How does cooperation take place when no one is explicitly in charge?

This article is based on the ECAA 2016 Exam.

“... there is nobody in charge. The entire vast enterprise of supplying shirts in thousands and thousands of styles to millions and millions of people takes place without any overall coordination at all…"

- From Paul Seabright’s The Company of Strangers: A Natural History of Economic Life

There are three important themes to understand when learning how cooperation works when no one is explicitly in charge. The first is decentralisation. This means the free market economy where the production of goods and services is not intervened by the government. The second is that price acts as a signal. Considering that price is an information carrier, price tells that a good or service has become more expensive, incentivising consumers to consume a substitute, for example. Third, the invisible hand (aka supply and demand) controls the market. Interactions between production and consumption decide the output level and price.

There are further assumptions to achieve the three themes. First is large numbers of goods, households, and firms. This is necessary to assume perfect competition and a perfectly free market economy. Secondly, firms are profit maximising and price takers. Firms base their decisions on profit maximisation, and price takers suggest that a single firm has a negligible influence on the economy. Lastly, consumers are utility maximising and also price takers.

Given this, economic cooperation can be explained by the Edgeworth Box and the concept of Pareto efficiency. Essentially, firms and consumers have no reason to deviate from Pareto efficient points. Although the Edgeworth Box assumes pure exchange between two goods by two consumers, the theory is still valid when producers/firms are introduced to the economy.

The above diagram shows consumers A and B’s indifference curves (I1 and I2). The further I1 moves to the right, the more increasing utility it is for consumer A. Similarly, moving I2 to the left will increase the utility for B.

Initially, A and B operate at the initial endowment allocation, Z, producing x1 and x2. If B moves to point Y, then B’s utility remains the same, while A’s utility is better off since its indifference curve is further to the right (A1 → A2). Thus, point Z is not Pareto efficient, as moving to Y is a Pareto improvement. A is better off without making B worse off.

Similarly, if A moves to X, then A’s utility remains the same. However, B is better off as its indifference curve is further to the left (B1 → B2). Thus, X is also a Pareto efficient point and a Pareto improvement from Z.

Thus, the point at MRSA = MRSB, is a Pareto efficient outcome; an economic change cannot make anybody better off without making someone else worse off. MRSA = MRSB is also a tangential point — the right of any Pareto efficient point is preferred by A, however, the left is preferred by B. Thus the tangential point X or Y is where no other allocation Pareto dominates.

No government had explicitly told consumers A and B to exchange at these Pareto efficient points. However, because consumers A and B are rational and utility maximising, they have no reason to deviate from the allocation.

Then, a contract curve, a line connecting all tangential/Pareto efficient points, is introduced. (refer to the yellow line of the diagram). It is also called a Pareto set because any point along this line will allow both consumers A and B to operate at Pareto efficient points.

Knowing that A and B will exchange only at these points, firms can then cooperate within this economy. No government told firms to produce certain goods and services at a certain output level. However, because firms are profit maximising, they will recognise the contract curve and predict the consumers’ behaviour. With predictable consumer behaviour, and price acting as a signal, firms know how much to produce, and thereby economic cooperation is possible in this decentralised economy.

Similarly, workers produce goods and services without knowing their final consumers nor being forced to. This is because knowing or not knowing their final consumers has no effect on their reward for labour. Also, firms did not force these workers for labour. Rather, workers are utility maximising, so the cooperation between firms and workers takes place with the exchange of money and labour.

In conclusion, the utility and profit maximising behaviour of consumers, workers, and firms lead to economic cooperation, even when nobody is in charge. Two consumers in a pure exchange system without production operate at a Pareto efficient point. Since both have no reason to deviate from the Pareto set, their behaviour becomes predictable. Firms then decide the output level with price acting as a signal. Finally, the exchange of labour and money allows economic cooperation between firms and workers.

This intuitive study of general equilibrium can further provide insights for the study of the fundamental theorems of welfare economics and microeconomic analysis.