Free Market
 

The price of gas thread got me thinking about this. Just something to promote a discussion:

What are some of the assumptions that a solid free market economy relies upon? What, if anything, should be done if those assumptions turn out to be false?

--- I'll get the ball rolling ---

Assumption: Market actors act rationally and in their best interests

Re: Free Market
 

There are many factors but I will just choose one:

The markets rely on many players. The larger the market the more efficient it is. When there are only a few players it can becomes easy to manipulate.

"Market actors act rationally and in their best interests"

Can you give me an example when this is not the case?

Re: Free Market
 

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"Market actors act rationally and in their best interests"

Can you give me an example when this is not the case?

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Wouldn't every financial crash be an example of this? From the tulips in Holland to the dotcom bubble? Everyone should understand, rationally, that such races cannot go on forever, yet a lot of people loose a lot of money every time it happens. Exponential growth again.

Re: Free Market
 

There is the fallacy of the commons. The assumption that each individual acting in his own best interest is in the best interest of the group as a whole has been disproven. Did you ever see the movie "A Beautiful Mind." Remeber the seen where John Nash has his big breakthrough, thinking about trying to get the hot blonde. He explains that if they all acted in their own interests and approach her at the same time, she will turn them all away. Then her friends, who will be insulted by being chosen second, will turn everyone away as well. However, if they work together, and act for the good of the group by not automatically going for the girl they found the most attractive, everyone would end up happy.

As far as the price of gasoline is concerned. The market only considers the here and now, for the most part. Supplies might be considered for the next couple of months, but you don't see investors dumping shares because oil's gonna run out in fifty years. That would be silly, there's still money to make. The market has absolutely no idea how to serve the long term interests of the society in which it functions, especially when it comes to something as tricky as resource depletion.

Re: Free Market
 

No. Crashes are not the result of irrationality or lack of self interest. Players bet the bubble because because, even knowing it is a bubble, the players still feel it will go higher.

Now, you might argue that they are incorrect about some underlying principles. However, that is a completely different thing.

They put in brakes in the market to supposedly stop fast slides. However, analysis shows that those stops do nothing because the slides are not based on irrationality that can be cured by taking pauses.

On a short horizon, the overwelming (only?) reason that stops rise or drop is from true or perceived changes in the underlying information that is discounted into the stock price.

Re: Free Market
 

Utah posted:

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There are many factors but I will just choose one:

The markets rely on many players. The larger the market the more efficient it is. When there are only a few players it can becomes easy to manipulate.

"Market actors act rationally and in their best interests"

Can you give me an example when this is not the case?

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You responded:

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There is the fallacy of the commons. The assumption that each individual acting in his own best interest is in the best interest of the group as a whole has been disproven.

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Where did Utah assume that each individual acting in their own self interest is always in the best interest of the group as a whole? Better yet, if you would be so kind, give me an example of a market where all the actors would be better off if actors acting in their own self interest didn't happen.

Elwood I'll have more on this topic later.

Re: Free Market
 

"There is the fallacy of the commons. The assumption that each individual acting in his own best interest is in the best interest of the group as a whole has been disproven. Did you ever see the movie "A Beautiful Mind." Remeber the seen where John Nash has his big breakthrough, thinking about trying to get the hot blonde. He explains that if they all acted in their own interests and approach her at the same time, she will turn them all away. Then her friends, who will be insulted by being chosen second, will turn everyone away as well. However, if they work together, and act for the good of the group by not automatically going for the girl they found the most attractive, everyone would end up happy."

The problem with this is the "free ride" principle. Everyone has an interest in breaking the pact if they think the others will follow it. This is the reason these cartel situations breakdown.

"The assumption that each individual acting in his own best interest is in the best interest of the group as a whole has been disproven."

This has not been disproven. It has only been shown not to work in all cases.

"The market only considers the here and now, for the most part. Supplies might be considered for the next couple of months, but you don't see investors dumping shares because oil's gonna run out in fifty years."

No, the market considers the future. The market simply applies a discount rate of future potential earnings. Sometimes that rate is small and sometimes that rate is quite large.

"The market has absolutely no idea how to serve the long term interests of the society in which it functions, especially when it comes to something as tricky as resource depletion"

The free market does an outstanding job of serving the long term interests of its society. Just look at the long term rise in the standard of living in the U.S.

It also does an oustanding job of serving the resource interests. If the market thought that fuel will run out anytime soon then the proper resources will be thrown at the problem. Today, the market looks at the fuel issue and says, "we dont think there is a real issue here".

The two areas where the markets do a poor job is in national security and in pollution/environmental damage.

Re: Free Market
 

Market actors not selling food to a group because of the color of their skin. Irrational and not in their best interests.

Re: Free Market
 

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What are some of the assumptions that a solid free market economy relies upon? What, if anything, should be done if those assumptions turn out to be false?

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There are multitudes, since the "free market" is really just a fictional model rather than an empirical entity.

The biggest assumption, or perhaps fallacy, is that anything resembling a "free market" has ever existed. In fact, the term is self-contradictory - markets are constructed upon rules and human institutions, ones that require government for enforcement. They therefore cannot be "free."

The second biggest assumption is that the role of the state
in the economy should be minimized as much as possible since intervention is equated with "rent seeking" and inefficiencies. Curiously enough, the historical fact is that the vast majority of examples of great economic growth in individual nations have been induced by states that were fairly interventionist.

The third biggest assumption is that individuals are rational actors with transitive preferences. Obviously, this is untrue. But for the purpose of modeling economic phenomena it is often the case that the models are still powerful even under violation of this assumption.

Re: Free Market
 

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Assumption: Market actors act rationally and in their best interests

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There was just a long discussion on this in the Magazine Forum, in response to Dr. Al's magazine article about the social value of poker.

The point here is that the free market does not need rational behavior for the market to work efficiently (obviously, or our economy would have collapsed years ago). But an economic model based on such an assumption is easy to understand and it has very good predictive value. In fact, the aggregate economy behaves as if every consumer is acting rationally, even though many individuals are not.

In the specific example, you can often see people buying gas at a station when the station across the street is showing a much lower price. Near my office, the SuperAmerica raises prices every Thursday morning, and the BP across the street doesn't match them until mid afternoon. People continue to buy gas at the SA. Why? Didn't see the signs; habit; they like the coffee at SA better; the BP cashier is grumpy; etc. None of those things are rational, but they drive the economy.

What do you do when the rational behavior assumption turns out to be false? Advertise the irrational benefits of your product. (I.e., use our product and you will be thinner, richer, and get laid more.)