Saturday, 20 June 2009

The market: catalyst for rationality and filter of irrationality

If we assume that consumers can be irrational, an interesting question is, What effect does this have on market outcomes? Do markets become "irrational" because of the irrational participants or does the market filter out the effects of irrational participants?

Given this question, I was interested to come across this paper "The Market: Catalyst for Rationality and Filter of Irrationality" by John A. List and Daniel L. Millimet, The B.E. Journal of Economic Analysis & Policy: Vol. 8: Iss. 1 (Frontiers), Article 47.

Available at:

The abstract reads
Assumptions of individual rationality and preference stability provide the foundation for a convenient and tractable modeling approach. While both of these assumptions have come under scrutiny in distinct literatures, the two lines of research remain disjointed. This study begins by explicitly linking the two literatures while providing insights into whether market experience mitigates one specific form of individual rationality—consistent preferences. Using field experimental data gathered from more than 800 experimental subjects, we find evidence that the market is a catalyst for this type of rationality. The study then focuses on aggregate market outcomes by examining empirically whether individual rationality of this sort is a prerequisite for market efficiency. Using a complementary field experiment, we gathered data from more than 380 subjects of age 6-18 in multi-lateral bargaining markets at a shopping mall. We find that our chosen market institution is a filter of irrationality: even when markets are populated solely by irrational buyers, aggregate market outcomes converge to the intersection of the supply and demand functions.
What this suggests is that we must avoid making the leap from individual irrationality to "market failure." List and Millimet suggest that even if there is individual irrationality then market failure does not immediately follow. The List and Millimet results point towards the view that markets actually filter out individual irrationality and thus help channel individual action to social benefit.

This kind of result also backs up the Levitt and List critique of behavioural economics in which they argue that while no one argues that exceptions to the standard rational actor model cannot be found in the lab, there are pressures in the real world that means these exceptions are not of great significance. As Steven D. Levitt and John List have put it,
Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets. We have recently discussed several factors, ranging from the properties of the situation — such as the nature and extent of scrutiny — to individual expectations and the type of actor involved. For example, the competitive nature of markets encourages individualistic behavior and selects for participants with those tendencies. Compared to lab behavior, therefore, the combination of market forces and experience might lessen the importance of these qualities in everyday markets.

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