The irrationality of markets

Great Debates
1

rational (adj) 1. Having or exercising the ability to reason.
2. Of sound mind; sane.
3. Consistent with or based on reason; logical

Many people have told me that markets are rational, meaning, in most cases, that markets can make decisions about various topics (prices, wages, quantities to be manufactured, etc…) in a rational way. Some hold this belief so strongly that they use the word “rational” to mean in accordance with the workings of the market. Hence some assert that it’s rational to charge the highest price you can get for a service, pay the lowest wages you can for your employees, choose the lowest available prices when buying an item, and so forth. I disagree. I think that all of those decisions can be highly irrational in certain circumstances. Further, I think that the widespread existence of markets compounds the problem and leads to peaks of irrationality far beyond what individual humans would ever reach.

Before looking at examples, I suppose I should explain what I do mean by rationality. As we see in the above definition, rationality is not defined by markets. Rational means in accordance with logic and reason. We start out with premises based on reason, and we use the rules of logic to derive conclusions from those premises. In order to have this discussion, we must agree that human reason and logic exist, are valid, and are not completely arbitrary. Since those who believe that markets are rational generally accept this much, that shouldn’t raise much controversy.

Then it’s possible, in theory, for markets to oppose rationality. For instance, we have a reasonable statement: 2+2=4. Anything contradicting this is unreasonable: 2+2=5, 2+2=3, 2+2 can be anything, 2+2 is unknowable, and so forth. Thus, publishing a book asserting that 2+2=4 is rational. Publishing a book asserting one of the other approaches to 2+2 is irrational, even if you can make a profit by doing so. (Not a purely theoretical question, by the way.)

Now let’s look at some serious violations of rationality by markets.

  1. Wages. Some professional athletes are, as Calvin’s Dad said, among the most overpaid people on the planet. Several earn more than $10,000,000 per year. Compare that to a brain surgeon earning about $300,000 per year. That’s irrational. A rational individual who needed a brain tumor removed and wanted to watch a baseball game would spend money assuring that they got the best brain surgery, even if it meant watching mediocre baseball players, rather than the other way around.

  2. The dot-com bubble. A classic example of “irrational exuberance”, this was when worthless companies such as furniture.com, priceline.com, theglobe.com, and kozmo.com, raised ridiculous amounts of money, sometimes in the tens or hundreds of billions, without ever having a sound business plan. If you actually read the IPOs of some of these companies, they clearly stated that there was little hope of them ever making a profit. No rational individual would ever sink a hundred billion into a company that was almost guaranteed to go bankrupt.

These cases and others, to me, disprove the claims that markets are rational. Discuss.

(A final note: this is not a debate about whether markets are morally right. That’s been debated in many other threads, and doubtlessly will be again.)

2

Markets don’t make decisions – people make decisions. Markets aren’t rational or irrational as you use the word. Markets are neutral. They are simply the process by which people obtain goods and services desired. I may think it’s irrational that my neighbor has a dog. Myself, I would never want a dog and don’t derive any pleasure from a dog. My neighbor, though, does derive pleasure from the dog and therefore it’s rational to my neighbor to own a dog. For me, it’s not. So is the market rational or irrational in providing a way for him to have a dog? It’s a ridiculous question.

As far as athletes and surgeons, that’s neither rational or irrational. It’s simply a measure of which one’s services are in greater demand. There are probably more brain surgeons than top level basketball players. More people desire the services of basketball players than surgeons. Therefore, basketball players (especially good ones) are in demand. It’s ridiculous to compare the wages of the two and say that it shows the market is irrational. Their wages are in no way comparable becacuse they offer two completely different services.

3

People are the only things on this planet that make decisions. To say that a market makes decisions is short-hand for saying that a market is a conceptual means by which a group of people makes a decision. The same is true for governments, religious bodies, charities, and many other institutions, yet we can talk about those insititutions taking certain actions.

The point of this discussion is that when markets come into existence, they lead to the group of people taking certain actions. In the state of nature, when primitive people wandered through the forest, eating poorly-cooked mammoth meat for dinner, there were no markets. A caveman sitting at the fire never said to his fellow hunter, “Thag, let us invest twenty billion dollars in a company that sells dog food online.” A market designates the machinery that allows certain actions to become possible. The stock market, for instance, gives people the opportunity to invest money in whatever corporation they choose. The question is, does that machinery lead to more rational behavior?

4

Even in caveman days there was a market. Og wanted some of Thag’s meat, so Og gave him a rock in exchange for it. That’s the market and that’s what exists – in much a more complicated form – today.

The market doesn’t make anyone more rational or less rational. It simply lets us buy whatever we want. Some of us want irrational things. The market lets us have it. Some of us think that people will want irrational services (kozmo.com, for instance). The market lets us invest in those irrational things. So what? To the person making those decisions, however, they are not irrational. They may be irrational in hindsight, but not at the moment.

So, again, I don’t think there’s a way to prove or disprove your contention. Markets themselves are not rational or irrational. They simply let people buy things. Your question should be whether or not the economic decisions of people are rational. That seems to be more along the lines of what you want to discuss.

5

I think part of the problem is that you’re defining “rational” differently than economists would define it. In economics, an action is “rational” if it’s the action that the actor sees as most likely to accomplish his ends. In other words, if we assume I like black pants better than blue pants, and (all other things being equal) I have a choice whether to buy black pants or blue pants, I’m acting rationally if I buy black pants and irrationally if I buy blue pants. Likewise, if I’m an NBA owner, and my main goal is to increase my team’s profits, paying a player $10 million a year is rational if by paying him that much money, we can win more games, thereby increasing the number of people who watch us, and make greater profits than if I didn’t.

But an action can be rational without being best for society, or even best for the individual.

6

But that isn’t how the decision of salary is made. If the surgeon decided tomorrow that 300K per year is not enough to live on, he has two options:

a) Shop his skillset to another hospital
b) Find something else to do

In either case, chances are that there are people lining up to fill the position. Not that being a surgeon isn’t difficult, but there are tons of very smart, very motivated medical students waiting to do surgical internships and fill his shoes. So, the surgeon is likely to find that no hospital is willing to pay him 10 million per year. Why would they, when they can hire another guy, just as qualified, 300K per year?

The baseball player has the same options. But, love him or hate him, Barry Bonds hits the ball out of the stadium quite a bit. There is no one who can fill his shoes. Thus, when he opts for option “A”, there is someone willing to pay him virtually whatever he wants.

To me, this is very rational. I would love to see a world where hitting a ball really, really far isn’t such a coveted ability. But, as long as there are fewer people who can do that than there are people who can navigate the brain with a scalpel, it will remain so.

7

And then Thag hit Og with the rock and kept the rock and the meat.

8

Let me address this, since others have debunked your first example.

The thing is, you can’t know in advance that “furniture.com” is going to go bust. Sure, there are a lot of whacky ideas that a lot of people can guess will fail, but how do you differentiate the EBays of the world from the Pets.coms? You can’t. So you try a bunch of things and see what works. The alternative is a command and control economy, like the old USSR had. That market was “rational” in the sense that you are using. Unfortunately, it leads to rationing, not growth and innovation.

If what your are saying were true, you’d be a billionaire from the procedes you made in the stock market-- picking out the winners and the losers in advance. So, unless you are, you’re confusing hindsight with foresight.

9

Markets are very good at filtering out optimal solutions, where they already exist, amongst a mass of suboptimal competitors, they’re even reasonably good at provoking obvious adaptation towards optimality, but they aren’t so good at making raw innovation happen. This isn’t meant to be a criticism, just an observation.

10

It is pretty easy to differentiate between a Dodo IPO and something sensible

  • the Dodo has no trading record and a P/E of about 400

I think the phrase was ‘total shareholder returns’

  • where the hype merchants tried to confuse ‘real returns’ and stock market hysteria

The simple rule is if something does not have a P/E of 20 then it is a waste of space, unless, and only unless one can see it getting zooming profits

  • the South Sea Bubble approach is just a chain letter
11

You have, of course, made yourself a billionaire with that “simple rule”, right? If not, why not?

That rule works reasonably well for mature companies, not for IPOs. And even then, there are plenty of mature companies with > 20 PE ratio that do just fine. You have to be able to judge their potential for future growth, not just plug in some one-size-fits-all formula.

12

You can talk about how the market (IYHO) made an irrational decision, I can come up with a dozen more examples of how people (IMHO) made irrational decisions. Of course, none of those individuals felt their decisions were irrational.

The free market, being a compliation of decisions by individuals, is going to show the characteristics of individuals. Therefore, if you think decision X is irrational, and enough people think it IS rational, then the market may show something you think is irrational.

13

Interestingly, or maybe not, both of the examples in the OP came up in a recent conversation that I started about the influence of advertising on the economy. It had occurred to me that advertising is only a means by which genuinely productive elements of the economy can enhance their place in the market. However you now have other elements of the economy who rely on advertising in order to exist at all - newspapers, magazines, free to air TV, all the internet “businesses”. During the conversation someone mentioned secondary benificiaries such as sport stars and how much they owe to marketting gurus.

14

Rationality in economics simply refers to the fact that individuals act rationaly, meaning that individuals do what is in their best interests. The product of this rationality, in classical economics is well functioning efficeint markets. Of course ther are plenty of caveats - free rider, public good, externality, game theory (prisoner’s dilemma) - which show that individual ratinality canlead to sub-optimal market solutions, these are more noted for being, although common, outside of the main focus of most markets.

Your first example is an age old paradox now as the Paradox of Value which is also commonly thought of as diamond-water paradox. Why are diamonds so much more valuable than water, which is obviously far more necessary for living. Because water is plentiful, compared to water. Because water is more readily substitued. Because water is easy to obtain, etc. It’s all about marginal valuation.

As for your contention that athlete’s are paid too much. That is hardly obvious and there were plenty of studies that I was aware of when I was in grad school (early 90’s) that actually showed that athlete’s were underpaid.

15

You ask a good question but unfortunately illuminate it with two poor examples.

As Gangster Octopus noted, sports stars are probably underpaid. That is, for most of the people deciding they wanted to be a sports star, looking at the amount stars are paid multiplied by the chances of getting paid that much, being a sports star is often an irrational choice. The top, most visible sports stars earn huge amounts of money but theres a huge pool of people who tried and came out earning nothing or even less than nothing. It’s impossible to really calculate whether it’s rational or not because you would have to put a value on prestige and following your dreams and future discounting but it’s certainly not a clear cut case of sports stars being paid too much.

The second example perfectly agrees with economic theory. Economics only claims that markets are rational in the long term. All the investors of Pets.com went broke, exactly like the market expects. Saying the internet bubble is an example of market failure is like saying evolution doesn’t work because the dodo went extinct.

But no, the market is clearly not rational. Almost no serious economist really contends that the market is perfectly rational. The main schools of thought seem to be:

a) Markets are not rational but the divergence from rationalistic models are small enough that rationality can be treated as a useful approximation (Austrian/Neo-classical Schools)
b) The markets do not follow rationalistic models but the models can be refined using key insights from psychology (Behavioural/Bounded Rationality schools)
c) Rationalistic models are seriously flawed at their conception and fail under all but the most basic conditions because the very foundations of the field are flawed. It might even be possible that most economic situations defy analysis as it can be proven there is no closed form solution to many economic problems. (This isn’t really a coherent group but they tend to come to economics as outsiders. Game theorists, psychologists, chaos mathematicians, evolutionary biologists and the like).

Theres evidence to support all 3 views. I wish I could find the link that I read this from but it’s possible to indirectly prove market rationality in certain markets. If a market is not rational, then there is scope for a rational player to enter and make a consistent profit leveraging these market oppurtunities. This process is called arbitrage. It’s impossible to prove arbitrage ahead of time but what can be done is to look at historical market data and see if certain arbitrage oppurtunities exist using a hypothetical seer who always makes the right choices. If you run this
over stock market data looking for certain types of arbitrage, how the market responds to certain types of news for example, you can show that the market not only reacts almost instantaneously, it reacts with almost uncanny accuracy as to how the news will affect the stock price. Since almost no arbitrage oppurtunity exists, the market can be classed as rational, at least for that particular factor. Apologies if I got any of the details wrong on this, this is all from memory.

However, it’s also fairly easy to construct situations in which is impossible to be rational. That is, in order for the market to be rational, each individual actor would have to possess a super-human amount of information and reasoning ability which scales super-linearly. In such cases, it’s simply not humanly possible to act rationally and you have to accept a certain amount of shortcutting which leads to systematic irrationality.

In other cases, it’s easy to prove via simple psychological experiments that the human brain does not calculate in a rational manner. I’ll skip the examples since I’m sure most people are familiar with them but the same parts of the brain that cause people to believe in the supernatural also causes them to act economically irrational.

Another indirect factor proving market irrationality is the prevelance of marketing & advertising. The most rigid rational theory predict that no advertising can exist at all since people will always make the most rational choice and no amount of advertising can change that a whit. More relaxed versions of rational choice allows advertising that informs since it reduces the cost of information acquisition but still predicts that advertising that tries to persuade is useless. The fact that marketing compromises about 9% of GDP in the US clearly suggests that this is wrong.

I’ll leave the stuff about how economic theory is flawed until tomorrow as this post has already grown long enough.

16

Actually, I’m under the impression that this wasn’t how it worked in caveman days. Admittedly our knowledge of their social structure is limited, but most accounts that I’ve read portray hunting, gathering food, and preparing other basic necessities as collective tasks, with the final products shared out equally among members of the tribe. We do know for a fact that ill and injured individuals were treated and cared for until they recovered; it’s unlikely that caveman medical insurance covered this. We’re moving up towards the dawn of civilization before we see trade as a way of life.

Here’s the big point, I think. I believe that the existence of the market makes us want more irrational things and to use more illogical methods to get them. Consider the parents who used to riot in shopping malls and break windows in order to get a Cabbage Patch Kid, a Tickle Me Elmo, or whatever. The market creates that behavior. First of all, the toys are designed and sold by people with a profit motive. Secondly, market forces drive up the demand to the point where parents will go to such extremes to get the toy. Such behavior didn’t happen before the existence of brand names, modern advertising, and nationwide distribution chains. If we can agree that turning violent over a doll is irrational, then we can agree that the market has made people irrational where they formerly weren’t. (In that particular case. Perhaps it other cases markets have made people more rational.)

17

From what I’ve been told by a stockbroker friend of mine, the stock market is often irrational. A mere rumor of something affecting a company’s fortunes can cause a wildly disproportionate inflation or deflation of the value of its publicly traded shares. An incipient change of government in a major country can, depending on whether the new government is expected to be more or less business-friendly than the old, depress or whip up the whole market. And this can happen even if no individual investor acts irrationally. I might, having researched the matter carefully, decide that the plaintiffs’ verdict returned this afternoon in the big class-action product-liability suit against Amalgamated Blivets will not significantly affect the company’s quarterly earnings – but I’ll still dump all my AB shares within fifteen minutes of the exchange opening tomorrow, because I expect all the other investors are going to react the same way; thus, it’s the only rational course for me; and such rational behavior by a lot of rational second-guessers produces an aggregate result that is wildly irrational.

18

Behavioral economics has shown that people often do not act rationally, where rationally is defined as being in their best interest as measured by classical economics.

Two examples. One study asked people to play a game, where person A was given a certain amount of money, say $10, some of which she was to offer to person B. Person B could either accept the offer, in which case it was split, or reject it, in which case neither got anything. Clearly Person B comes out ahead even if the offer was only a penny, but in practice (with real money) person B would refuse low offers.

Example two: The newly passed pension law makes 401K participation the default. This is a really good thing, since studies by Thaler have shown that making participation the default case dramatically increases participation rates. Explain that with classical economics!

My daugher and I (she just got an econ degree) have a paper coming out applying this to my little specialty. Some very odd habits of engineers only make sense when viewed in these terms.

19

I don’t have much to add since Gangster Octopus and Captain Amazing already stated what I was going to say: Markets do not behave irrationally. A market is really, simply stated, a bunch of people getting together to sell and buy stuff, i.e. trade.

Your latest observation seems to place blame on people supplying the market (e.g. vendors, suppliers, sellers, etc.) I reasonably observe this thought process in a lot of anti-market people (even though they might not outright state it). This is illogical, because these sellers would not be supplying the market if there was no demand in the first place.

Your Cabbage Patch Kids example illustrates that illogical thinking. The sellers in this market are at most times, guessing what the market wants. Does anyone rationally need a Tickle Me Elmo doll? With this thought taken to the extreme, no one really needs anything beyond their basic needs. It’s only because we have created enough wealth to actually invest in things that we want does demand cause us to act irrationally. That’s what I have to say in a nutshell. I have to go catch a train.

20

You surely are not claiming that each purchase during the bubble was made rationally, are you? If so, you might try to explain the Dutch tulip bubble rationally.

The alternative to a totally free market is not a command and control market, which works on even more inadequate information and is thus worse. It is a regulated market, for instance one like ours where trading is stopped at certain points to avoid panics. There is another threat to free markets, that of players with unequal information unfairly gotten leveraging it to corrupt the market. Freedome without regulation is just as much a fantasy as the existence of someone with perfect knowledge who can set prices optimally.