Irrational Markets

Austrian economists - and others, with a similarly simplistic understanding of markets - operate under the unthought assumption that humans are rational maximizers, and if given the opportunity to negotiate deals, will inevitably choose to do that which is in their own best interest.

But humans are not always rational, and human institutions are not always rational.  This is not only due to quirks of our neurological make-up: even theoretically perfectly rational agents may behave in ways that are ultimately contrary to their own interests, thus, in a sense, irrational.  This is one of the key insights of game theory. One famous example is the "prisoner's dilemma," which shows that even when people are rationally doing that which is in their own best interest, nonetheless, this can inevitably produce a result that is in no one's best interest.  Then there's Newcomb's problem - after considering it for a while, many people come to the conclusion that there may be circumstances in which the rational strategy is to behave irrationally.  Or there are the thought-experiments of "Dollar Auctions," proposed by economist Martin Shubik.

Once we consider these game theoretical examples, and, to make matters worse, we reflect that humans are not logical abstractions but flesh and blood beings with all the infirmities, limitations, and foolishness that flesh is heir to, it becomes clear that we should not expect that markets always produce the most rational, the most efficient, or the most beneficial results. 

Mark Twain once observed that we can learn "too much" from experience:

“We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and that is well but also she will never sit down on a cold one anymore.”

We might say that Twain's cat is "overreacting" - or that it is traumatized, suffering from PTSD, triggered, or showing the signs of apophenia - the tendency to see patterns in one's experience that aren't actually there - a common human trait.

Markets can be like this, as well: predictably irrational.  Like humans on the individual level, markets can "overreact."  Consider a stock market after an earthquake.  Markets are notoriously "skittish," responding to all kinds of exogenous shocks with brief downturns, usually followed by quick corrections.  People become more cautious and thus less willing to buy, and the decreased demand causes the prices of stocks that are often completely unrelated to the earthquake to drop.  But why is this?  Well, you may know, and I may know that an earthquake in New Jersey has nothing to do with the price of tea in China - or with the stock price of a company that imports tea from China - but we can also predict that "other people" will irrationally sell their stock, leading to a price drop, and so we can maximize profit if we sell just before it falls.  But of course, it's a self-fulfilling prophecy - worries that the price will fall will cause the price to fall.