I was reading Bob Murphy's Chaos Theory, some of which I agree with some I don't. But I came across an interesting point that he seemed to glance over.
The framework is insurance companies would offer insurance against property damage. These companies would find that they can decrease the risk of damage from foreign invasion (and thus payout) by providing defense services (ie. a military). As long as the savings generated by providing the defense is greater than the cost of doing so, we will have a military provided on the free market.
Now, I agree with all of this, but he touches upon a game theory problem and then doesn't address it.
If a firm does do this and successfully lowers the risk of invasion. Competitors could enter the market and take advantage of the new lower risk of invasion. Because they are not paying for the defense themselves, they could offer cheaper premiums and undercut the original firm. Of course once they do this they bankrupt the firm that is providing the defense and the risk of foreign invasion goes back up to the original level, thus premiums would have to rise.
To me the market equilibrium seems to be that no firm would actually pay for defense services because they would risk bankruptcy by competitors that can free ride and offer cheaper premiums.
Murphy says that insurance companies might use long term contracts to try to avoid this problem, but i'm not sure if that would work.
Is there anyone who has a strong knowledge of game theory who can offer up a solution? Specifically, what the market equillibrium would be in this case?
Just a note, I'm not looking for people to say "that's for the market to decide" - that would be obvious. I'm looking for an economic answer.
At least he wasn't a Keynesian!
Wow, this is a good question. I suppose we can say that everyone knows this outcome, too, and since they don't want to be invaded, a marginal decrease in premium is not worth an action that they know will lead to invasion...but of course, the game theoretic answer is obvious. The Nash equilibrium here is that everyone will defect because their own cooperation is not enough to keep the defense providing firm in business. However, maybe we don't have to view it as a one-time game? Maybe we can use reputational arguments to keep people from pursuing the Nash outcome? I'm not sure.
However, let's say there's no game theoretic answer, and it does tend to the Nash equilibrium. What then? This certainly would mean that Murphy's answer is wrong, and instead we'll have a field of insurance companies offering payouts in the event of invasion, but not preventing it. Well, those payouts would mean nothing, because we all know we're not going to get paid once this happens. So, no one would buy insurance (under the same assumptions that got us this far.) So the field is now empty, creating the possibility for a firm to try again...
Have you tried asking this to Murphy?
Chris Pacia:. Competitors could enter the market and take advantage of the new lower risk of invasion. Because they are not paying for the defense themselves, they could offer cheaper premiums and undercut the original firm.
A quick answer would be that, although free riding is always available, it is not always available to public knowledge. The public may not be willing to take the chance on free riding benefits or even know that they have the option to free ride. For example, if you have a duplex home and one side of the duplex buys fire insurance, while the other side refuses, then one side could free ride off of their benefits. However, if it is demonstrated that the noninsured side will be burmed down first, or the fire company will not risk going inside after you and your family, or that you will be held responsible for rebuilding your side of the home, etc, etc. the individuals may purchase the insurance.
Still, the neighbors need not know what each other is paying per month. Therefore, why not factor in a free-riding discount whereas the second party would pay a smaller premium (we see this often in other services. The taxi cab may give a discount to someone on the return trip to the airport since the individual who left the airport has already covered their expenses of the ride. The costs of providing the extra services are already low and thus the fee may be discounted).
Finally, the real point missing is that premiums may rise and fall, but not equally across all the populations. For example, imagine a gated community where the house in the middle of the community wants to free ride off the houses on the edge of the gate.
Yet, they only want to free ride at the communal rate, maybe not the discounted rate. The insurance companies could offer the houses in the middle of the community a discounted fee based on their geography (meaning the home prices may be higher since the insurance costs are lower), since they are by definition easier to insure.
Another point is that if the homes are financed by banks, the banks may require the owners pay a protection agency premium.
Read until you have something to write...Write until you have nothing to write...when you have nothing to write, read...read until you have something to write...Jeremiah
Chris Pacia:The framework is insurance companies would offer insurance against property damage. These companies would find that they can decrease the risk of damage from foreign invasion (and thus payout) by providing defense services (ie. a military). As long as the savings generated by providing the defense is greater than the cost of doing so, we will have a military provided on the free market.
More likely outcome would be that communities hire defense services separately from insurance, then enjoy the likely benefits of lower property insurance premiums resulting from it. This way anyone can get whatever insurance they want or forgo it completely.
Z.
JAlanKatz: Wow, this is a good question. I suppose we can say that everyone knows this outcome, too, and since they don't want to be invaded, a marginal decrease in premium is not worth an action that they know will lead to invasion...but of course, the game theoretic answer is obvious. The Nash equilibrium here is that everyone will defect because their own cooperation is not enough to keep the defense providing firm in business. However, maybe we don't have to view it as a one-time game? Maybe we can use reputational arguments to keep people from pursuing the Nash outcome? I'm not sure. However, let's say there's no game theoretic answer, and it does tend to the Nash equilibrium. What then? This certainly would mean that Murphy's answer is wrong, and instead we'll have a field of insurance companies offering payouts in the event of invasion, but not preventing it. Well, those payouts would mean nothing, because we all know we're not going to get paid once this happens. So, no one would buy insurance (under the same assumptions that got us this far.) So the field is now empty, creating the possibility for a firm to try again... Have you tried asking this to Murphy?
I tend to agree with you...while this framework appears to work with only one firm, i'm not sure it's sustainable in a competitive environment. And i'm not sure if it solves the free riding problem with military expenditures. Anyone else have any thoughts?
Defense is not a public good
Peace
I hate to click my own suggest as answer button...
First of all, there is no definitive answer. Many good arguments have been put forth here: that defense would not be a one-time game, reputation of the protecting firm would skyrocket, when faced with the choice to be invaded or agree on premiums its hard to see how an agreement could be impossible, gated communities, separate service providers, etc.
I forward an other argument: defense is a losing game. Buying a single F-15 SE, to assume a rather decent, but not spectacular, aircraft, would cost well over 100 million bucks, and whatever numbers you buy an enemy with three times your number of F-16 could wipe you out. Plus you’d have to buy an AWACS, ground stations, ground radars, missiles, spares loads of fuel for training alone and I’m not even talking of a ground force. No premium could pay for that.
Bottom line: armies do not work, form the economical point of view. The whole conception that Murphy has of ‘defense services’ falls to the ground.
That’s how I assume firm would find it profitable to discourage foreign invasion:
* reduce premiums for client owning a weapon (guerilla warfare, yum-yum)
*reduce premium for clients with military training
*buy friggin’ nukes and pledge to use them on whoever uses military force on your clients ( public good bye-bye)
*accept x% of your premium payment in the potential invader’s currency: people will start to print like crazy and the other guys economy will go south within the year.
There are all low cost alternatives to buying armies. And they work much, much better. In the real world that’s how I thing it would be played.
Chris Pacia: If a firm does do this and successfully lowers the risk of invasion. Competitors could enter the market and take advantage of the new lower risk of invasion. Because they are not paying for the defense themselves, they could offer cheaper premiums and undercut the original firm. Of course once they do this they bankrupt the firm that is providing the defense and the risk of foreign invasion goes back up to the original level, thus premiums would have to rise. To me the market equilibrium seems to be that no firm would actually pay for defense services because they would risk bankruptcy by competitors that can free ride and offer cheaper premiums. Murphy says that insurance companies might use long term contracts to try to avoid this problem, but i'm not sure if that would work.
The even bigger problem is that for the defence providers the rational course of action in face of an imminent huge invasion is to flee. More.
scineram: The even bigger problem is that for the defence providers the rational course of action in face of an imminent huge invasion is to flee. [url=http://rationalargumentator.com/issue91/Steele_reviewChaosTheory.html]More.[/ulr]
before I follow your link does the article you promote address how individuals who form the states military do not face the same incentives to flee as would their private counterparts?
Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid
Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring
Just briefly mentions, but it does.
scineram: The even bigger problem is that for the defence providers the rational course of action in face of an imminent huge invasion is to flee. More.
It hurts form a nationalist point of view, but one must give credit to the abominable Serbs when they deserve it: check out how even nation-states with brains but no money tackle these objections (bolds mine):
“The Federal Republic of Yugoslavia evolved a variant of the Warsaw Pact force structure and doctrine during the Tito decades, designed largely to discourage a Warsaw Pact invasion of the ilk seen in Hungary and Czechoslovakia, in 1956 and 1968 respectively. Comprehensive national service and an ongoing reserve scheme were developed, and strong mechanised land forces, patterned on the Warpac model, were built up. A large network of underground tunnels, bunkers and munitions caches were developed, exploiting the cavernous sedimentary geology of much of the region. Were the FRY to be invaded by the Warpac, its forces would vanish into heavily wooded areas and into various bunkers and tunnels, and wage a protracted war of attrition aimed at inflicting a maximum of casualties. Unlike flat Hungary, or heavily urbanised Czechoslovakia, the mountainous and largely rural FRY would subject the Warpac to a much more intensive repeat of the doctrine developed to fight the Axis during WW2. “
I'm sure everyone here is already thinking of privately efected policies along these lines.