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.