Do Companies Really Act in Their Own Interests?

Economics 101 would make one think that all actors always act in their own self-interest and that that is what makes a free-market economy work so well. But deeper economic study helps you to appreciate that the reality is much more nuanced.

This is emphasized in posts today by James Kwak at The Baseline Scenario and Felix Salmon at Reuters. What they are saying confirms my frequent observation that economic actors — from individuals to large companies to governments — can do really stupid things that are contrary to their own self-interests, as well as to the benefit of society.

In his post “Why banks are self-defeating on housing,” Salmon discusses banks’ disinclination to move ahead with short sales (in the real-estate sense — in such a case, the sale price is less than the amount owed on the loan — see the Wikipedia entry on this kind of short sale), even though the bank will lose in the long run if they let the property go into foreclosure. The problem is the human disinclination to got through pain in the short term, even though they will benefit in the long run:

Bank executives, it’s worth remembering, are human. Every time you do a short sale, you take a substantial loss on your loan. And no one likes doing that: it’s painful. So it’s understandable, from a psychological perspective, that they will drag out the process as much as possible, putting off until tomorrow the pain they know has to come at some point.

In his post, “The Private Sector Fallacy,” Kwak makes a similar point about large companies in general. He points to three factors as to why that is so:

One [factor] is that big company executives are prone to exactly the same sort of cognitive fallacies as ordinary people, and hence make stupid decisions routinely.

The second is that the incentives of individual people who make decisions (or provide information to people who make decisions) are only tangentially related to the interests of the company as a whole, and certainly not when you think of those interests over the long term.

A third factor is simply that companies are big, dumb, poorly designed institutions.

In spite of these problems with the classical “invisible-hand” model of economics, says Kwak,

the belief that the private sector is the answer to all our problems remains deeply rooted. One might even call it an ideology. I would hope that the financial crisis (and the BP disaster) might cause people to question that ideology, at least a little bit.

AB — 30 June 2010