Wednesday, July 22, 2009

Rationality and markets

I've now had a chance to read the article that Steve referred to in his post of June 24. I am not convinced by the claim that their evidence indicates that rationality is not required for market efficiency. The experiment on which this claim is based does not require the participants to access their own preferences or assess their own economic welfare. They are given reservation prices for a good that has no value to them at all (deliberately defaced baseball cards), and paid for making deals. They only way they could act "irrationally" in such circumstances is if they did not understand the instructions. The "equilibrium" that is reached is indeed the one the experimenters constructed, but it does not correspond to an efficient competitive market because information is limited (transaction prices are not publicly reported), and the law of one price does not hold. This experiment does not get at the psychological mechanisms that cause choices to depart from preferences, and preferences to depart from welfare. No conclusion about "efficiency" is warranted.

They use a separate but related experiment to determine if this "market experience" makes their subjects more rational, and conclude it does. The evidence seems to confirm this, but the effect is so small that I doubt it can be consistently replicated.

The canonical theory of consumer choice is a wonderfully flexible thing. It can be interpreted in such a way that it covers any conceivable behavior. The problem is that these interpretations empty it of content. It becomes a mere tautology, explaining nothing. I'm afraid that this paper is in the spirit of these tautological constructions of economics.

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