Tag Archive for 'Equilibrium'

Individually sub-rational, collectively rational (near equilibrium)

Alex Tabarrok has had an interesting idea.  It’s short enough to quote in its entirety:

Rationality is a property of equilibrium. By this I mean that rationality is habitual and experience-based and it becomes effective as it becomes embedded in the rules of thumb and collective wisdom of market participants. Rules of thumb approximate rational decision rules as market participants become familiar with an economic environment. Individuals per se are not very rational; shift the equilibrium enough so that the old rules of thumb no longer apply and we are likely to see bubbles, manias, panics and crashes. Significant innovation is almost always going to come accompanied with a wave of irrationality. When we shift to a significant, new equilibrium rationality itself is not strong enough to tie down behavior and unmoored by either reason or experience individuals flail about liked naked apes – this is the realm of behavioral economics. Given time, however, new rules of thumb evolve and rationality once again rules but only until the next big innovation arrives.

It seems appealing to me on a first read, but there are plenty of questions to go with it.

There is a language difficulty here.  On one level, an equilibrium is defined by the actions of everybody aggregating to demand and supply in any given instant, so we are always in an equilibrium by definition.  On another level, an equilibrium is a deeper, fundamental attractor that (at least in the short run) exists independently of people’s choices.  In what follows, I will call the first “where we are” and the second “the attractor”.

Why would agents use rules of thumb instead of making decisions on a fully-rational basis?  Is it just because they aren’t entirely rational people (not very satisfying) or are there constraints that induce a fully rational individual to use rules of thumb?

Under what market mechanisms do the individually sub-rational agents aggregate to collectively rational decision-making when we are close to the attractor and – potentially – to collectively irrational decision-making when we are far away from the attractor?

What form of decision rules do the sub-rational (rule of thumb) agents use?  Could we say that agents use taylor-series approximations around the point they believe to be the attractor, with the exact location of the attractor being uncertain?  If so, would it be interesting to imagine that simple agents use first-order (i.e. linear) approximations and sophisticated agents use second-order (quadratic) approximations?

What is the source of uncertainty?  With my example in the previous paragraph, why doesn’t everybody instantly know the new location of the attractor and adjust their rules of thumb accordingly?

How do agents learn?  Could we bypass this question by proposing that agents update their understanding of where the attractor is in a manner analogous to firms setting prices in the Calvo pricing (i.e. a fixed percentage of agents discover the truth in any given period)?