Free Market

[elwoodblues]

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

[Utah]

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?

[Il_Mostro]

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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?

[/ QUOTE ]
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.

[Utah]

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.

[Il_Mostro]

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Players bet the bubble because because, even knowing it is a bubble, the players still feel it will go higher.

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Well, yes, some "players" do that. But I would say that most people just go with the flow. Since we have had a bubble every 20 years or so for a long time, and it's still a lot of people that lose a lot of money everytime, I would not say they are rational.

maybe this comes down to a difference in definition on rational.

[ QUOTE ]

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

[/ QUOTE ]
I don't understand what you mean here. If this is a commentdon my "exponential growth again" remark I find it strange. If you call that to be " incorrect about some underlying principles" I would say you are wrong, that is not an underlying principle at all, and everyone should be able to understand it cannot go on, yet a lot of people lose money every time.

[Utah]

"I don't understand what you mean here. If this is a commentdon my "exponential growth again" remark I find it strange. If you call that to be " incorrect about some underlying principles" I would say you are wrong, that is not an underlying principle at all, and everyone should be able to understand it cannot go on, yet a lot of people lose money every time."

Lets say I buy a stock that appears to be in a bubble situation. I believe that the stock will keep rising because the frenzy shows no signs of letting up. I am making some assumptions when I place my buy (e.g., the frenzy will continue, the economic situation hasnt changed, etc.). My assumptions may be wrong but it doesnt mean that I was irrational.

Maybe I can explain with another example. When I buy stock I assume the books arent cooked. Now, if it comes out that the books are cooked and the stock drops dramatically, it doesnt mean that I was irrational. It only means that my information is incorrect.

[Voltorb]

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.

[adios]

Utah posted:

[ QUOTE ]
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?

[/ QUOTE ]

You responded:

[ QUOTE ]
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.

[/ QUOTE ]


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.

[Voltorb]

Adios, I was not responding directly to a statement made by Utah at the time, but instead to the question put forth by the original poster. I was trying to point out an assumption made by a free market (this may or may not be a free market assumption, I really don't know) and then point out that it is wrong.

As providing a specific example, I refer you to this link.

Games With Dominant Strategy Equilibrium

I figured that since John Nash basically revolutionized the way economists thought about economics, simply citing the example in the movie would be enough. Because I have no practical skill in economics, I cannot come up with a specific example involving market actors etc. The mathematical truth of the principle stated by Nash is evident to me, and being as such, it should be valid for many situations.

[Utah]

"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.