Wednesday, April 25, 2007

Somebody's got to pick the ten-dollar bill up off the sidewalk

Via Brad DeLong, this five-year old piece from Justin Fox that contains the following:

The dirty little secret of the behavioralists is that, for all their work on investor irrationality and market anomalies, they still believe that markets work pretty well and that trying to outguess the collective wisdom of millions of investors is usually futile.... But efficient-markets theory has a dirty little secret, too, which is that for the market to remain efficient, there have to be lots of rational investors who believe enough in the market's inefficiency to spend their careers trying to beat it....

It seems to me that this is true much more broadly than in financial markets. It's long since been recognized that entrepreneurship is, from the individual perspective, something like ahybrid between buying a lottery ticket and doing exceptionally generous charity work-- because few successful innovators are able to capture any large share of the social value of their innovation, so they bear the downside risk of the bankruptcy that is the fate of such a huge number of entrepreneurs without the full upside potential. The ones who seem to win the lottery by really generating a huge and important new idea rapidly see their profits for that idea whittled away by imitators. (Is this in Schumpeter? Or was this not fully put togther until Knight? I forget.) But we need the steady flow of cockeyed optimists to successfully identify potential innovations; and it's only the flow of them that suppresses the profits of each.

Opening a restaurant is the classic case-- the expected return of this behavior is large and negative, and if one day someone in your family comes home and announces a plan to do it, you should hold their head under running water until they sober up. The expected value of their income would be higher if they went and bagged groceries. But a) this is true because competition in the restaurant business is so intense, which is to say because there are so many other foolish people as well, and b) it's very good for the rest of us that there are these foolish people. Good for me, anyways; my restaurant-rich neighborhood always has places closing, but also always has new places opening...

Has anyone performed the standard behavioral economics experiments on defined subsets of persons such as entrepreneurs or day traders? Do the standard results (e.g. loss aversion) hold?