leaders; second, separation of powers within the resulting multi-person leadership; and third, term limits for those in the role of leadership. However even in such settings, we still see the emergence of power structures that gradually shape outcomes to looking more authoritarian even though the institution still remains a democracy in name.

Power tends to corrupt, and absolute power corrupts absolutely (Lord Acton, 1887).

In free markets, this is no different. What is a monopoly? or what does concentrated market power (as in the case of oligopoly markets) mean? It means absolute power… in the production of a desired product and the resulting price that will be asked. Are markets fundamentally different from any other institutions? Perhaps not. When we choose to have a political arrangement in which we have people make decisions for the rest, we are allocating power to those who are behaviorally prone to taking up leadership positions for better or worse. When we choose to organize economically by markets, we are allocating power to those who are behaviorally prone to being entrepreneurial (or/ and who have a prior resource allocation that enables them to exert productive dominance over others).

Representative democracy requires this type of subjugation. Markets (i.e. employment relations) also require similar subjugation. However, in both, this tends to be OK, so long as there is no “in your face dominance” being experienced by those submitting. People will start to lose confidence in the democratic process if it systematically concentrates power and favorable policy outcomes to particular groups in society to the detriment of others. Similarly, people become disenchanted with markets when they observe very high levels of income inequality and limited or no prospects for upward mobility.

Humans for the most part do not mind being subjugated to others to meet a goal, and wisdom and strong leadership are admired and readily submitted to by most, but not usually willfully to the point of being dehumanized. Our capacity to tolerate such excesses, where they have occurred, and for long periods of time, even as they became very severe, has a lot to do with our resilience and this is often in tandem with two other things – the absence of a common voice of resistance and the threat of “pain” (retribution).

So how do these outcomes come to happen? Well in whatever way we wish to describe this, it is summarily called ingenuity. Political and economic ingenuity.

In politics one could surmise that interest groups seem to realize that there are huge gains to be made from organizing, and they incur the costs necessary for collective action and later reap the reward from being an organized voting block. Similarly, in markets, some would be entrepreneur discovers a production niche and works really hard at creating a brand that focuses on that desired product, and later on reaps the rewards from a prior period of painful sacrifice associated with creating and developing that product. These are just instances, not necessarily generalized, where we see how ingenuity comes into play.

Ingenuity is not bad. In fact it is a powerful underlying driver of economic growth. The problem is that ingenuity has the potential for creating the super human, the demigod, and this is where the conflict starts to brew. The super human craves adoration, the demigod wants to be worshipped. As a result, even with democracies that have striven hard to create mechanisms of inclusion by the polity and checks and balances within the leadership, political ingenuity exploits a weak link for the contribution of the polity through the presence of asymmetric information, and this is in the form of both adverse selection in leadership choice, and moral hazard in the performance of the leadership. This is how the power structures get formed and over time they tend to neutralize or greatly diminish the mechanisms of broad inclusion by the public and effectively reduce their contribution. The public could end up being “conditioned” to systematically making “wrong” choices and the so called democracy becomes authoritarian in effect.

Now let’s think about how this plays out in markets. For starters, if we do not have the analogous mechanisms that allow for participatory inclusion of most and for checks and balances we already have a problem. What will be the analogues of these in markets: They are Market Access and Market Competition. By market access I mean making present and affordable to individuals on the lowest rung on the income ladder the opportunity to acquire valuable resources needed for production. Such opportunities should always remain present at every rung on that ladder. I will expatiate on this shortly. By market competition, it is meant here that market power in all forms is absent. Any market power that is deliberately provided for as a policy incentive e.g. patents, copyrights, etc. should be limited, run their course and have no recourse for extensions of any kind. Again, I will expatiate further on this below.

All institutions are social contracts of some sort. As has been explained previously they are formed in order to achieve some goal while allowing for the recognition and respect of the parties involved. The humanity of the parties involved need not be violated in the process. Political institutions that effectively nullify the participation of the polity, and economic institutions that create extreme income inequality violate humanity because they unduly create superhuman classes that exert their will over the rest. This leads to a violation of the contract - an erosion of the social capital implicit in that contract.

Consider this illustration, when some rich CEO “decides” to unilaterally raise the wages of her lowest level workers by reducing her own income and benefits, she is implicitly saying something: I am also human as they are. While the value of my entrepreneurial contribution and skilled decision making may appear to be deserving of that much, the huge disparity may really reflect the presence of market power, or the inability of these low-level workers to access the relevant markets that allow them to move up on the income ladder. In effect she is making an allocation toward social capital through that action.

So I surmise that the way that societies can ensure that social capital is provided for in production, when we have chosen to organize by markets, is by providing market access and ensuring market competition, as opposed to any forms of price controls.

So what is market access?

Market Access

When societies agree to having markets allocate resources and production, they are making an implicit statement about the distribution of the resulting surplus or gains in the market. Those who value the product highly, usually in terms of their willingness to pay more than others, will get the products. Those who can produce the goods at lowest costs, get to produce the products. The initial distribution of “means” – whether for ability to pay, or for willingness to supply – thus biases the market surplus or gains toward those having more of those means.

So how do we address the allocation neglect that comes up for two composite groups within this society: first, those who are biased against, for whatever reason, by the initial distribution that exists (think about those perhaps previously disenfranchised, those who fall on hard times perhaps due to no fault of theirs); and second, what about those who come into that setting from outside of it? (think legal immigrants, asylum seekers, etc.). They will systematically be left out of the market allocations regardless of whether they intend to be on the demand or the supply side of the markets. Income inequality and consumption deprivation will tend to be rife for these individuals.

At the extreme are those who will advocate for social reform and call for more equitable redistribution. An offshoot of this is the perspective that suggests that expanding Welfare or/ and requiring a wage consistent with minimum living standards be paid by employers. This is not what I would call responsible policy intervention, and the main reason is because these are policies that do not exploit the incentives that markets work with yet they are imposed within market economies. The result is usually unintended consequences, which are well documented. On the contrary, ensuring Market Access will be a preferred policy that should blend well with market incentives.

Market access means creating credible opportunities for everyone to participate in relevant markets in such a way as to obtain fruitful returns - usually in the form of acquiring or accumulating viable productive resources that allow for significant net improvements in economic outcomes over short durations of time.

The details behind how this can be implemented will be fleshed out elsewhere but the idea is not new. We have similar structure in place here in the US, the design will however need to be more focused and perhaps the current incentive mechanisms in place changed, but the core structure will have free universal education through an optional two year vocational college education. Low rate student loans for four year and beyond college education, with disbursements on a semester basis, where failure to succeed in any semester defaults student back to the vocational college education program. From this program students can still get back on a four year program if they choose and will qualify for student loans based on meeting any one of two situations: high success on the vocational program or at least one year work experience utilizing the training received from the vocational program. Student loans will be disbursed for these individuals on yearly basis and continuity conditioned on success. This is the core structure but added dimensions can be designed to create proper incentives and ensure quality regardless of school district and at all levels. Ancillary packages to aid families that are steeped in poverty so that there is minimal distraction from education pursuits for members will also need to be included.

Such opportunities will also be available and designed to provide similar paths for success to legal immigrants, asylum seekers, and similar others coming into the setting.

As an economist one is not oblivious of two things to always never forget, the first being the cost of such a project (there is no such thing as a free lunch and the funds for this have to come from somewhere), and the second, being the unintended consequences that tend to dog social driven policies. I will also address these elsewhere, but for now I will take as a given that the costs associated will impose only a trivial deadweight loss to society, and that the design will mitigate possible perverse incentives.

The end result of this will then be a structure where upward mobility remains feasible with good faith effort at developing the relevant skills including entrepreneurial pursuits. This will allow for workers to escape more readily any oversupplied labor markets through attaining higher levels of productivity, resulting in raising their own wages, and the wages of those that remain in such now less crowded labor markets.

Workers can "vote with their feet" on jobs that they are dissatisfied with by accessing at a fairly cheap rate, the training required to make that change. Their already attained vocational training will serve as collateral should their attempt not succeed, and this will be nipped fairly early (after a semester, or a year, depending on their unique situation). Still these opportunities will remain available to them repeatedly but after meeting the not too burdensome requirements (paying off their short term debt).

This is a necessary contribution to social capital, in that it corrects for the status quo bias that markets pay heed to in making allocations, and sets most on a fairly general level playing field to succeed. Everyone can feel that the process is respecting of their humanity in that it makes good faith effort to reduce preexisting institutional barriers.

Now market competition.

Market Competition

This here is the analogue of providing the checks and balances that ensure that markets and the incentive for ingenuity do not create the monoliths that exercise market power and prevent the necessary entry that helps to both raise labor market wages, and keep corporation profits (and the entrepreneur's return) from being inordinately too high as to erode social capital.

In traditional economic theory the idealized market structure is the one that is perfectly competitive. This structure presumes that we have a market with many buyers and many sellers, where each seller sells the same type of product or resource. There are usually no barriers for additional would-be sellers to either enter the market to sell or to stop selling if they would prefer to do so.

We may also want to add that a few other technicalities to round this out: there is perfect information (no hidden private information about any aspect of what is on offer or what it will actually do when purchased), no externalities present (all benefits and costs associated with the production and consumption of the product or resource remain with the market actors), production reflects constant returns to scale (to put this in simple terms, there are no cost savings for society by locating entire industry production within a single business).

What this perhaps fictitious market allows us to do is to demonstrate why the market allocation is also going to be societally efficient. In other words our strongest argument for choosing to organize using markets hinges crucially on the market taking on a very restrictive form that arguably rarely holds in practice. Yet we still hold on to markets for a number of reasons, to name a few they include, first, the idea that markets even if not perfect are contestable. That is, the way businesses tend to behave even with costly and perhaps successful efforts to differentiate their products is still one where they act as if their market power is continuously under threat.

Another reason we hold on to markets is that we have permitted some role for the government to iron out the kinks - there is antitrust regulation (laws passed by Congress and enforceable by the Department of Justice and the Federal Trade Commission that try to ensure that monopolies and monopoly-like behavior are prohibited, and that collusive (price fixing) behavior in markets with few firms does not take place etc.), there is regulation to correct for the presence of externalities, to try to reduce asymmetric information in the market, and to limit the exercise of market power in industries where it is indeed cost effective to locate entire production within a single business.

The point of this section is to point to the fact that looking across the US business landscape today it is clear that for some reason or another the reasons advanced above are weak. The force of ingenuity in markets continues to push hard and what we see for the most part are industries that are highly concentrated (that is, with few firms that dominate most of the production within that production niche). Tacit collusion is arguably present in most of these industries rather than competition, even if it appears on surface that they are competing (there is a reason it is called ingenuity). Regulatory capture - the situation where regulation is in practice at the behest of the regulated industries and for their interests - appears to be pervasive. We therefore have not just a failure for markets in achieving efficiency but the resulting erosion of social capital as the market surplus is systematically distributed away from the majority to a select few.

Market competition therefore as advanced in this article means the restoration of true regulation in the market place that seeks as best as possible to replicate in practice the fictitious market that should deliver on efficiency. Interestingly because such a structure also provides for analogous checks and balances, it contributes to social capital by both ensuring that market access, as discussed earlier, allows for workers to easily switch to entrepreneurs, without facing barriers to entry perhaps from predatory pricing, threats etc. and by limiting how quickly prices and profits can rise thus preventing incomes from diverging too quickly.

Bringing it all Together

Easier said than done. The purpose of this piece is not to achieve some type of dramatic reform that sees wholesale changes in government policies and regulation aimed at creating market access and fostering true market competition. That of course would be great if possible, but I am also a realist. What I hope this piece does is to highlight two very important things

First, that markets are great! Markets are not just this tool devised by some ruling class of elites to subtly extract wealth under the guise of claims that markets allow us to avoid waste. They are a very powerful allocative device with incentive mechanisms that encourage and promote continued economic growth. Whatever their failings it is not so much that markets are by themselves bad, as it is more that we must still provide vigilance over any institutions we create. We can't create robots and let them run loose. Markets are a creation of ours, we must provide vigilance to ensure that they do operate freely within the bounds that allows them to achieve not only efficiency but continuity in the social contract that permits the relationships inherent within markets.

Second, that vigilance for the most part falls within the purview of the government, and a good government is itself a process in which social capital also plays a role. I have not gone into the details of this, as that is a whole different animal, but I have alluded to this in the discussion above where democratic institutions were contrasted with markets. The point is, our policy interventions - to provide market access and market competition - will only be as good as the political institutions we have in place as policy is inherently a political process. So perhaps the starting point for this whole reform thing begins with political will - the will by those currently in power to ensure that the public's participation in the democratic process is meaningful, and that there is true separation of powers that occurs within the government.

The bottom line then is this. In rethinking what makes up our productive resources, we need to include social capital. It is however a concept that exists within any institutional structure we have in society, so it has to first be provided for within political institutions, and then it has to be provided for within markets. Within markets, it is provided through creating credible market access and ensuring genuine market competition.