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Invisible Hand
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Author Topic: Invisible Hand  (Read 5175 times)
wodan46
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« on: September 10, 2009, 02:58:52 EDT »

If you want the invisible hand to work, you need the following three precepts to be true:
1. Those outside the deal are not affected by the deal in any way.
2. Those making the deal have complete and accurate knowledge about the terms of the deal.
3. Those who are part of the deal making process maintain consistent preferences even when the deal is viewed from different angles.
In short, for the invisible hand mojo to get its groove on, dealmaking needs Fair Participation, Fair Knowledge, and Fair Taste.  Unfortunately, the world does not appear to be constructed around precepts of fairness.
« Last Edit: September 10, 2009, 03:01:04 EDT by wodan46 » Logged

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Ihlosi
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« Reply #1 on: September 10, 2009, 11:35:17 EDT »

If you want the invisible hand to work, you need the following three precepts to be true:
1. Those outside the deal are not affected by the deal in any way.
2. Those making the deal have complete and accurate knowledge about the terms of the deal.

Those two boil down to "perfect information".

Another prerequisity would be that all involved actor are making rational decisions.

I recently read a highly interesting book ("Predictably irrational", by Dan Ariely) about the latter. The author concludes that humans do not act rationally quite often (even if they think they do), and, even worse, the irrationality is quite predictable and hence easily exploited.
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wodan46
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« Reply #2 on: September 10, 2009, 13:08:29 EDT »

Those two boil down to "perfect information".
The first has more to deal with externalities.  It doesn't matter whether or not a person is in the know that the deal impacts them, so long as the deal impacts them without their participation in the deal.  Though a person not realizing the deal impacts them while they aren't participating in the deal is definitely a bad thing.

Another prerequisity would be that all involved actor are making rational decisions.
That's what the third precept is talking about.  A "rational" individual will have stable preferences regarding the deal regardless of how it is portrayed.  The thing is, people dislike losses more than they enjoy gains, so depending on which they interpret as a loss and which they interpret as a gain, their weighting will differ.

I recently read a highly interesting book ("Predictably irrational", by Dan Ariely) about the latter. The author concludes that humans do not act rationally quite often (even if they think they do), and, even worse, the irrationality is quite predictable and hence easily exploited.
I'm uneasy with the term irrational.  Irrational people aren't actually being irrational.  Their behavior is an attempt to compensate for the second precept.  No person has the time or resources to consider all relevant information, and even if they did, they likely lack either the capacity to obtain the correct and complete knowledge, and the brainpower to analyze it properly.  As a result, people take shortcuts.

The simplest example of this would be where a person in an experiment is offered two choices.  Either the person can take 1 dollar while a plant takes 5 dollars, or they can both take 0 dollars.  According to economists and their vaunted "rationality", the person should always take the 1 dollar, because 1 is less than 0.  However, most people will instinctively choose to have both take 0.  This is because, in the real world, if you were to accept such a deal, you would declare yourself to be an easy target, and you would likely be exploited even worse in the future, whereas if you refuse the deal, your opponents will be more likely to make reasonable offers.  While in the experiment, where this interaction will only occur once and have no impact on future events, it might make sense to take the 1 dollar, the experiment is a very unrealistic reflection of the actual world.

In short, taking 0 dollars instead of 1 dollars isn't a truly irrational act, it is simply the person taking the mental shortcut that "unfair deals are bad", because the average person has neither the time nor resources to analyze every unfair deal and determine which ones are safe to take and which ones they should pass on.

You will find that most "irrational" behavior is a product of this.  It is not a product of stupidity, it is a compensating mechanism for stupidity.
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Ihlosi
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« Reply #3 on: September 11, 2009, 14:11:04 EDT »

I'm uneasy with the term irrational.  Irrational people aren't actually being irrational.

They are irrational, but in a predictable fashion. The author of the book (he's also a professor for behavioral economics at the MIT) goes into quite a bit of detail and describes many experiments he has performed. It's also written in a fairly entertaining style.

Quote
No person has the time or resources to consider all relevant information, and even if they did, they likely lack either the capacity to obtain the correct and complete knowledge, and the brainpower to analyze it properly.  As a result, people take shortcuts.

But even if people have all relevant information (which you can ensure in an experiment), they still act irrationally, simply because of how the brain functions.


For example, the brain finds it hard to work on an "absolute" scale. It always tries to compare options to each other. If there are three options, and two of them can easily be compared to each other and the third is quite different, people tend to pick the "better" of the two comparable options, even if the different option was the best on an absolute scale.

And that's just one of the chapters of the book.

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wodan46
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« Reply #4 on: September 11, 2009, 16:58:55 EDT »

I'm uneasy with the term irrational.  Irrational people aren't actually being irrational.

They are irrational, but in a predictable fashion. The author of the book (he's also a professor for behavioral economics at the MIT) goes into quite a bit of detail and describes many experiments he has performed. It's also written in a fairly entertaining style.
I have the book, but am probably never going to read it.  Currently, I'm taking no less than 5 social science classes, 3 of which are specifically decision science, which means the last thing I want to do with my free time is read MORE decision science.  I;m majoring in it because it represents the center of my field of interest, not my entire interests.  Hell, I'm pretty sure I've read several of his scientific papers, Ariely sounds quite familiar.

Also, I was supposed to be taking Behavioral Economics under George Loewenstein, but got waitlisted.  Even though its one of my core major classes and I'm a junior... not that I'm annoyed about it or anything.  Guess I have to wait until senior year.

Pity that Herbert Simon isn't around any more.  His building has awesome food though.

Quote
No person has the time or resources to consider all relevant information, and even if they did, they likely lack either the capacity to obtain the correct and complete knowledge, and the brainpower to analyze it properly.  As a result, people take shortcuts.
But even if people have all relevant information (which you can ensure in an experiment), they still act irrationally, simply because of how the brain functions.

For example, the brain finds it hard to work on an "absolute" scale. It always tries to compare options to each other. If there are three options, and two of them can easily be compared to each other and the third is quite different, people tend to pick the "better" of the two comparable options, even if the different option was the best on an absolute scale.
As I've just explained, they aren't being irrational, they are simply taking a shortcut.  It is rational for them to take the shortcut in the real world, where they have only a limited amount of time, resources, and mental mettle to analyze their options.

Also, define irrational.  That might help clarify perspectives.
« Last Edit: September 11, 2009, 17:36:08 EDT by wodan46 » Logged

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Ihlosi
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« Reply #5 on: September 11, 2009, 17:47:53 EDT »

Also, define irrational.  That might help clarify perspectives.

Irrational as in "making a decision that easily identified as being against their own interests".

Basically (almost) knowingly shooting yourself in the foot.

My copy of the book is in German, and the way the changed the title is ... interesting. Translated back into English, it means "Thinking helps, but it's no use."
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wodan46
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« Reply #6 on: September 11, 2009, 20:23:42 EDT »

Also, define irrational.  That might help clarify perspectives.
Irrational as in "making a decision that easily identified as being against their own interests".
Is that even possible?  By making a decision, they declare their interest in making it over alternatives.
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Ihlosi
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« Reply #7 on: September 11, 2009, 21:21:06 EDT »

Is that even possible?  By making a decision, they declare their interest in making it over alternatives.

According to the many experiments described in the book, it's not only possible, but you can also predict in which way people will make the suboptimal choice.
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wodan46
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« Reply #8 on: September 12, 2009, 01:32:26 EDT »

Is that even possible?  By making a decision, they declare their interest in making it over alternatives.
According to the many experiments described in the book, it's not only possible, but you can also predict in which way people will make the suboptimal choice.
That's not the point.  By making the choice, they are declaring their valuation of it over alternatives.  Whether or not it is the genuine choice that generates best returns is irrelevant, because from their perspective, they have rationally chosen the best option.
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Ihlosi
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« Reply #9 on: September 13, 2009, 16:43:31 EDT »

That's not the point.  By making the choice, they are declaring their valuation of it over alternatives.  Whether or not it is the genuine choice that generates best returns is irrelevant, because from their perspective, they have rationally chosen the best option.

But rationality is an absolute property. "Their perspective" and "rationally" is an oxymoron.

And in the experiments, the rational (best) choice is usually quantifiable (by counting the grams of chocolate/dollars/etc the participants end up with).
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wodan46
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« Reply #10 on: September 17, 2009, 00:06:57 EDT »

But rationality is an absolute property.
Irrational as in "making a decision that easily identified as being against their own interests".
Interest is a subjective term.  What if the person wants to lose?  What if the person lacks all the information or knowledge needed?

According to your interpretation, if I step out the front door of my home, then get blown up by a landmine, I'm being irrational, even though I had no reason or warning to presume such an event would happen.  If a person acts within the boundaries of their knowledge and talents to pick the choice they want the most*, then they are being rational.  That is my perspective.

*and they can pick no other, for if they did, they'd by definition want it more.
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Ihlosi
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« Reply #11 on: September 17, 2009, 08:32:34 EDT »

Interest is a subjective term.

That is why the experiments first try to eliminate the subjectivity. "Maximize the amount of money/chocolate/etc you have at the end of the experiment." is a fairly objective goal.

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What if the person wants to lose?

That would also be irrational, at least as far as market actors are concerned. The free market only delivers the predicted results if everyone wants to "win".

Quote
What if the person lacks all the information or knowledge needed?

This concern can also be eliminated in the experiments. They show that even if people want to win and have all the information they need, they'll still make suboptimal choices.

Quote
According to your interpretation, if I step out the front door of my home, then get blown up by a landmine, I'm being irrational, even though I had no reason or warning to presume such an event would happen.

No, that's not what I said, and neither does the book.

However, if you did an experiment and offered the participants to take either $100, $80, or €85, and told them the exchange rate, you'd still end up with a significant fraction of the participants picking the $100, because it's easier to compare $100 to $80 than $100 to €85. (of course, this experiment should be done in a place where the official currency is neither US-$ nor Euro, or you'll have people just pick the local currency for the sake of simplicity, which is another type of irrationality and not part of this experiment).
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wodan46
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« Reply #12 on: September 18, 2009, 15:13:46 EDT »

However, if you did an experiment and offered the participants to take either $100, $80, or €85, and told them the exchange rate, you'd still end up with a significant fraction of the participants picking the $100, because it's easier to compare $100 to $80 than $100 to €85. (of course, this experiment should be done in a place where the official currency is neither US-$ nor Euro, or you'll have people just pick the local currency for the sake of simplicity, which is another type of irrationality and not part of this experiment).
That example only works because the conversion is easy, accurate, and given.  However, in most cases, conversions are not as easy or accurate or obvious, and as such, its safer to go for the definitively high value.  People act according to what makes the most sense in the real world, not the experiment's sterile one.
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Ihlosi
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« Reply #13 on: September 20, 2009, 17:16:32 EDT »

That example only works because the conversion is easy, accurate, and given. 

The experiments cited in the book are less clear in this regard (one of them used faces, for example). The result is that if there are two similar choices (with one being clearly better than the other) and another choice that is not easily comparable to the other two (but in general as good as the better of the first two choices), there's a statistically significant bias toward picking the better of the two easily comparable ones.

So, if you're trying to sell a product and your competitor offers something that's roughly as good as your product, how do you boost your sales? Introduce a slightly inferior version of your current product.
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