[EDIT: my original response was too harsh and didn't directly address your point -- my sincere apologies if you caught it before I edited it for an intemperate post.
Dandy wrote: ↑
Sun Oct 15, 2017 7:57 am
What amazes me is that an educated body of economic thinkers had a hard time accepting that people don't always make rational economic decisions
People go for a free dinner and end up buying a timeshare they don't need and can't afford, people who are thrifty their whole life and then send all their money to someone who calls them and convinces them that gold is the only answer. Interest rates are at historic lows and people give their life savings to someone who guarantees them a 15% return. People invest in active funds with poor track records that have outrageous fees. The beat goes on. Oh and I have made some irrational decisions so I know from personal experience. While people can make irrational decisions all on their own, we often get a lot of help with sales pressure that is geared to play on our ego, dreams, or fears.
I happen to agree with you that people do behave irrationally, and that is why we have advertising etc.
I wanted to consider though the assumption that economists assume that is not the case. Actually most economists do believe as individuals that we are flawed decision makers-- however they assume that in aggregate that that does not matter. I would suggest that it depends very much which markets we are considering-- financial markets for example are pretty efficient]
The famous quote is from (George Stigler? It might be Milton Friedman) "to drive your car home you solve a complex system of dynamic differential equations, but that's not how we experience driving".
So economics has assumed that, on average, we are rational.
Even though we all have biases, and make mistakes, on average the market behaves rationally. If it does not, then there would be systematic biases which could be exploited-- in other words, arbitraged away. Hence the famous (apocryphal?) line between Stigler and Friedman "there's no point picking up that $20 bill, it will be arbitraged away by the time you get to it".
This Forum is in fact dedicated to that proposition. Because we believe in efficient financial markets-- there are no $20 bills just lying around. You don't get higher returns without higher risk.
And, most importantly, if you beat the markets you were just lucky, and you are just as likely to underperform for the next arbitrary sub period. Therefore the rational investor uses low cost mutual funds which minimize costs (which you can control) and taxable distributions (another cost that can be reduced).
Besides Vanguard, ishares (Blackrock) and to some extent DFA have built whole businesses on that assumption (Donald Mackenzie has some academic studies of how DFA manages dealing, for example, to reduce liquidity costs).
If irrationality was so pervasive that it prevented arbitrage, we'd see it in financial markets
- -there would be people out there making billions at everyone else's expense
. The best evidence (short of a few hedge funds like Renaissance, and it is estimated that if they lose a tax case, all of those billions of outperformance are lost) is that no one is doing that-- asset prices really do follow a random walk.
It's a decent bet, though, that not all markets are so rational
. Hence events like the US housing bubble. There are quite significant limits to arbitrage. And product and labour markets are much more complex, and characterized by limited information/ informational asymmetry, and that has a huge impact on whether the markets are efficient (and for which George Stiglitz and George Akerlof got their Nobel Prizes). Note though that informational asymmetry does not mean irrationality-- it can be quite rational to behave in an "incorrect" way if there is significant uncertainty.
https://krugman.blogs.nytimes.com/2017/ ... egion=Body
Paul Krugman's blog introduces the concepts quite well.
Where you are coming in is Modern Macroeconomics, where the "rigorous microfoundations" approach (aka "the Freshwater School" after U of Chicago, Carnegie Mellon, Rochester, Minnesota where it is most prominent
) that dominates the academic journals (and determines any chance of getting tenure) has taken root. There, the assumption of ultrarationality and the generalization from individual microeconomic agents (firms and individuals) has led to a series of depictions of the real world that seem stretched, and have not really stood up.
As international economists have long known, and most economists should know post the 2008 Crash, the assumption that the causes of recessions are "sunspots
" i.e. exogenous fluctuations in things like technology or preference for leisure time, has not held water.
Do we really believe that the recession of 2008 and after, the worst of the postwar years, and the weakest recovery, was really caused by American workers seeking more leisure time? Or by some technology change?
That tradition inherited from Milton Friedman (Permanent Income Hypothesis, Adaptive Expectations -- and hence the U of Chicago roots) but took it much further than Friedman was ever willing to go. It emerged in response to "stagflation" and the crisis of Keynesian economics in the 1970s-- it's seminal contribution to economics has been the role of expectations
in forming behaviour (Robert Lucas, Thomas Sargent, Robert Barro - another Nobel Prize).
So in summary and conclusion:
- economists assume on average individuals are unbiased estimators - i.e. that they, on average, lead markets to behave as rational (otherwise arbitrage opportunities would emerge)
- in financial markets the lack of investing strategies and individuals who sustainably outperform and whose past performance is a guide to future performance (consider Bill Miller at Legg Mason) suggests that that's not a bad assumption
- other markets, which are more informationally inefficient (labour & product markets) this is less clear and in fact in some areas (such as exchange rates) it's absolutely clear that the markets don't behave "rationally"
- we don't have a good explanation of financial bubbles and crashes, and the best ones (Hyman Minsky) are Keynesian ones
- we need structuralist interpretations (that look at how financial markets are constructed) to explain the link between financial bubbles and crashes and subsequent recessions and depressions-- again the best evidence for that is various Emerging Market crises, and Japan
- the best applications of Behavioural Economics, for Bogleheads who are devoted to market efficiency as a key concept, is in terms of understanding our own biases (towards undersaving, overtrading etc.) and in particular the use of precommitment devices to control our behaviour and overcome our irrationality
(Kahneman's 2nd "Slow system" beating our 1st "Fast system").