Games People Play

Nobel Games

Game Theory is a theory of human decision making, and one that’s very popular in the dismal science: no less than thirteen of the forty four Nobel Prizes in economics have been awarded to practitioners in the area.  And, indeed, Game Theory is a powerful tool for researchers in many fields, the only problem being that if you give a man a powerful tool they’re likely to want to wave it around and use it on everything, regardless of taste and applicability.

Thus we find that Game Theory and behavioral economics collide in odd ways, which turns out not to surprising as the former is built on the foundations of the standard economic approaches.  Even so, a basic appreciation of the mysterious workings of economic gamers is an essential part of any investor’s kitbag of mental models.

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Perpetual Novelty, Santa Fe Style

Learnings from Science

By the late 1980's there was a growing recognition that the existing understanding of financial systems was flawed. Not only did markets not behave as the economic theories predicted but they often exhibited behaviour that didn't seem to have any pattern or cause at all.

In response to this a number of economists began looking at some of the research emerging from physics, biology and computer science in the area of complex adaptive systems and this led, in 1987, to a group of economists and scientists getting together at the Santa Fe Institute. The program of work that came out of this seminal event is still unfolding today, but suggests why academics and traders have had such different views on markets: one set lives in the real world, and the other doesn't.  Wanna hazard a guess as to which is which?

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Exit the Walras, followed by Equilibrium

Blinkered

As we saw in Economics and Psychology: The Divorce, the two queenly social sciences long ago parted ways. What we haven’t yet seen is quite what the economists did next, when they abandoned the idea that people had any part to play in economic behaviour.

To do this they chose to follow a path predetermined for them by physicists, which would have been all very well were it not for the fact that the bit of physics they choose to use turned out to be incomplete. Unfortunately, by cloistering themselves away from new research for nearly a century, this new reality was missed and by the time they emerged from their bunkers economics wasn’t so much wrong as irrelevant.

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Tâtonnement: Groping for Stock Equilibrium

Old Saws, New Rocks

One of the oldest saws in the book of economics is the idea of supply and demand; it even pre-dates Adam Smith, with a legacy stretching back to Muslim thinkers of the eleventh century. If people demand the Pet Rock as the next must-have toy but supply is limited then prices of Pet Rocks will go up. If some enterprising rock counterfeiter then floods the market with a supply of good-enough fakes then the demand is likely to fall, and price with it.

This iron rule of economics is actually a bit less rigid than you might think. In fact, it’s rather too wibbly-wobbly to describe it as a rule at all. But at the margins it more or less works which means it’s rather curious that it’s rarely cited as a reason for long-term changes in stock prices. It stands to reason, though, that if lots of people decide they want to buy shares just as companies start to withdraw them from the market that prices should go down. Or does it?

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