Slide 1

Rationality & the Efficiency of Markets

(Steve Lambert)http://visitsteve.com/made/capitalism-works-for-me-truefalse/Steve Lambert

1Gekkonomics

(image: dcclothesline.com)Video: http://vimeo.com/15568742Image: http://www.dcclothesline.com/wp-content/uploads/2014/06/Greed-is-good.jpg2

Greed is a vice, a bad attitude, an excessive, single-minded desire for gain. (Sandel, 2009, p. 15)

Sandel, Michael (2009). Justice. New York: Farrar, Straus and Giroux.Harvard political philosopher3

Is there some society you know that doesnt run on greed?... The world runs on individuals pursuing their self interestIn the only cases in which the masses have escaped fromgrinding povertyare where they have had capitalism and largely free trade. There is no alternative way of improving the lot of ordinary people that can hold a candle to the productive activities that are unleashed by the free enterprise system. https://www.youtube.com/watch?v=RWsx1X8PV_Ahttps://www.youtube.com/watch?v=RWsx1X8PV_A4Markets and the need for policyMarket: a decentralized collection of buyers and sellers whose interactions determine the allocation of goods through exchange.

5Markets and the need for policyWhy study markets?dominant form of economic organizationmuch environmental degradation stems from the actions of consumers and producersNeed to understand how these agents react if we want to influence their choicesGovernment regulation: can be costly and intrusiveHow well can the free market do on its own? IF we decide to intervene: How can we use markets to achieve the highest level of environmental quality for our investment?6Sources of pollution: e.g. air pollutantsFigure: Major Sources and Health and Environmental Effects of Air Pollutants

Consumer-related pollution (tailpipe)

Producer-related pollution (smokestack)

Source: World Resources Institute. August 2008 Monthly Update: Air Pollution's Causes, Consequences and Solutions by Matt Kallman

7DefinitionsMarginal benefits and demand: [Recall] MB, Marginal benefits (or MWTP): the (maximum) willingness to pay for a one unit increase in quantity of a good.

Demand curve: summarizes how much buyers will buy at a given market price (individual or aggregate)

Marginal costs and supply:[Recall] MC, Marginal cost: the change in total cost when the quantity is increased or decreased by a unit.

Supply curve: summarizes how much sellers will sell at a given market price (individual or aggregate)

8Market equilibriumthe combination of quantity and price at which SUPPLY = DEMAND

Equilibrium a stable outcome

Welfare measures:Consumer surplus: the difference between (maximum) WTP and actual payment.

Producer surplus: the difference between minimum WTA and actual payment.

CS+PS = social surplusNote: change in Marshallian CS reflects a monetary measure of the gain or loss of consumers only when the marginal utility of income is constant. This is because a price change involves both a substitution effect and an income effect (due to the change in purchasing power). For a price change, the appropriate monetary measure of a welfare effect is either compensating variation (price decrease) or equivalent variation (price increase), which reflect monetary equivalents to the price changes (WTP for a price fall; WTP to avoid price increase). 9Getting to equilibriumIf consumers are demanding more than firms are prepared to supply, the shortage will induce the price to rise (those with greater WTP will bid up price). When quantity supplied exceeds quantity demanded price will fall. Adjustments are made until we achieve market clearance (supply = demand) at an equilibrium point.

Excess demandExcess supplyEquilibriumImage source: livingeconomics.orgExercise: Suppose price is P1:What qty is supplied? Demanded?Response from suppliers? Demanders?Suppose price is P2:Same questions.10EfficiencyKaldor-Hicks efficiency: an allocation in which the collective net benefits are maximized (in which there may be winners and losers, relative to the status quo, but where winners could, in theory, compensate losers for their losses)

Pareto efficiency: an allocation in which no one can be made better off without making some else worse off.

11When will the market equilibrium be (Pareto) efficient?If our goal is efficiency, under what conditions can we argue that the government should get out of the way and let the free market determine outcomes?

12When will the market equilibrium be (Pareto) efficient?Some theoretical guidance:

First theorem of welfare economics (FTWE): A market economy will result in an (Pareto) efficient resource allocation when:

The market is complete: no externalities exist Agents have good information on the quality of goods/services being traded.Markets are competitive: there are no monopoly buyers or sellers (agents are price takers, no one has market power).

(and some other technical conditions but we will focus on the three above.)13

Arrow (1963)FTWE:2nd TWE:http://www.jstor.org/stable/10.2307/1812044Uncertainty and the welfare economics of medical care.Arrow, K.J.The American economic review 53(5)941973196314

http://yosemite.epa.gov/ee/epa/eerm.nsf/vwAN/EE-0568-50.pdf/$file/EE-0568-50.pdf15Inequalityhttp://g-mond.parisschoolofeconomics.eu/topincomes/

Saez and Piketty Four key periods (Paul Krugman):The Long Gilded AgeThe Great CompressionMiddle class AmericaThe great divergenceFor discussion of Saez and Piketty see: http://www.nytimes.com/2012/04/17/business/for-economists-saez-and-piketty-the-buffett-rule-is-just-a-start.html?_r=1&hp16How economists see the environmentFullerton and Stavins (1998)Myth #1: the market solves all problemsFTWE is powerful: greatest good for greatest number will arise without central planning (under certain conditions)But the focus of many economists is on settings in which the conditions identified ARE NOT MET i.e. market failure. Markets are not complete: There are externalitiesInformation problems: Firms and consumers do not have good information about the quality of goods and services.Markets not competitive: there exist monopoly buyers or sellersIncreasing returns to scaleDistortions between the costs paid by buyers and the benefits received by sellers (transaction costs, no taxes)17Market failure

EPA (2010)http://yosemite.epa.gov/ee/epa/eerm.nsf/vwAN/EE-0568-50.pdf/$file/EE-0568-50.pdf18

EO: executive order (issued by Pres. of U.S.)OMB: Office of Management and Budget(exec. branch)Name that market failure

20The Rational ModelHamlet: What a piece of work is a man, how noble in reason, how infinite in faculties, in form and moving how express and admirable, in action how like an angel, in apprehension how like a god! the beauty of the world, the paragon of animalsand yet, to me, what is this quintessence of dust? Man delights not me nor woman neither, though by your smiling you seem to say so.

Rosencrantz: My lord, there was no such stuff in my thoughts.

Hamlet, Act 2, scene 2, 303312

Star Trek version: http://www.youtube.com/watch?v=irYYBx8djsU

21The rational modelRational choice:Behavior that is consistent with the values and objectives of the decision maker given the available information; objective typically taken to be maximizing net value.sensible, planned, and consistent (McFadden, 1999)

Believed to describe behavior because of:self-interest tendency of markets to punish foolish behavior

22The rational modelMcFadden (1999) on Homo economicus/ Chicago-manconvenient, successful, unnecessarily strong, false.Almost all human behavior has a substantial rational component, at least in the broad sense of rationality. However, there is overwhelming behavioral evidence against a literal interpretation of Chicago-man as a universal model of choice behavior.

Image: performancetrading.it23

24Behavioral failure?framing effects: how a question is asked (or how a decision is posed) matters

the willingness-to-accept (WTA) willingness-to-pay (WTP) gap

time inconsistency: make a choice today about tomorrow but then dont stick to itShogren and Taylor (2008)25Behavioral economicsexplores, catalogues, and rationalizes systematic deviations from rational choice theory.

Deviations or limits on human behavior are driven by (Mullainathan and Thaler, 2000) bounded rationalitybounded willpowerbounded self-interest.Shogren and Taylor (2008)26

Bounded rationality: (P)eople do not have unlimited abilities to process all the information needed to make rational choices. People have inherent behavioral biases and use rules of thumb and shortcuts to make decisions (Mazzotta and Opaluch 1995).

Bounded self-interest:Reflects the observation that people:care about others, can be selflessvalue: reciprocity, altruism, paternalism, aversion to inequality

Shogren and Taylor (2008)Bounded self interest -- Ohio Runner Stops in State Final to Aid Fallen Opponent-06-2012 West Liberty-Salem (Ohio) High junior Meghan Vogel, 3200M final, 20ft from finish helps Arden McMath27Bounded willpower:people lack self-control sometimeswe consume too much, save too little, make rash decisions, procrastinate, and so on.

Homo economicus

Homer economicus

VS.

28Pessimistic takes (Shogren and Taylor, 2008):Numerous empirical studies over the last four decades reveal that rational choice might, in some circumstances, be a poor guide for economics in general, and for environmental economics in particular (see Tversky and Kahneman 2000).

nature's goods and services frequently lack the active market-like arbitrage needed to encourage consistent choice (Crocker, Shogren, and Turner 1998).

Optimistic takes:Vernon Smith (2003): identification of behavioral failure follows from a program to deliberately search the tails of the distributions for deviations from the standard model.

There are some free lunches in design which takes into account cognitive limitations. Dan Ariely (2008)Shogren and Taylor (2008)29Deviations from the rational model:Effective consent rates for organ donation

Explicit consent/opt-in: must check box to donate.

People dont check/dont donateDan Ariely: Much of decision-making is determined by designer of decision context.Presumed consent/opt-out: must check box to not donate.

People dont check/do donate

Do Defaults Save Lives?Johnson, Eric J., and Daniel Goldstein. 2003. Science, 302(5649): 133839.http://www.ted.com/talks/lang/eng/dan_ariely_asks_are_we_in_control_of_our_own_decisions.htmlAriely on Netherland: begging only gets you so far.it gets you 28% in organ donation30

Age 67half of all households are at risk for coming up short on retirement money. Why? Partly because people aren't saving enough. Well, new research suggests a novel way to change that. (NPR, 4/11/12)

Hershfield et al. 2012

Age 107http://people.stern.nyu.edu/hhershfi/resources/Research/Annals-of-the-New-York-Academy-of-Sciences-2011-Hershfield.pdf31Optional additional slidesAriel Rubinstein on behavioral economicsintuitive and sexy results are gladly accepted by behavioral economists without sufficient criticismGneezy and Rustichini (2000): [In the words of C. Camerer]To discourage parents from picking their children up late, a day-care center instituted a fine for each minute that parents arrived late at the center. The fine had the perverse effect of increasing parental lateness. The authors postulated that the fine eliminated the moral disapprobation associated with arriving late and replaced it with a simple monetary cost that some parents decided was worth incurring. Their results show that the effect of price changes can be quite different than in economic theory when behavior has moral components that wages and prices alter.Rubinstein, 2006http://arielrubinstein.tau.ac.il/papers/behavioral-economics.pdf33Rubinsteins skeptical response to Gneezy and Rustichini (2000):Israelis a country where rules are rarely enforced. It is hard for me to believe that teachers would really fine a parent who is ten minutes late. In my experience, any excuse for lateness is accepted.Furthermore, it is impossible for me to imagine that Israeli teachers would have kept even roughly accurate records of late arrivals with noisy parents crowding around the entrance of the school to take home their screaming kids.Therefore, I at least want to know what the procedure was for collecting data. The paper does not provide such details. In correspondence, one of the authors claimed that professional standards had been maintained. Apparently, an RA went to the schools once a week and asked the assistant teacher who was late the previous week. There was no attempt to control the accuracy of the RAs records. Oddly, I was not allowed to talk with the teachers.Behavioral Economics. must become more open-minded and much more critical of itself.

Is greed good? Part 2

(2012)We reason that increased resources and independence from others cause people to prioritize self-interest over others welfare and perceive greed as positive and beneficial, which in turn gives rise to increased unethical behavior.

We predict thatupper-class individuals should demonstrate greater unethical behavior and that one important reason for this tendency is that upper-class individuals hold more favorable attitudes toward greed.

http://www.pnas.org/content/early/2012/02/21/1118373109.full.pdf+html?with-ds=yes35

Study 6 (of 7):Participants: play game of chance; computer presents them with one side of a six-sided die, ostensibly random; five separate rolls. Told: higher rolls increase chances of winning cash. Asked: report their own total score. In fact, die rolls were predetermined to sum up to 12.Results:Average score: 12.85 (SD=2.78). Cheating: extent score exceeds 12 Significant correlations:Social class and attitudes toward greedCheating and social classCheating and attitudes toward greedCheating and {Social class + attitudes toward greed}More favorable attitudes toward greed among members of the upper class explain, in part, their unethical tendencies.When social class and attitudes towards greed both included only greed was sig. 37