There is an equilibrium concept in Financial Economics referred to as ‘Pareto optimality’. Whenever an economy is in a Pareto optimal equilibrium, no one can be made better off without some other person being made worse off.
Whenever an economy is in a Pareto optimal equilibrium, that equilibrium, which only can exist in presence of a Nash theoretic game equilibrium (see below for definition), is the best equilibrium attainable for all agents involved in a specific market interaction.
By the way, a Nash Game Equilibrium is not an exercise in cunning, or falsehoods. In spirit of sports, it is called a game only because it involves two parties whose objectives can be conflicting, e.g. workers and shareholders; two different political parties in midst of an election season etc. The objective of a Nash Game is not ‘winning’, it is arrival at a state within which both parties can look at each other and say,
“we both have done as best as we could. This is the best we both can attain to without the other being unhappy. Why not let things rest so we both can focus on enjoying living of life.”
Why is a Nash Game Equilibrium not about winning? Each party to the game is willing to be satisfied with outcome attained, which while it may not be the best possible outcome, is an outcome that ensures the other party will not continue to agitate for change. Given absence of desire for continued agitation works both ways, conditional on existing parameters, both parties are satisfied with outcomes of their negotiations.
It is well established that Pareto optimality can contradict value maximization by firms (Stiglitz 1972). It is the case then that market mechanisms that function on value maximization do not necessarily guarantee that the best societal equilibriums always are achieved.
In presence of devotion to value maximization, some segments of society can be left behind. Pareto optimality is about value optimization, not value maximization.
Increasingly, American capitalism is deviating from attempts at establishing of Pareto optimal equilibriums, to attempts at establishing of value maximization equilibriums. This is evident for instance in the fact that it is ridiculous for a firm making over US$1 Billion in profits yearly to not pay a living wage to the lowest paid permanent or full time worker.
Within context of Pareto optimality, an equilibrium characterized by a living wage for lowest paid full time workers, and profits of US$900 Million dominates the equilibrium characterized by profits of US$1 Billion and a non-living wage for lowest paid full time employees.
How is this the case and how is this not contradictory to maximization of shareholder value?
There exist two complementary rationales — a Nash Game specification violation rationale, and an arrival at a ‘less than fully rational’ behavioral — power game — equilibrium rationale.
First, the Nash Game specification violation rationale.
Within context of a Nash Game, Party A to a negotiation does not have the power to specify Party B’s payoffs. This implies shareholders cannot specify workers’ minimum payoffs. Minimum payoffs for workers are specified by living wage conditions. Shareholders can pay more than a living wage, they cannot pay less.
By the same token, workers cannot specify shareholders’ minimum returns. Minimum returns are specified by returns that enable shareholders earn back their costs of capital. Shareholders can demand a return higher than their cost of capital.
If shareholders demand a return that violates the minimum living wage implied by cost of living parameters, they attempt to alter workers’ payoffs. Under such conditions, interactions between workers and shareholders no longer can be modeled as Nash Game Equilibria. The interaction devolves into a Power Game equilibrium.
It is not impossible that Labor Unions lost out in America because they attempted to turn a Nash Equilibrium game into a Power Game. But two wrongs do not make a right. It is equally wrong for employers or shareholders to turn what ought to be Nash Game interactions with workers into a Power Game.
Next, the Less than Fully Rational Equilibrium
Whenever there remains cash available for investing, investors invest in all projects that generate a positive return on capital. Investors, however, never accept a project which, a priori, will generate less than their cost of capital. For lowest paid workers, working cannot be construed to generate positive returns on capital if wages cannot facilitate payments for all needs that ought reasonably to be accommodated by a living wage.
Since some capacity for saving is a normal good in financial economics, a living wage ought to incorporate some capacity for saving.
If rationality of shareholders demands they never accept projects that do not generate a positive return on capital, it cannot be fully rational for same investors to demand workers accept full time positions that generate negative returns on capital, in contexts within which the lowest wage that generates a positive return on capital merely induces a decrease in shareholders’ returns of no more than say, a proportional 10 percent.
For illustration, for most publicly quoted companies, payment of a living wage to lowest paid full time workers likely decreases shareholders returns from no more than an hypothetical 20% to about 18 percent.
If shareholders insist on a return of 20%, they impose a specific desired return on their firms, act behaviorally for maximization, as opposed to remaining committed to their own principle — rationality of returns that exceed costs of capital for all agents in society.
Shareholders can be rationally behavioral in demand for value maximization in contexts within which full adherence to rationality implies commitment to value optimization.
A society which demands lowest paid full time workers accept non-livable wages because a 20% return for shareholders is more attractive than an 18% return, in contexts within which the cost of capital is much lower than 18%, lives on precipice of social upheaval.
While a wage that is less than a living wage can be a rational behavioral outcome — a take it or leave it attitude to wages of lowest paid workers — it is well accepted in financial economics that such Rational Behavioral equilibriums never are as good as Pareto optimal equilibriums that are outcomes of arrival at Rational Expectations equilibriums. Rational expectations implies investors believe in positive returns on capital in all of their activities. Rational expectations implies lowest paid workers expect to earn a living wage from full time employment. Given workers are able to generate positive returns on capital from a living wage, and shareholders are able to generate positive returns from paying a living wage, the rational expectations equilibrium generates a Pareto optimal Nash Game Equilibrium within which profitability is optimized and optimal.
Within context of rational expectations equilibriums, only in contexts within which investors cannot by paying a living wage arrive at positive returns on capital, can a lower than living wage for lowest paid full time workers be justified. Given returns generated by all companies decrease in presence of institution of a market wide minimum living wage policy, a minimum wage policy cannot serve for disenfranchisement of any one company. Only companies already paying minimum living wages serve to benefit.
But do these companies not deserve such an outcome?
It is well established that within context of functioning of markets, Rational Behavioral equilibriums never yield equilibriums as good as equilibriums generated by Rational Expectations of all agents (Milgrom and Stokey, 1982).
It is not rational expectations for companies to set their hearts on a specific return on capital (a power move), then work backwards to pay non-living wages (application of power moves) for arrival at target returns.
Rational expectations equilibriums always are forward looking, never backward looking, never outcomes of backward induction. Never outcomes of power moves (specifications of desired returns) that induce violations of other agents’ rational expectations (minimum living wages).
Rational Expectations equilibriums are rooted in Financial Economics as best feasible market equilibriums. Rational Expectations equilibriums ensure Capitalism with a Human Face is predicted best rubric for a capitalist society.
Capitalism with a Human Face is not Socialism, is rooted in theories of best functioning capital markets.
Based on existing theories of financial economics, Capitalism with a Human Face trumps hands down, Hedonistic ‘Power Move’ Adaptations of Capitalism.