Jun 26 JDN 2459787
A common rejoinder that behavioral economists get from neoclassical economists is that most people are mostly rational most of the time, so what’s the big deal? If humans are 90% rational, why worry so much about the other 10%?
Well, it turns out that small deviations from rationality can have surprisingly large consequences. Let’s consider an example.
Suppose we have a market for some asset. Without even trying to veil my ulterior motive, let’s make that asset Bitcoin. Its fundamental value is of course $0; it’s not backed by anything (not even taxes or a central bank), it has no particular uses that aren’t already better served by existing methods, and it’s not even scalable.
Now, suppose that 99% of the population rationally recognizes that the fundamental value of the asset is indeed $0. But 1% of the population doesn’t; they irrationally believe that the asset is worth $20,000. What will the price of that asset be, in equilibrium?
If you assume that the majority will prevail, it should be $0. If you did some kind of weighted average, you’d think maybe its price will be something positive but relatively small, like $200. But is this actually the price it will take on?
Consider someone who currently owns 1 unit of the asset, and recognizes that it is fundamentally worthless. What should they do? Well, if they also know that there are people out there who believe it is worth $20,000, the answer is obvious: They should sell it to those people. Indeed, they should sell it for something quite close to $20,000 if they can.
Now, suppose they don’t already own the asset, but are considering whether or not to buy it. They know it’s worthless, but they also know that there are people who will buy it for close to $20,000. Here’s the kicker: This is a reason for them to buy it at anything meaningfully less than $20,000.
Suppose, for instance, they could buy it for $10,000. Spending $10,000 to buy something you know is worthless seems like a terribly irrational thing to do. But it isn’t irrational, if you also know that somewhere out there is someone who will pay $20,000 for that same asset and you have a reasonable chance of finding that person and selling it to them.
The equilibrium outcome, then, is that the price of the asset will be almost $20,000! Even though 99% of the population recognizes that this asset is worthless, the fact that 1% of people believe it’s worth as much as a car will result in it selling at that price. Thus, even a slight deviation from a perfectly-rational population can result in a market that is radically at odds with reality.
And it gets worse! Suppose that in fact everyone knows that the asset is worthless, but most people think that there is some small portion of the population who believes the asset has value. Then, it will still be priced at that value in equilibrium, as people trade it back and forth searching in vain for the person who really wants it! (This is called the Greater Fool theory.)
That is, the price of an asset in a free market—even in a market where most people are mostly rational most of the time—will in fact be determined by the highest price anyone believes that anyone else thinks it has. And this is true of essentially any asset market—any market where people are buying something, not to use it, but to sell it to someone else.
Of course, beliefs—and particularly beliefs about beliefs—can very easily change, so that equilibrium price could move in any direction basically without warning.
Suddenly, the cycle of bubble and crash, boom and bust, doesn’t seem so surprising does it? The wonder is that prices ever become stable at all.
Then again, do they? Last I checked, the only prices that were remotely stable were for goods like apples and cars and televisions, goods that are bought and sold to be consumed. (Or national currencies managed by competent central banks, whose entire job involves doing whatever it takes to keep those prices stable.) For pretty much everything else—and certainly any purely financial asset that isn’t a national currency—prices are indeed precisely as wildly unpredictable and utterly irrational as this model would predict.
So much for the Efficient Market Hypothesis? Sadly I doubt that the people who still believe this nonsense will be convinced.