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Is Anyone Rational?

posted by Oren Bar-Gill

Many people, myself included, believe that consumer behavior deviates in important ways from the predictions of the rational choice model. This belief has led to the development of alternative, more realistic models of decisionmaking, and to the application of these new models in studying consumer markets. But while the rational choice model inadequately describes consumer behavior, it is believed to offer a fairly accurate description of the behavior of more sophisticated parties, like sellers and lenders.

Of course, sellers and lenders are also human and prone to error, but the assumption is that organizational and market forces serve as an effective check on the behavior of these sophisticated parties, preventing substantial departures from the predictions of the rational choice model. As Milton Friedman famously argued, it is not that firms are necessarily rational profit-maximizers, but firms behave "as if" they are rational profit-maximizers. Otherwise, they would be selected out of the market.

Recent events have caused me to question this belief that sellers and lenders behave rationally. I am referring to the rise in foreclosures in the subprime mortgage market, and its effect on lenders. It is not a surprise that irresponsible practices in the subprime market have caused substantial harm to consumers. The surprise is that allegedly sophisticated lenders, and the Wall Street firms that back them, have been suffering substantial losses. Numerous lenders have filed for bankruptcy. Bear and Stearns recently invested $3.2 billion to rescue a hedge fund that was heavily invested in the subprime market—the biggest such bailout since 1998. Wall Street is supposed to be good at managing risks. But here it looks like some top-of-the-line professionals have made big mistakes. Of course, suffering losses is a part of taking risks. But this looks like more than absorbing the foreseeable downside of a calculated bet.

This is not an isolated case of irrational behavior by sophisticated market players. To take another example, my colleague at NYU, Florencia Marotta-Wurgler, has found that large online sellers systematically fail to design their contracts in a profit-maximizing fashion.

Many of us have abandoned the rational choice model when analyzing the behavior of consumers. Should we abandon the rational choice model also when analyzing the behavior of sellers and lenders? Was Milton Friedman wrong? The evidence suggests that the rationality of sellers and lenders should not be blindly assumed. Still, I am not prepared to abandon the rational choice model when studying the behavior of market actors that are subject to the forces of competition. True, markets are imperfect. This means that irrational behavior can survive, at least for some time. And this "grace period" grows longer as competition grows weaker. But competition cannot allow sellers and lenders to make substantial mistakes in the long-run. Of course, in the long-run we are all dead….


Can't it be argued that the failure of subprime lenders is just an example of the selection out of the market of firms that fail to behave "as if" they are rational profit-maximizers?

It seems to me that the problem with the economic model of lender behavior isn't one of rationality, per se, but how to account for careless error and ignorance in the decision making of rational actors. Lenders are sophisticated parties that will react rationality to incentives, but only to the incentives that they perceive. Mistakes (for example forgetting a zero in a spreadsheet calculation) or ignorance (e.g. not knowing about an important tax consequence of a transaction) can affect perceptions of incentive structures and lead to poor decisions relative to an omniscience situation.

Oren, If Bear Stearns is plowing more money into this fund, does that show an independent business risk calculation or a manifestation of the (irrational) sunk cost fallacy? More generally, is it too simplistic an explanation that these bureaucratized institutions (Bear Stearns) are at greater peril for their agents' shirking through "herdism" than nimbler, more private investment funds? J.

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