Uncertainty and behaviour in markets

1
Uncertainty and behaviour in markets

• Can we assume individual rationality by people or
  firms?
• Can we assume that natural selection will force
  rationality?
• If not what does it mean for markets?

2
Uncertainty and evolution

• Pure economic rationality vs bounded rationality
• Prospect theory losses more felt than gains
• http//en.wikipedia.org/wiki/Prospect_theory
• Financial markets are biassed (Shiller
  Irrational exuberance)
• http//www.irrationalexuberance.com/
• Firms learn slowly and not always correctly

3
Game Theory approach supports case by case
analysis

• Multiple equlibria
• History matters
• Psychology, and expectations
• Strategy of firm matters cf Cournot vs Bertrand
• Unless entry totally free

4
Evolution Irrationality can persist

• Two-armed Bandit model shows that if a gambler
  is allowed to choose between two gambling
  machines. One has a "known" probability of
  paying off the other is totally unknown. "If the
  machine whose probability payoff is known is ever
  played, it will be played for ever". (Rothschild,
  JPE 1973).

5
New research you can get locked in to wrong
strategy

• Exploiting these properties, they show that in a
  very large class of bandit problems, it is the
  case that with non-zero probability, the optimal
  strategy will involve the play of just a single
  arm of the bandit forever. Moreover, this need
  not be the best type of arm (i.e., one that
  would be optimal under complete information)
  indeed, it could even be the case that arms that
  are optimal under complete information willbe
  discarded in finite time with probability one,
  under the optimal strategy.
• http//pages.stern.nyu.edu/rsundara/pdf/Bandits.p
  df

6
Adam Smith on rationality

•  Adam Smith assumes rationally self-seeking
  behaviour but not necessarily ex post correctness
  of calculations.
• People tend to overestimate odds of winning
  lottery esp. if one-off eg career choice

7
Adam Smith overweening conceit

• The lottery of the law, therefore, is very far
  from being a perfectly fair lottery and that, as
  well as many other liberal and honourable
  professions, are, in point of pecuniary gain,
  evidently under-recompensed.
• 26 Those professions keep their level, however,
  with other occupations, and, notwithstanding
  these discouragements, all the most generous and
  liberal spirits are eager to crowd into them. Two
  different causes contribute to recommend them.
  First, the desire of the reputation which attends
  upon superior excellence in any of them and,
  secondly, the natural confidence which every man
  has more or less, not only in his own abilities,
  but in his own good fortune.
• http//geolib.com/smith.adam/won1-10.html

8
Modern Econ has rediscovered this

• Overconfidence A large amount of recent research
  by psychologists and decision-researchers
  provides systematic empirical support for Smith's
  observation, based simply on personal experience,
  of the "over-weening conceit which the greater
  part of men have of their own abilities."
  According to Smith, "the chance of gain is by
  every man more or less over-valued, and the
  chance of loss is by most men under-valued, and
  by scarce any man, who is in tolerable health and
  spirits, valued more than it is worth". Smiths
  overweening conceit reappears in modern
  behavioral economics in the form of executive
  hubris which motivates so many failed mergers
  (Roll, 1986) and widespread business failures
  (Camerer and Lovallo, 1999), and has been
  reverse-engineered in evolutionary economics
  models (Postelwaite and Compte, 2001 Heifetz and
  Spiegel, 2000).
• http//www.hss.caltech.edu/camerer/jepadamsmith15
  .doc

9
Prospect Theory and Adam Smith

• Loss aversion Smith's work is packed with basic
  insights about preferences. Perhaps most
  significantly, approximately 200 years before
  Kahneman and Tversky (1979) identified the
  regularity that has come to be known as 'loss
  aversion', Smith displays an acute awareness of
  the phenomenon. On page 121 of TMS, he writes
  that "breach of property, therefore, theft and
  robbery, which take from us what we are possessed
  of, are greater crimes than breach of contract,
  which only disappoints us of what we expected.
• http//www.hss.caltech.edu/camerer/jepadamsmith15
  .doc

10
Evolution of the system to optimum?

• Jacquemin New Industrial Organisation , Ch 2
  expresses doubt "on any long run tendency to
  attain the "Pangloss" equilibrium", p.29 maybe
  be no equilibrium at all
• Axelrod less fiercely competitive behaviour in a
  population (eg tit-for tat) evokes less
  retaliation so enhances survival.

11
Will non-optimal behaviour be killed off?

• Chicago on natural selection
• A.Alchian in 1951 argued only profit maximising
  would actually survive.  
• Austrians
• Austrian theorists believe that competition will
  kill off incompetent entrepreneurs and excess
  profits.
• Winter NPDE
•  "Assumptions that firms maximise profit or
  present value will have to stand on their own, at
  least until someone invents a better crutch for
  them." (Winter).

12
Evolutionary games

•  
• "if the game is repeated infinitely often, if
  there is uncertainty about the end of the game or
  if the one-shot game has multiple equilibria,
  virtually any outcome can be sustained...The
  question thus changes from 'can tacit collusion
  occur?' to 'what form is it likely to take'?.."
  Jacquemin in Schmalensee and Willig p.443.

13
The process

• Jacquemin asserts the
• "necessity to be more open to an evolutionary
  perspective in which the competitive process is
  more important than equilibrium and in which
  cumulative interactions among agents' vast
  strategy space and industrial structure have no
  chance of leading to an optimum."
• (New Industrial Organisation).

14
Irrational exuberance

• In this bold and potentially urgent volume,
  Robert J. Shiller, a respected expert on market
  volatility, offers an unconventional
  interpretation of recent U.S. stock market highs
  and shows that Alan Greenspan's term "irrational
  exuberance" is a good description of the mood
  behind the market.
• http//pup.princeton.edu/titles/6779.html
• http//www.irrationalexuberance.com/

15
Slides from Shiller

• 1. The stock market - rose far more than profit
  growth could explain
• 2. How did it happen? technology and psychology
• 3 leading to...

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19
Jacquemin Theories of IO .p11

• Rather than looking for the model which permits
  simple generalizations that can be applied to
  most industries, we must develop a menu of
  theoretical models from which the best adapted
  model to the market under study can be selected.
  ..F. Fisher (1989, p. 119),said "the role of a
  generalizing theory is to tell us... how conduct
  and performance depend upon structure... It may
  very well be the case that one cannot understand
  the history of the American rubber tire industry
  without knowing that Harvey Firestone was an
  aggressive guy who believed in cutting
  prices...The job of theory is to discover what
  characteristics of the rubber tire industry made
  such aggressive behaviour a likely successful
  strategy." But he adds "That question would be
  answered if we had a generalizing theory of
  oligopoly".
• S. Martin (1993, p. 564) says "A theoretical
  model tailored to the specific characteristics of
  the American rubber tire industry would answer
  the same question. Quite likely, it would supply
  the answer with greater clarity".