Russ Roberts

Vernon Smith on Rationality in Economics

EconTalk Episode with Vernon Smith
Hosted by Russ Roberts
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Nobel Laureate Vernon Smith of Chapman University and George Mason University talks with EconTalk host Russ Roberts about the ideas in his new book, Rationality in Economics: Constructivist and Ecological Forms. They discuss the social and human sides of exchange, the robust nature of equilibrium in experiments and the real world, the seeming contradiction between Adam Smith's two great works, the unpredictability of how innovation emerges and its rationality, what neuroscience might tell us about economic decision-making, and the challenges of small-group intimate exchange and our interactions with strangers in the extended order of the marketplace.

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0:36Intro. Survey on EconTalk main page. Essence of economics: how do people think, choose, behave, trade; experimental approach. Two different concepts of rationality, constructivist vs. ecological, from Hayek. Constructivist: the way we tend to think about problems traditionally in economics, models, mathematical or not, used to construct. Paper-and-pencil model of supply and demand. Difficult to understand the supply and demand story and what it is that people do in markets. Alternative approach is empirical: to use the constructivist model, borrowing from the world some well-defined institutions of markets. Will people be able to do it without the model? Astonishingly, yes. Participants in these experiments achieve equilibrium with a limited amount of information. Equilibrium means they eventually come to a price that has a set of properties that come from the supply and demand models. Consumer surplus. Used actual cash payoffs related to profits in the experiment to motivate participants. This is a constructivist model. It predicts that if people behave rationally as profit maximizers, they will maximize the surplus and produce an equilibrium in price and quantity/volume as predicted by the supply and demand model. But in book, constructivist model is use of reason to solve problems, e.g., policy rationally designs the best institutions. Adam Smith, preferences are expressed in demand and costs in supply, way of simplifying reality to explain competitive equilibrium and maximizing social welfare. One way to capture buying and selling.
9:56Why individual transactors have much less limited use of their reason and yet it turns out that the entire system is rational. Walras, auctioneer tries out different prices. Gold-fixing market is closest. First experiment: oral outcry double-auction, bid-ask market. Enormously popular, currency markets, stock markets, all use that mechanism. Other kinds of institutions: sellers post take-it-or-leave-it prices. Those converge, too, but they tend to take longer. Introduce policy variables and ask abstractly the best way to set those. How would it work? What is best? Economics struggles with the policy questions. People assume they can intervene in some way and make the world better but people will not change their fundamental baseline behavior as a consequence of the legislation. E.g., bailing out the mortgage and housing industries. But that will have future consequences. Why worry about being cautious if you believe the government will bail you out? Moral hazard problem. Inevitably people don't think about that, or at least not very deeply, when they try to do something for the people who are in distress.
15:35Ecological rationality. It turns out in supply and demand model people find the equilibrium if they have time to repeat trades over time. People, using their own devices, communicating through whatever the trading institution is, are able to achieve rational outcomes. Supply and demand is actually a moving target; nevertheless this gives you an illustration of how the information that we model by the use of reason is somehow aggregated out there by individuals to produce an outcome that's completely equivalent to the rational theoretical model. But the subjects in these experiments can't really model themselves! If you ask, "How did you do this?" they do not know. Bounded rationality of individuals should be changed to the bounded rationality of theorists. Duggan podcast, neuroscience of eureka, problem solving. We solve a lot of problems in life in ways that we don't understand yet we manage to produce solutions that have attractive properties. Examples. After deregulating airlines in the 1970s, which meant deregulating their routes so they could choose their routes. What astonished transportation economists was the emergence of the hub-and-spoke system. People had expected more non-stop service between secondary cities but it didn't work. People have a desire for frequency of service to allow them to leave at a certain time of the day. Complex problem involving networks. Interestingly, industry found an equilibrium. Example of an ecological equilibrium.
24:10Federal Express. Complaints about wanting to go through particular hubs without knowing the cost. Fed Ex directed everything through Memphis, TN. Seems inefficient, but Fred Smith probably knew what he was doing. Some waste, but waste that is well spent. Reduced total number of flights by an enormous factor; but that wasn't copied by other airlines. Hubs and spokes in the rest of the industry emerged only after others tried many other things. Fred Smith's Yale paper talked about some of these ideas. He also put some of his sister's money into this and was sued--a lot of optimism. Entrepreneurs often don't use their own money, but they find people who are willing to bet on them.
27:48Rudiments of exchange. Adam Smith, propensity to truck, barter, and exchange. We think of our commercial side, the human propensity to shop. But it's much more comprehensive than just commercial exchange. Insight from experiments, two-person interactions in a sequential move game tree. Game theory predicted people will always choose the dominant one, and if two people follow that rule and perform backward induction then the game has an equilibrium. There are better outcomes for the two parties if they can figure out a way to cooperate. Each player may defect on an offer of cooperation by the other, and if you are strictly self-interested that's what you will always do. But a good half of our experimental subjects don't follow the dominant strategies. But you can't say it's irrational because on average the people who follow cooperative strategy make more money than those who play the equilibrium of the game. Led to Adam Smith's Theory of Moral Sentiments, 1759 first edition; but major rewrite just before his death. Book never enjoyed the popularity of his Wealth of Nations. Who are we likely to be benevolent toward? Those who have been benevolent to us in the past. Talking about reciprocity, without using that word. What would we do if we were in the situation someone else is in? Should have become the foundation of the field of psychology, social psychology. Seeming tension between the two of Smith's books. In TMS, he says people are motivated by love, caring; but in the Wealth of Nations, he focuses on self-interest. Some claim that's contradictory. Reconciled: trading of favors and sharing and local social groups is really an exchange system. Form of trading system, gains. Family, extended family, tribes, anthropological evidence. We don't know how that may have evolved into trade with strangers, use of money, sophisticated forms of trade and exchange, global trade. That history is lost. Probably rooted in religious traditions emphasizing the great "Shalt Nots": thou shalt not steal, thou shalt not covet thy neighbor, etc., property rights rules expressed as moral behavior. Hayek made this point. Became encoded in legal systems. Lead to some unfortunate consequences: we think of good being something that people deliberately bring about. I do good when I return your favor. We think of good acts as being deliberate. But unfortunately we carry that type of thinking and reasoning over when we look at markets, thinking we can make markets do good by intervening.
38:33Hayek quote: "Part of our present difficulty is that we must constantly adjust...". We are not well-equipped to live in those sorts of worlds, melding our small social groups with strangers. The good that markets do is not something that we experience directly as individuals. If I'm a buyer I see markets as biased toward sellers and vice versa. People within the market don't see the structure or how and why it is effective. Humans have an incredible ability to solve problems that they don't really understand themselves. Involves motivations, social brains. People are interacting in a double-auction market, taking into account information, and are somehow responding to that in a way that turns out to be dynamically the right way to respond to end up in the predicted equilibrium--which maximizes their surplus. People who solve problems can't explain how they do it. Neuroscience, limits. What insights do we need to understand about the brain? Neuroscience is only at the beginning. Example of results: People are well-motivated to earn money. How does the brain encode the value of money? Turns out that it encodes it the way items of pleasure like food are encoded. Brain latched on to the reward centers, interpreting money as goods, same as commodities. Raises question: What happens when the State debauches the money supply? Governments frequently inflate the money supply. The brain at some point must make a switch to adapt to that, but we don't know how that's done. Neuroeconomics may be able to answer that in the future. MRI machines. Even an activation, though weak, if it's not real money. Brain imaging of choice.
48:23Mainstream textbook model of economic man is a utility-maximizer; we may toss in a little altruism. Is that the right way to teach economics? Temper it with a healthy dose of reading the Theory of Moral Sentiments. The economic model is good and we were right to pursue it, but there are non-market processes that are important. Rich possibilities of understanding the economic model better through being multi-disciplinary. Important to expose the model to these other considerations. Mystical understanding of markets, prices that emerge from our trucking, bartering, and exchanging. Quote: "We can never fully understand how this process works in the world because the required information is not given or available to any one mind." Recognition of the limits of human reason in grasping the rationality of a system that is greater than the individual participants. Policy implications. Important role of freedom in our society. It's through freedom that people are able to discover new ways of connecting, creating new institutions, and those institutions tend to be very much influenced by technology. Communications, computer revolution. Possibilities for people to link up formally or informally, blogs. Enriching opportunity. Why did our ancestors walk out of Africa? They had the tools to do it. New Zealand settled 1000 years ago, 500 years before the square rigger sailing ship had been invented. Rediscoveries happened after the square rigger, driven by entrepreneurial spirit, inventive spirit, ability to create social connections in tribes that make those tribes powerful investigators of the unknown. March of the Penguins. We've populated almost all the globe, now we turn to the human mind. Can the mind understand itself? Not clear that it can.
57:33Long trend in Western Civilization, especially among the intellectual elite, to argue that commercial activity is degrading, bad for the soul. Are markets, or even the study of economics, is degrading? Do they destroy virtue? Commercial enterprise in the human career has been just as important and valuable as the art and poetry enterprises. All reflect who we are and what we are as humans. Commercial enterprise is an engine of wealth creation that enables people to do art and music and all these intellectual activities. All remarkable examples of human ingenuity. Can't take one part away and say humans are better off.

COMMENTS (13 to date)
Rodney writes:

Hi Russ,

I gather you're a free-trade advocate so you might find it interesting to interview Ha-Joon Chang. His new book 'Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism' challenges the economic orthodoxy and would be a good basis for a lively debate.

Regards,

Rodney.

nick ronalds writes:

In fact there have been active markets where supply and demand are equalized by moving prices up and down: the Japanese futures markets. Under the pre-electronic system, which wasn't that long ago, the "Saitori" would call out a price and traders and brokers would convey via hand signal the sizes of their bids and offers. The Saitori would move his price up or down as long as there was an imbalance; the moment supply and demand matched, he would clap two wood blocks together to indicate the transactions were executed at that price. The exchanges held multiple sessions over the course of the day, and they each lasted anywhere from a couple of minutes to a maximum of twenty. I think they might even be using an electronic version of that system at the Tokyo Commodity Exchange.

Nick Ronalds writes:

I forgot to say in my post about the Japanese Saitori system that this was a fantastic interview. The subtlety and profundity of Smith's thinking came through distinctly. How refreshing to hear a Nobelist who is both confident yet cognizant of the limits of our understanding--his own as well as ours as humans.

James writes:

I found this podcast a bit slow and boring. The guest spoke very slowly and his voice was grating. Not one of the best.

Nick writes:

It's true he was a relatively slow speaker. But the words tended to be the right ones, in that the word you waited for was not necessarily the expected one but suggested, at least for me, an unexpected way of looking at things.

jp writes:

Great podcast.

I found the observation that people with limited information will naturally converge to the equilibrium market conditions determined by economic models quite fascinating.

But it also made me wonder: if models arrive at the same market solutions that freely transacting individuals do, why even have markets? Just use the models to administer prices.

Russ Roberts writes:

jp,

Alas, the models are not as smart as the people transacting and choosing inside them.

See Buchanan's "Order Defined in the Process its Emergence."

It's maybe a single page. It's very deep.

Russ writes:

Good stuff.
There was one question where you asked Vernon how he came to read Hayek on a particular topic and to explain Hayek's point. Vernon never got to that in his answer and you moved on.
As a budding Hayek fan, I was disappointed in that one segment.
Russ

Unit writes:

Modeling the market process is a bit like modeling scientific discoveries. The outcomes are hard to predict, but once the end-product is available it's fairly easy to go back and retrace all the steps that lead to it.

Douglas B. Rasmussen writes:

In the interview with Smith, someone quoted Hayek's distinction between two types of social orders. One is where relationships are local, and the other is where they are wide. Also, the need for different norms for these two orders was noted. What is the reference?
Doug

Russ Roberts writes:

Douglas,

It's from The Fatal Conceit. Here's the quote:

"Part of our present difficulty is that we must constantly adjust our lives, our thoughts and our emotions, in order to live simultaneously within the different kinds of orders according to different rules. If we were to apply the unmodified, uncurbed, rules of the micro-cosmos (i.e. of the small band or troop, or of, say, our families) to the macro-cosmos (our wider civilisation), as our instincts and sentimental yearnings often make us wish to do, we would destroy it. Yet if we were always to apply the rules of the extended order to our more intimate groupings, we would crush them. So we must learn to live in two sorts of world at once."

Matthew Wavro writes:

Excellent discussion. The implications of the rationality Dr. Smith speaks of has huge implications in political science. The orthodox political science position holds that citizens can not hold such complex concepts as supply and demand for a product in their mind much less identify an equilibrium. Applied to politics, if citizens can identify the supply and demand of legislation on a particular issue, a reconsideration of the last 50 years of political science is required! That is a ton of work and a steady uphill climb/battle. Thanks a lot!

Amy writes:

As a graduate student, it's nice to hear long-time professors explore theory and models and acknowledge models aren't perfect. Thank you.

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