Tuesday, January 16, 2007

'Rational' Markets Theories May Predict But Do Not Explain Real Markets

Adam Smith highlighted the one motive that people share from ‘cradle to grave’, namely to seek ways to ‘bettering our condition' (TMS I.III.2.1: p 50). That is how people are and they don’t necessarily behave ‘rationally’ in making their choices in how they go about meeting their central motive.

It is a requirement of neoclassical equilibrium theory that rationality be exhibited. Take that away and look for models that can contain all consequential actions of people and we move closer to explaining how markets work.

Craig Newmark in his interesting Blog, “Newmark’s Door” (‘Things one middle-aged economist finds interesting’), takes up the theme posted by Don Bourdreaux, which I commented on the other day:

Nice article by Don Boudreaux explaining why, even if some individuals are sometimes irrational, the market is still rational.
Asked differently, doesn't human weakness and irrationality make the invisible hand of Adam Smith at least a bit palsied? And, if so, doesn't a palsied hand need some conscious guidance from caring attendants?


The case for the market doesn't require that each of us behave in textbook rational fashion. One of the great benefits of free markets is that they both reduce the frequency of irrational behavior and temper the ill consequences that would otherwise occur when people do behave irrationally.
[at: http://newmarksdoor.typepad.com/mainblog/]

Neoclassical markets are ‘rational’ in that they conform to their assumptions, but do they map how real markets operate? If not, then the question posed is non-operational; it is an abstraction. Economics should move on and seek to explain how real markets operate with real persons transacting in them, rather than try to squeeze people into strictures from the requirements of mathematics, more concerned with precisely predicting than with explaining.


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