PART IV.

SOCIAL FORCES

CHAPTER 11: Social Forces: Selfishness or Altruism

RECALL: Three Key Economic Ideas:

1. People are rational
2. People respond to incentives
3. Optimal decisions are made at the margin

HOMO ECONOMICUS
● John Stuart Mill - 19th century economist
● Also known as the “Economic Man”, is a figurative rational human character who:
- attempts to maximize utility as a consumer and economic profit as a producer;
- pursues wealth for his own self-interest; and
- avoids unnecessary work by using rational judgment.
● Used as a basis for the majority of economic models, where economists assume that all human
beings are 100% rational.
● “Economic man” is unswervingly rational, completely selfish, and can effortlessly solve even the
most difficult optimization problems.

*The economic man is only used in economic theories and models. The economic man is the ideal
decision-maker and a master of rationality, as he has been cut-off of some of the complexity of human
behavior. That is why even though he is a useful tool, a lot of economists still disagree. Using the
economic man on some models will make it nonsensical as it disregards how people actually behave and
the fact that people have limited or bounded rationality.

Bounded rationality - the idea that we make decisions that are rational, but within the limits of the
information available to us and our mental capabilities.

Self-Interest Theory
- suggests that humans are ALWAYS selfish and will always make a choice that will please them.
- supports the evolutionary argument that human beings are naturally selfish creatures,
programmed to pursue their own interest. In order to succeed in the struggle for survival,
humans always look for what is “number 1”.

FAIRNESS, RECIPROCITY AND TRUST

- suggests the importance of social rules for influencing decisions and economic behavior.
- it challenges the assumptions on the “Economic Man” and “Self-Interest” theories of classical
economics.
- behavior is often a reaction to intentions of other people. If someone is kind to us, we have a
desire to return favour. If someone is mean, we want to retaliate – even if it is personally costly.
(Rabin, 1993)

Ultimatum and Dictator Games

Ultimatum Game
● Responder - will accept any positive amount
● Proposer - will make the smallest possible offer
Observations:
1. Contrary to the maximization of their self-interest, responders reject positive offers.
2. Proposers’ behavior may indicate a taste for fairness as they, on average, send more than the
minimum offer. Proposers may behave strategically and offer more than the minimum if they anticipate
the retaliation of the responders.

Dictator Game
● Receiver - has no decision to make
● Proposer - can send nothing at all unless he cares about fairness

The Trust Game

● Self-interested trustees - will return nothing
● Investors who has no zero trust to the trustees - will send nothing to begin with
* If there is trust, all players can potentially be better off.

SOCIAL INFLUENCES MATTER

How social preferences might impact market competition and optimal contract design

Competition in Markets
● We can’t understand how competition impacts market prices if we ignore the effect of fairness
● Modified Ultimatum Game - similar to a good market with one seller (the proposer) and multiple
competing buyers (the responders)
- since everyone in the market knows the value of the good to everyone else, the
seller should set the price at the buyers’ maximum willingness to pay (which is same for all buyers)
- seller takes all the gains
● Competition among buyers is not expected to change the price (since both buyers and sellers are
self-interested, the seller is already setting the highest price possible)
● Competition among buyers doesn’t give the seller more power
Incentives and Contract Design
● Stockholders want to design contracts that would best motivate managers to act in the owner’s
best interest
● workers respond to wage offers that are viewed as generous or fair by working harder than
predicted by models of self-interested agents.
● Workers may perceive incentives negatively by thinking it as an indicative of distrust
● Fehr and Simon Gächter - there is a tension between motives generated by fairness and reciprocity
and those generated by material incentives.
● Workers may respond to explicit incentives with hostility.

CONFORMITY
- compliance to a set of standards
- behaving in accordance to socially accepted standards
- when people conform they give to real or imagined social pressure

Testing Conformity
Asch’s Experiment - found that student participants conformed to an incorrect majority about one-third
of the time. Three-fourths of the students conformed at least one time.
- has been replicated many times. Since the level of conformity
changes over time, psychologists believe that conformity reflects social norms and culture.
Groupthink - extreme form of conformity
- can happen in a small group who are insulated from outside influences
- members of the group begin to think alike, showing loyalty and suppressing
Dissent
- groups thinks they are invulnerable and ignore relevant information

Obedience to Authority
Milgram’s Experiment - Participants were more likely to disobey the experimenter when other subjects
in the room also disobeyed, the experimenter left the room, the learner and teacher were in the same
room, or there were two experimenters giving conflicting direction.

SOCIAL BEHAVIOR AND EMOTION

Through research using FMRI, evidence that emotions and social interaction are inextricably linked have
increased.
Neuroscience - investigates the social brain which is the neural circuitry that operates when we deal
with other people.

FMRI on Ultimatum Game Participants

● After scanning the ultimatum game participants using FMRI, heightened activity was observed in
the limbic system when unfair offers were rejected.
● Limbic system being the part of the brain involved in a person’s behavioral and emotional
responses makes it clear that emotions won the argument.

SOCIAL BEHAVIOR AND EVOLUTION

● A person can always act in terms of his own, narrow self-interest. However, evolution favored
people who were cooperative and equitable in exchanges.
● Evolution may favor reciprocal behavior because groups that are pro-social outperform groups that
are not.
CHAPTER 12: Social Forces at Work: The Collapse of An American Corporation

CORPORATE BOARDS
Corporation - a legal entity separate from its founders or owners
- life is not limited
- shareholders have limited liability
Securities and Exchange Commission (SEC) - its mission is to protect investors, maintain fair, orderly,
and efficient markets, and facilitate capital formation.

Benefits of a Corporate Board

● Corporate boards advise and counsel executives and provide discipline to managers.
● Having a corporate board is one way of mitigating conflicts of interest between managers and
shareholders.
● A board of directors that is responsible for monitoring management may be an efficient solution to
the agency problem. If shareholders trust the board, they may indicate their trust by investing in
the firm.
Free rider problem - arises when some shareholders shirk their responsibility to monitor, assuming
others will monitor managers

Types of Board Directors

1. Insiders/Inside directors - managers or executives of the company
Advantages:
- privileged access to firm-specific information
- dedication to the firm
- better expertise relating to the firm’s activities
2. Outsiders/Outside directors - members of the corporate board who are not employees of the
company
Advantages:
- broad background
- independent evaluations
- shareholder orientation

Outside Directors
● Studies reveal that it is more advisable to have a majority of outside directors in a corporate board.
● Evidence suggest that outsider-dominated boards more often produce outcomes that are
consistent with the interests of owners.

It’s a small world

Six degrees of Separation Theory - In 1929, Hungarian author Frigyes Karinthy published a volume of
short stories named Everything is Different. In one of his stories titled Chains, he said that with growing
communication and travel, the friendship network would grow irrespective of the distance between two
humans. And with a growing social network, the social distance would shrink immensely. All the people
on the planet could be connected to one another by 5 or fewer people.
Directors, Compensation, and Self-Interest
Little White Lies
• People view it as harmless
• Used to mold the impressions others have of them
• May actually be viewed as beneficial if they smooth social situations
• PROBLEM: often lead down a slippery slope to harmful deception

Directors and Loyalty

• Loyalty is valued by people and may be particularly valuable in business relationships.
• Loyalty might have important consequences in the boardroom if directors are prone to blindly
follow the CEO.
• From research we know that the impact of loyalty can be mitigated by encouraging dissenting
opinions, a diverse board, and truly independent directors.

ANALYSTS
What do professional analysts do?

Security analysts
• Are information intermediaries.
• They assimilate a great deal of information and provide recommendations concerning
investment opportunities
• Analysts consider information from financial statements, trade shows, the press, conversations
with corporate executives, and other insiders.
• In some cases they make recommendations (strong buy, buy, hold, sell, strong sell) regarding
whether a stock should be purchased, with recommendations being discrete.
• Analysts also provide forecasts of future performance, including earnings and growth rates.

Three types of professional analysts

1. Sell-side analysts
● Typically employed by brokers, dealers, and investment banks.
● Often their reports are used to attract investment banking business to the firm.
2. Buy-side analysts
● Usually employed by large money management firms, including mutual and hedge funds and
insurance companies.
● These reports are usually generated for internal purposes.
3. Independent analysts
● Not associated with any large investment or money management firm.
● They provide independent research, and their firms generate earnings through subscriptions or
fee-based research.

Do Analysts Herd?
➢ Research shows that when the uncertainty surrounding a firm they follow is low, analysts tend
not to be too optimistic.
➢ When uncertainty is high, however, analysts are less concerned about harming their reputations
and are not so afraid to issue optimistic forecasts.
 ● Irrational herding, another type of intentional herding, refers to behavior that is driven by
irrational belief or sentiment.
● Rational herding is a situation in which market participants react to information about the
behavior of other market agents or participants rather than the behavior of the market, and the
fundamental transactions.
● Social Learning
○ People learn through observing others’ behavior, attitudes, and outcomes of those
behaviors.
○ “Most human behavior is learned observationally through modeling: from observing
others, one forms an idea of how new behaviors are performed, and on later occasions
this coded information serves as a guide for action.” (Bandura).
○ Social learning theory explains human behavior in terms of continuous reciprocal
interaction between cognitive, behavioral, and environmental influences.

ENRON
● The bankruptcy of Enron is the second largest bankruptcy in US next to the failure of Worldcom
● The leaders of Enron Corporation were known for their hubris ((excessive self confidence)) and
unparalleled arrogance

The Performance and Business of Enron

● Enron Corporation was formed in 1985 by Kenneth Lay by the merger between Houston Natural
Gas Co. and Omaha-based InterNorth Inc. Around that time, the natural gas market was
deregulated and with its large pipeline network, Enron benefited. The firm diversified into natural
gas trading and later applied its trading model to other markets.
● The company is at its peak in the year 2000 when they are trading at $90.75 per share. By the end
of 2001, the company’s stock only worth $0.25.
● Enron’s stock price from 1990 to 2001, compared to S&P 500 stock index does not seem to suggest
that Enron’s price experience prior to 2001 was particularly out of the ordinary because the market
as a whole was bullish.
● In addition to stock price, a commonly reported performance measure is the P/E ratio. At the end
of 2000, Enron’s P/E was 68 and S&P’s P/E was 37. Clearly Investors were willing to pay a high price
per dollar of current earnings to acquire Enron’s stock.
● Evidence suggests that Enron’s management engaged in numerous questionable accounting
practices.
● Enron created hundreds of special purpose entities (SPEs). Some were used to hide foreign income
from US taxation and the other were used to hide huge amounts of debt financing.
○ What is a SPE?
■ A shell created by a sponsor and financed by independent third parties.
● Under current accounting rules, Enron was not required to consolidate their financial statements
as long as an independent party had an equity stake of 3% of the SPE’s assets. Enron used large
amounts of debt to finance the activities of the SPEs, and their principal asset was Enron stock.
Shareholders may not have understood that Enron had taken on huge amounts of debt. When the
stock price fell, the assets of the SPEs could not cover the debt, and Enron was then forced to take
over the debt.
● Another practice followed by Enron involves fair value accounting. With mark-to-market
accounting, the value of a position is fairly easy to estimate if market values are observable. All
models need inputs and managers are expected to make reasonable estimates, but it seems that
Enron executives only picked those taht are attractive to the eyes of the investors .
The Directors
● The directors of Enron seemed to rubber-stamp (meaning to approve without proper
consideration) anything management brought before them. In 2000, their average compensation
for serving on the board was $380,000, among the highest in the U.S.
● Along with the two CEOs of Enron during this time, the company have 15 external directors. These
external board members had much experience and significant expertise and though they were
classified as external, we do not know for sure that they were truly independent. It appears that the
standard that the board should have a majority of outsiders was satisfied.
● Another feature of the board structure that stands out is that the board was relatively large, and
research suggests that in many cases small boards are better because the directors are more
involved. These board members did not seem to be particularly involved or question information
brought forth by executives.
● In the end, the directors did not get away without penalty. Their reputations were tarnished and,
perhaps, can never be reclaimed. In 2005, 10 of the directors agreed to a settlement in litigation
brought by shareholders. Though board members are normally protected by insurance paid for by
the firm, in this case they actually had to pay $13 million out of their own pockets.
● As outsiders ourselves to the board room, it is difficult to assess the extent to which self-interest,
loyalty, and groupthink affected directors’ behavior, but it certainly seems likely that these
behavioral forces played a role. It is a challenge for future research to isolate and measure the
impact of these effects on decision-making.

The Analysts
● During the time leading up to Enron’s bankruptcy, analysts continued to be optimistic about the
firm. Even after the SEC began inquiring about conflicts of interest at Enron, the average analyst
recommendation was buy or 1.9, where 1 = strong buy and 5 = strong sell.
● The evidence is consistent with conflicts of interest among analysts. They may have been optimistic
because of the large investment banking fees generated by Enron. Even analysts that were
employed in an investment banking firm that did not currently do business with Enron would have
been subject to these conflicts of interest because there was always concern about future business
relationships.
● Since the dot-com boom of the 1990s, sell-side analysts have received a great deal of attention. The
SEC implemented Regulation Fair Disclosure (Reg FD) in an attempt to to prevent selective
disclosure by publicly traded firms to large investors. According to the regulation, firms must
disclose material information to all investors, large and small, simultaneously. Later in 2002, the
Sarbanes-Oxley Act (SOX) was signed in response to corporate scandals such as the Enron
bankruptcy. In SOX, there was a requirement that walls be established between analysts in research
and a firm’s investment banking arm. The goal was to promote increased public confidence in the
research reported by analysts.

Other Players in Enron’s Downfall

● The directors and analysts are not the only players who have received blame in the fall of Enron. In
the hype of the dot-com run-up in stock prices, investors seemed to focus entirely on short-term
gains. Executives seemed to care a great deal about the short run, possibly because a significant
amount of their compensation package was in terms of stock options.
● As what will be discussed in the next chapter, if investors are irrational, managers may be in a
position to benefit from temporary gains in stock prices and can pursue actions that cater to the
desires of such investors.
● Enron’s auditor, Arthur Anderson, readily accepted Enron’s business model and method of
accounting. The financial transactions were complicated, but it is an auditor’s responsibility to gain
the necessary level of expertise and exercise skepticism. Perhaps Anderson’s partners were blinded
by the huge fees earned.
● In 2000, Anderson earned $25 million in audit fees and $27 million in consulting fees from Enron.
In 2002, Anderson officials were found guilty of obstructing justice based on its shredding of Enron
documents, and the firm voluntarily gave up its licenses to practice accounting. In 2005 the
Supreme Court overturned the conviction of Anderson.

Organizational Culture and Personal Identity

● Everyone loved Enron, including its employees, the investors, board members, and analysts. Even
as losses mounted, many analysts and investors remained optimistic about the firm.
● In recent years, Wall Street researchers have been overwhelmingly enthusiastic about Enron, even
as though they do not understand the complex financial transactions that accounted for its soaring
profits. Now, Enron is reporting steep losses from some of its most complicated transactions, which
many on Wall Street still can’t figure out.
● The firm had a unique corporate culture. Employees of Enron were very loyal to the firm. They
thought their firm was invincible. Earlier in this chapter we discussed the perils of loyalty. Loyalty to
an organization can be even more dangerous than loyalty to a person.
● According to Milgram: Each individual possesses a conscience which to a greater or lesser degree
serves to restrain the unimpeded flow of impulses destructive to others. But when he merges his
person into an organizational structure, a new creature replaces autonomous man, unhindered by
the limitation of individual morality, freed of human inhibition, mindful only of the sanctions of
authority.
● One crucial lesson exemplified by the fall of Enron is that it is important for any person in any
organization to keep a separate identity. Whether a member of a board, an analyst providing
information about a firm, an employee, or a stockholder, it is important to take a step back and
make an independent evaluation of the situation at hand to avoid being pulled by social forces.