Market Logic

What’s wrong with this?

Posted in behavioral econ, economics, microeconomics by mktlogic on September 6, 2010

Cost benefit analysis takes market prices as accurate indicators of how much different things are valued.  This is only a valid assumption about market price in the case where it is also assumed that people behave rationally.  If people are behaving rationally, then they are already behaving in the way which is best for their welfare.  So, there can be no argument based on cost benefit analysis to the conclusion that people should change their behavior in order to make themselves better off.

This “feels wrong” but I can’t say why.

My first reaction would be to name a counterexample like the tragedy of the commons.  If multiple parties are fishing in the same pond, no one has any incentive to leave fish behind to breed because the others will just take those fish.  So I might claim, on the basis of a cost vs benefit argument that the fishers using the pond should come up with a new arrangement like a collectively enforced quota.  Another option would be an auction where the winner buys the pond and the the winning bid is distributed equally to all of the other people who fish in that pond.  Then the winner could rent out fishing rights to the others, so there would be no major disruption.

But this is no counterexample.  Why?  Because we have to make some assumption about the rationality of the fishers.  If we assume that the fishers are not rational, then the costs of setting up an auction or a quota don’t properly reflect the value of the resources that would be used in setting up the auction or quota system.  Maybe it would still be a good idea but the results of any sort of cost/benefit analysis would be unreliable because the inputs to that analysis would be suspect.  On the other hand, if we assume that the fishers are rational, then the fact that they have not already implemented some solution to the commons problem indicates that the actual benefits of a new arrangement are not enough to overcome the actual costs.

Goodbye, homo economicus. Hello, what?

Posted in behavioral econ, economics, philosophy by mktlogic on March 27, 2009

Concerning the recent financial crisis, Anatole Kaletsky writes

“Academic economists have thus far escaped much blame for the crisis. Public anger has focused on more obvious culprits: greedy bankers, venal politicians, sleepy regulators or reckless mortgage borrowers. But why did these scapegoats behave in the ways they did? Even the greediest bankers hate losing money so why did they take risks which with hindsight were obviously suicidal? The answer was beautifully expressed by Keynes 70 years ago: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

What the “madmen in authority” heard this time was the distant echo of a debate among academic economists begun in the 1970s about “rational” investors and “efficient” markets. This debate began against the backdrop of the oil shock and stagflation and was, in its time, a step forward in our understanding of the control of inflation. But, ultimately, it was a debate won by the side that happened to be wrong. And on those two reassuring adjectives, rational and efficient, the victorious academic economists erected an enormous scaffolding of theoretical models, regulatory prescriptions and computer simulations which allowed the practical bankers and politicians to build the towers of bad debt and bad policy.”

The whole article continues in a similar vain:

More challenging to the orthodoxy of academic economics have been approaches that rejected the principle that economic behaviour could be described by precise mathematical relationships at all. Benoit Mandelbrot, one of the great mathematicians of the 20th century, who pioneered the analysis of chaotic and complex systems, describes, in The (Mis)behaviour of Markets, how economists ignored 40 years of progress in the study of earthquakes, weather, ecology and other complex systems, partly because the non-Gaussian mathematics used to study chaos did not offer the precise answers of EMH. The fact that the answers provided by EMH were wrong seemed no deterrent to “scientific” economics.

This is fairly representative of the large number of recent articles and essays suggesting that the current economic distress calls for a rejction of some or all of what the author believes to be the mainstream approach to economics.

Some of these criticisms are valid, although the recent crisis doesn’t make them any more valid.  But most miss their targets entirely.  Eugene Fama was writing (with Mandelbrot!) about fat tails and non-Gaussian distributions since about the same time he was writing about efficient markets. Bad loans were originated mostly on the basis of data driven credit scoring models, not general equilibrium models where the representative agents have rational expectations.  And so on…

That doesn’t mean there aren’t things about economics that could use some fixing.  But the proposed solution has to offer some potential for improvement.  Theories based on animal spirits, irrational agents, etc. can explain anything but economists ought to be able to do more than point out that “anything is possible and anything can happen.”  Even after the fact, theories based on irrationality and animal spirits don’t add very much to the historical narrative.  There may come a time when economics will be improved by a deliberate effort to reconcile mainstream economics with the methods and findings of psychology and sociology.  I’ll wait until those calling for such a change can enumerate a set of new and improved theories and their concrete implications.