Friday, August 24, 2012

Models and Assumptions: Efficient Markets, Imperfect Information, Rationality, and Prices

“The relevant question to ask about the “assumptions” of a theory is not whether they are descriptively “realistic,” for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.” – Milton Friedman, Essays in Positive Economics 

"The great free market economic thinkers from Adam Smith to F. A. Hayek never argued that individuals were hyper-rational actors possessed with full and complete information, operating in perfectly competitive markets.... Efficient markets are an outcome of a process of discovery, learning, and adjustment, not an assumption going into the analysis." -

 “the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan. Of course, these adjustments are probably never "perfect" in the sense in which the economist conceives of them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency. To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem away and to disregard everything that is important and significant in the real world” – Hayek, The Use of Knowledge in Society

"I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge" - F.A. Hayek, The Pretense of Knowledge

 “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” - Frederick Hayek, The Fatal Conceit

“Neither all ends pursued, nor all means used, are known or need to be known to anybody, in order for them to be taken account of within a spontaneous order.” - Hayek, The Fatal Conceit

 "The financial crisis invalidated a naïve notion of "efficient markets," but the most sophisticated version is still viable. Whereas the invalidated version holds that markets never err and always adjust instantaneously, the sophisticated version, associated with the ideas of Adam Smith and F. A. Hayek, holds that markets mobilize individuals to realize gains from trade and to innovate and thereby produce generalized prosperity."

Robert Murphy points out in his textbook 'Lessons for the Young Economist': "When we look at the world and try to make some sense of it, one of the most basic and crucial distinctions we all make—usually without even realizing it—is the difference between purposeful action versus mindless behavior...The lessons in this book apply to purposeful actions performed by conscious people who have goals in mind… The economic principles in this book are not confined to “perfectly rational people.” The lessons in these pages apply to real people who use their minds to make exchanges in the real world every day."

 Economics deals with the real actions of real men. Its [laws] refer neither to ideal nor to perfect men, neither to the phantom of a fabulous economic man (homo oeconomicus) nor to the statistical notion of an average man. . . . Man with all his weaknesses and limitations, every man as he lives and acts, is the subject matter of [economics]. —Ludwig von Mises, Human Action (Auburn, Ala.: Ludwig von Mises Institute, 1998), pp. 646–47