Rationality & the Efficiency of Markets

(Steve Lambert)

Gekkonomics

• “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.

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 that…upper-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.

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 greed• Cheating and social class• Cheating and attitudes toward greed• Cheating and {Social class + attitudes toward greed}

– More favorable attitudes toward greed among members of the upper class explain, in part, their unethical tendencies.

Markets and the need for policy

• Market: a decentralized collection of buyers and sellers whose interactions determine the allocation of goods through exchange.

Markets and the need for policy• Why study markets?

– dominant form of economic organization– much environmental degradation stems from

the actions of consumers and producers• Need to understand how these agents react if we

want to influence their choices– Government regulation: can be costly and

intrusive• How 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?

Sources of pollution: e.g. air pollutants• Figure: 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

Definitions• Marginal 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)

Market equilibrium• the 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 surplus

Getting to equilibrium• If 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 demand

Excess supply

Equilibrium

Image source: livingeconomics.org

Recall: Efficiency• Kaldor-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.

When 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?

When 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:

1. The market is complete: no externalities exist 2. Agents have good information on the quality of goods/services being traded.

3. 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.)

Arrow (1963)

FTWE:

2nd TWE:

“How economists see the environment”Fullerton and Stavins (1998)

• Myth #1: the market solves all problems– FTWE 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”.

1. Markets are not complete: There are “externalities”2. Information problems: Firms and consumers do not have

good information about the quality of goods and services.3. Markets not competitive: there exist monopoly buyers or

sellers4. Increasing returns to scale5. ‘Distortions’ between the costs paid by buyers and the benefits received by sellers

(transaction costs, no taxes)

Market failure

EPA (2010)

EO: “executive order” (issued by Pres. of U.S.)

OMB: Office of Management and Budget(exec. branch)

Name that market failure…

The 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 animals—and 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, 303–312

The rational model• Rational 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

The rational model• McFadden (1999) on Homo economicus/

“Chicago-man”– convenient, 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.it

Behavioral 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 don’t stick to it

Shogren and Taylor (2008)

Behavioral economics

• “explores, catalogues, and rationalizes systematic deviations from rational choice theory.”

• Deviations or limits on human behavior are driven by (Mullainathan and Thaler, 2000)

– bounded rationality– bounded willpower– bounded self-interest.

Shogren and Taylor (2008)

• 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 selfless• value: reciprocity, altruism, paternalism, aversion

to inequalityShogren and Taylor (2008)

• Bounded willpower:– “people lack self-control sometimes—we

consume too much, save too little, make rash

decisions, procrastinate, and so on.”

Homo economicus Homer economicusVS.

• Pessimistic 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)

Deviations from the rational model:Effective consent rates for organ donation

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

People don’t check/don’t donate

Dan Ariely: Much of decision-making is determined by designer of decision context.

Presumed consent/opt-out: must check box to not donate.

People don’t check/do donate

“Do Defaults Save Lives?”Johnson, Eric J., and Daniel Goldstein. 2003. Science, 302(5649): 1338–39.

http://www.ted.com/talks/lang/eng/dan_ariely_asks_are_we_in_control_of_our_own_decisions.html

Age 67

“…half 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 107

• Optional additional slides…

Ariel Rubinstein on behavioral economics

• “intuitive and “sexy” results are gladly accepted by behavioral economists without sufficient criticism”

Gneezy 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, 2006

Rubinstein’s skeptical response to Gneezy and Rustichini (2000):• “Israel…is 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 RA’s records. Oddly, I was not allowed to talk with the teachers.

• “Behavioral Economics…. must become more open-minded and much more critical of itself.”

Inequality

http://g-mond.parisschoolofeconomics.eu/topincomes/Saez and Piketty

Four key periods (Paul Krugman):The Long Gilded AgeThe Great CompressionMiddle class AmericaThe great divergence