The irrationality of markets

Great Debates
41

You did not read my post carefully:

   'unless, and only unless one can see it getting zooming profits'

As it happens just over a year ago, I was at the launch party of a company I used to work for.

The company had been highly successful, and the flotation had gone extremely well. It is a great shame that I traded in my options in 1992 in exchange for kit and software rights.

However, from things I know, I would never advize anyone to invest in that company, the party doubled as a leaving party for some, and a reunion for the rest, of the ‘old guard’ that built it.

On the advice of her stockbroker, my stupid and wealthy mother, invested in a load of ‘new paradigm’ stock - she lost a bundle. She refused to listen to me.
The stockbroker is well known in the UK - he used to be a guru - and now turns up in vitriolic letters from people who have been shafted.

The trouble with making money on the stock market is that you need to start off with reasonable capital, and it takes time. About six years ago, I put my money where my mouth was for a year, I did Ok in a falling market, but lost interest when I had a personal upheaval.

Incidentally, Warren Buffet appears to share my view.

  • being from the UK, I had barely heard of the ‘Sage of Omaha’ when I came to my conclusion.
42

Thats a nice textbook definition and all. The only problem is that it’s never actually used like that in the real world because it’s has virtually no predictive power.
With a statement that general, you can’t actually use it to prove or predict anything. Any useful definition of rationalism is going to have to include assumptions which can be attacked as not reflecting reality.

43

Grr… I was always rather peeved at the reporting of this research because it was always presented as some groundbreaking. paradigm shifting piece of knowledge rather than being perfectly in line with everything we know about game theory for the last 20 or so years.

Yes, the classical, Von Neumann style game theory predicts that the most “rational” choice of action is to accept $1 and that you should always defect in a prisoners dillema but classic game theory also assumes that people are unaccountably stupid and don’t have a memory. If you assume all actors have a memory, then the optimal solution to the prisoners dillema is know as “tit for tat”. That is, you co-operate with the other person until he stops co-operating and then you defect.

Studies such as the one you mention above are simply logical extensions of this new style of game theory and are perfectly rational.

44

There was one interesting catch in that one

  • whether one trusted the policeman making the offer

You may be interested in this, when I was at college, a guy called Parfitt presented a paper to us. I’ve never heard of him since, but he was recognized as a very smart cookie.

He merged Von Neumann Game Theory with Richard Dawkin’s The Selfish Gene

He used colonies of birds on islands, and their mutual grooming ‘rules’ as the example

He divided them into groups, I may get some wrong.

Suckers - those that groomed others regardless of whether they were groomed in return
Cheats - those who got groomed, but did not groom back
Grudgers - those who groomed first, but only if groomed back in game two
Retaliaters - those who did not groom first, but groomed back afterwards

I can’t remember whether there were any more categories - I don’t think so
If birds are groomed, they prosper, if not they get ill and snuff it

The jist was that Suckers and Cheats would die out, Cheats would initially prosper, but they would run out of Suckers.

Retaliators would co-exist with Suckers and Grudgers, but risked looking like Cheats

Grudgers would wipe out Cheats

  • ergo Grudgers (or Tit for Tat with an optimistic first game) were the only viable ones

There was a punch line, Cheats could always fly off to another island and leech on the Suckers in another colony.

I found that a fascinating model, beautifully simple, yet full of implications.

For example, why do kids ability to learn languages trail off around their mid teens ?
To make switching tribes difficult ?

With a little nudging, the Von Neumann model can be used to explain the existence of Law (certainty of outcome), and Parfitt grafted on evolution.

45

Congratulations, you have rediscovered “transaction costs.” They exist and are well recognized in economics. In making any decision, like changing jobs or moving, you must take them into account. This does not make the market or the bargaining process unfair. Employers have transaction costs as well, such as searching for and training a replacement employee should you leave. Your skill set largely determines the extent of these costs.

46

If the brain surgeon had a good enough fastball, and could bat .300, he would get the 10,000,000. If the athlete could do brain surgery, he could change his team nickname to “Doc”.

Tris

47

You’re broadening the definition of “market” to include almost anything. This example is not a true market, unless you believe that a rival parent may jump in and say, “Don’t listen. I’ll give you two cookies for a clean room.” Families are not markets. They are, ideally, small-scale communist dictatorships. The parent or parents make all the decisions: they apportion labor, distribute resources, and crush any rebellion against their authority. If a father does offer a cookie in exchange for room-cleaning labor, they’re presumably doing so to teach the kid about responsibility, not because a cookie is the market-determined wage. The father could just as easily order the kid to clean the room and give nothing in return.

I don’t believe that markets necessarily reflect human nature. In many cases they oppose it, which is what I started this thread to discuss. As I’ve just demonstrated, humanity’s fundamental institution (the family) is not market-based.

48

Okay, I guess I need to admit that I’ve conflated two different questions in this thread. The questions are:

  1. Do individuals act more rationally in a market scenario versus a non-market scenario, or less rationally?

  2. Does the market as a whole produce results more rational or less rational than what indvidual human beings produce?

So here we’re addressing question 2. You say that it’s “quite rational” for the sports stars to get paid better than the life-saving doctors. I say it’s quite irrational. Now, based on what you wrote, it seems that you’re using defining “rational” as being in accord with what the market produces. But as I stated at the outset, the definition of rational does not mention markets. So here’s my chain of thought:

  • An individual would put higher value on the brain surgeon than the baseball player.

  • Therefore it is rational (in accordance with reason and logic) that the surgeon get paid more.

  • We have established market machinery for paying these two professions. Ball players shop their services to teams. Teams try to sell tickets, broadcasting contracts, peanuts and crackerjacks, etc… Individuals decide whether to buy all that stuff. Surgeons, meanwhile, shop their services to hospitals. Hospitals mainly deal with insurance companies, and individuals decide whether to buy insurance. All of this is of recent creation; most humans who have ever lived never participated in such things.

  • The end result of this is that pro athletes get paid a lot more than doctors.

  • Thus, the market has produced something irrational.

The fundamental difference is our viewpoints stems from your analysis of how more people watch sporting events than get surgeries. True. But the huge crowds watching baseball games are a result of the markets. In the state of nature, you wouldn’t have fifty thousand fans each making a small payment which, when added together, justifies an obscenely huge salary for a baseball player. That can only happen after the market machinery gets built.

49

Then I would say the market is more rational than the individual (although I don’t think a market can be rational or irrational).

50

I should clarify, because i don’t hink individuals are acting irrationally. I am just saying that the prescece of the market allows mutually beneficial transactions to occur. Since all parties are better off (the athlete, the fans, etc.) the market in a sense performs better than the individual owuld in your example.

I do not value a brain surgeon more than an elite baseball player. I don’t have any need or demand for a brain surgeon, but I can see myself putting value on watchin Roger Clemens pitch.

51

This is so tiresome. You are aware that certain fields use certain terms in very special ways, right? In economics rational is a term of art. Accept this fact, because it is true. Nobody gets arrested for stealing second base. If you labor all day, but get nothing done, that doesn’t mean you haven’t worked. When an attorney appeals a case, that doesn’t mean she’s being extra earnest in her request. And a traffic platoon is not marching under the watchful eye of a seargant. There are terms of art in all sorts of fields, and they are accepted without difficulty.

So, if you are talking about rationality in terms of aggregating social choice, then Kenneth Arrow’s axioms are pretty standard and it has been well known since the '60s that social choice is not guaranteed to be rational, unless a single actor is making the decisions for the group. This is old news.

One thing you must keep in mind, by the way, is that in economics, rational has to do with the character of preferences, not whether a choice is sane. A cannibalistic serial killer may be completely nuts, but that is no indication that his preferences violate, say, transitivity. In terms of Arrow’s axioms, then, you need to show that the market may violate the independence of irrelevant alternatives. Which we know can happen, since Arrow has long since proven that social choice isn’t guaranteed rational.

So, in conclusion: rational is a term of art when used in economics; rational refers to the character of preferences, and therefore patterns in choices, and not to whether those choices may be completely nuts; and Arrow already proved that no method of aggregating individual preferences, other than a dictatorship, is guaranteed to be rational.

52

ITR’s OP looks to me like it is responding to those who show faith in the free market and who also use the word “rational” in a way conflating its technical sense with its usual conversational sense.

It may be that ITR was under the confusion you describe, as well, but as I read his post I don’t find that this detracts from the point he is making. It merely clarifies exactly which point he is trying to make.

-FrL-

53

In that case, I apologize to the OP for misreading him. :slight_smile:

54

Okay, I acknowledge that the word rational has a specific meaning for economists. I should have mentioned that in my original post to avoid confusion. However, I do think that it’s a poor choice of the term. The word “rational” is loaded with meaning in the real world, since our society places such high value on rational behavior and such low value on any other kind. Using that word strongly suggests that rational economic behavior is what we’d expect from rational people. Indeed many debaters on this board and elsewhere have declared it irrational to not support free market policies. So my point is that we need to tackle these facts: in maket-driven societies, some people act irrationally (by the non-economist definition), and market forces push people towards irrational results. So if for a Toys-R-Us employee whose customers are rioting due to absense of Tickle Me Elmos, it’s not helpful to know that economists classify that as “rational” behavior.

55

Possibly. Are they frequent and egregious enough to warrant concern? Is it the market that really causes these pathologies?

IIRC, even in ancient Greece people complained about how much attention and worship atheletes got. And the idea that people haven’t murdered, subjagated, and enslaved to acquire trinkets in non-market systems beggars belief.

Well, in experiments, non-market cultures have been found to be less generous in the ultimatum game, and more willing to accept unbalanced offers, than people in market cultures. I would say that is more sensible for people to offer and deman equitable offers than to accept inequity when offered.

I would consider our toilet-paper distribution system to be far more rational than what obtained in the former Soviet Union. Not to mention other little things, like bread. And, Soviet economists had to come up with thousands of pages of documentation to put a price on a particular item, and repeat this for millions of items. That is not sensible at all. Markets aggregate information and give us information on where resources need to go. They do this through prices. If we find a pathological situation (tickle-me elmo, for example), that doesn’t tell us anything about the market, it tells us something about us and our priorties.

56

I would have thought the market pretty much is* us and our priorities.

-FrL-

*Or to be more precise, “is wholly determined by”

57

I would say that it’s some of A, some of B. In some economic transaction, the demand side drives productions. Yet there are certainly other cases where the sellers are in control. All of advertising, after all, is sellers manipulating buyers. How much money gets spent every year on expensive brand name products when cheap, equivalent store brands are available? That’s an example where the sellers convince the buyers to behave irrationally because its in the interests of the sellers to do so. The market creates the motivation for manufacturers to promote irrational behavior. Nike Shocks and Tickle Me Elmo simply take that principle to extremes.

(There’s also a point there about surplus wealth. When people are only buying basic necessities because that’s all they can afford, strict rationality results. No one spends their last remaining dollars on Ralph Lauren socks when they need bread to survive. It’s only when we can afford luxuries that we see irrationality in the market. Every one of us could dig up some clothes we bought but never wore, books we never read, videos we never watched, and other junk that we paid for but never used. Living in a market society has made us grow sloppy like that.)

I entirely agree that markets are more rational than the Soviet system in almost all cases, but I don’t think that’s good enough for markets to deserve the label “rational”. I think there’s a standard of human reason that tells us what is rational. Anything that produces results that deviate a lot from that standard has to be called irrational.

58

Surplus wealth is what the markets create. This is unavoidable. Markets are more efficient than if a person or entity were to be self-sufficient. It is simply the nature of trade and economies of scale. Because you have identified this, it appears that you are also saying that “since markets create excess wealth, markets are irrational.” Markets also increase production and technology, things that people consider to be good things. Do you also think those things are irrational?

More to the point, at least in regards to wealth, are you saying that wealthy people are irrational? That after satisfying basic needs, anything beyong that is irrational? This is where your train of thought is leading. If we didn’t have markets, we would all be probably living in pre-Industrial society, assuming wars of attrition and strife didn’t keep us from progressing.

59

Well, no, not necessarily. I don’t know why you would assume this.

An individual who needs brain surgery (For themselves or a loved one) would of course put tremendous value on the services of a brain surgeon. An individual who does not would put no value at all on a brain surgeon. I, for instance, do not presently need brain surgery (A voice from the crowd: “You’ve got nothing to operate on!”) and so I put zero value on brain surgeons. I wouldn’t pay a brain surgeon a nickel right now. On the other hand, I do put considerable ongoing value on ball players, so I pay money to see them pay.

My, or any other consumer’s, rational value judgments of any given product are not static. They can’t be. They change from moment to moment depending on what will, at that moment, provide me with the greatest perceived utility. A year ago I had no use whatsoever for baby food; now I am willing to pay money to get it because now it provides me with utility, as I prefer to feed my baby instead of not feeding her.

Er, what makes it irrational? You’ve provided a simple but seemingly accurate explanation of why people are paid what they are and then say it’s irrational. I don’t understand where “irrational” enters into it, though. Why do you think it’s irrational?

But as you have yourself already pointed out, that is a fairly recent creation. Individual demand happened before the market was created, or else you cannot explain where the market came from. Prior to 1876 there was no such thing as organized professional team sports, and it didn’t really become a stable thing until the turn of the 20th century, and pro athletes in any sport did not earn more than brain surgeons, on average, until the 1970s. Where did the “market” come from if not from individual demand?

And heck - can’t we argue the same thing about brain surgery, in a weird sort of way? The expectation that the medical community can fix things like brain tumours is a recent thing, too; a century or so ago, if you had something go wrong inside your melon, you lay around until you died.

I’ll grant there’s more marketing involved in pro sports to be sure, but what about marketed products is inherently irrational? Now, I would agree that there may be some circumstances where the market does come up with a different result than individuals would collectively prefer - the Smoke Gets In Your Eyes Theory - but you’ve chosen a bad example here.

60

Some of this is based on lack of information. Yes, some generic brands are as good as name brands, but some aren’t. Advertising might try to make an equivalent brand look better, but it also might inform the public that the better brand truly is.

Tickle Me Elmo, by the way, is not an example of your thesis. My wife got a sample of it that summer (and we were good and gave it to our kid and didn’t sell it for a bundle :slight_smile: ) but there was no special push for it. That was an example of demand unexpectedly getting ahead of supply. Mattell (or Habro, I forget which) did not make any money on the panic. They could have made a lot more if they had manufactured more dolls. Even rational markets are not perfect without an oracle.