Quote of the day: Dan Davies on “microfoundations of macroeconomics”

In the “Bull Market” collection on Medium, Dan Davies writes:

The actual investment decision is carried out by a corporate manager. He wants to maximise his own income, so he is going to do what he thinks will generate a bonus for him. This depends on his boss, who reports to the corporate board, and who therefore wants to do what he thinks will get a bonus from them. The board are responsible to the shareholders, and it might be thought that the shareholders, at least, want to maximise profits. But actually, the shareholders are several levels of abstraction away from the actual investment decisions of the company. Most shares are held by fund managers, who want to beat the market, and who therefore want companies which do things which the rest of the market will value higher at a later date.

So, the investment decision, rather than being simply based on “what will maximise profits?”, is actually based on the manager’s perception of the CEO’s perception of the board’s perception of one group of fund managers’ perception of a larger group of fund managers’ perception of what the underlying owners of the shares are willing to pay for. There are six or seven levels of principal / agent problems between an already quite intractable profit-maximisation problem, and the individual decision-making agents who are meant to carry it out.

Seems like a pretty good summary of one of the big problems in contemporary economics right there.

Source: Dan Davies, “Microfoundations Ain’t So Microfounded“, 2015-01-28

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