American Economic Association

Experimental Economics: Reply

Author(s): Vernon L. Smith
Source: The American Economic Review, Vol. 75, No. 1 (Mar., 1985), pp. 265-272
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1812727
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 Experimental Economics: Reply
By VERNON L. SMITH*
More than in any particular method of
inquiry, I think the hallmark of science is to
be found in a constructively skeptical atti-
tude toward knowledge.' The more funda-
*Department of Economics, University of Arizona,
Tucson, AZ 85721.
1 The principal contribution of Popper's falsifi-
cationist methodology is, I believe, the influential at-
tempt to develop a formal logic of skeptical inquiry.
That the attempt has failed, in the sense that it has
produced no defensible codified set of procedures that
yield a science of scientific method (happily it would
appear that all such attempts will fail), should not
detract from the disciplinary value of the falsificationist
perspective in approaching scientific questions. Its value
to the experimentalist is to force him to ask "How can I
design an experiment with the property that the set of
potentially observable outcomes can be partitioned into
those that are consistent with one (or a given) theory
and those that are consistent with other theory(ies) (or
inconsistent with the given theory)?" That experimental
life is such that his effort is about as likely to fail as to
succeed by no means detracts from the value of the
exercise. Its value to the theorist (if he will just forgo the
career-advancing primeval incentive to publish yet
another technically tractable extension of the existing
theory literature) is to force him to ask "How can I
model this question so as to suggest (as Martin Shubik
would say) a do-able experiment, and so as to yield
observable implications that do not exhaust the set of
possible outcomes?" That this effort will often fail does
not detract from the value of the exercise. Having said
this I would not want to leave the impression that
experiments that are fishing expeditions in the labora-
tory to see what will happen are of no value; seeing
what happens can be essential in defining an analytical-
empirical research program. Similarly, when a theorist
builds (as Buz Brock would say) castles in the air, this is
not necessarily useless, for it may lead to more oper-
ational forms of theory. We should impute some non-
zero probability to the proposition that Feyerabend's
"anything goes" posture is right. But at this stage I
think it has become pretty obvious where our profes-
sional weaknesses are concentrated. Economists, while
spouting the rhetoric (Donald McClosky, 1983) of the
falsificationist, are in fact verificationist to the core. We
all do it. We take a proposition, conjecture, or theory,
then search for supportive historical or empirical exam-
ples. As everyone ought to know, seek and ye are likely
to find, whether one is a "Keynesian" or a "supply
sider." What is not sufficiently appreciated is that this
verificationist grubbing is a prescientific exercise in which
one asks whether there is any supporting evidence, and
265
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mental are the concepts and assumptions of
a science, the easier it is to take them for
granted and to abandon this skepticism. In
this spirit, Ronald Heiner (1985) is correct in
emphasizing that the "knowledge" obtained
from the study of the performance of experi-
mental markets is only as secure as the
classical preference model used to induce
prespecified value structures on the agents
in such markets. If the purpose of an ex-
periment is to test a theory (for example,
supply and demand), and the theory is not
"falsified" by the test, this in no way sup-
ports any premise of the theory which was
also a premise of the experimental design.
When we falsify a theory, the implication is
that one or more of its assumptions about
the behavior of economic agents (maximiza-
tion of expected utility, commonly shared
(homogeneous) expectations, risk aversion,
zero subjective costs of transacting, etc.) is in
question, and the immediate task is to mod-
ify the suspected behavioral assumptions of
the original theory. Other assumptions-such
as that agents have well-defined preferences,
or know the probability distribution from
which other agent values were drawn-are
not brought into question by the experiment
because the experimental design reproduced
(or should have) the environment posited by
the theory being tested. When testing formal
market theories in this way, we should al-
ways be aware of the fact that we are study-
ing behavior within the context of our repre-
sentations of the economic environment. If any
of these representations is wrong, then our
studies have only increased our self-knowl-
edge, not our knowledge of things (natural
economic processes).
If we are to increase our knowledge of
things, then our ultimate aim should aspire
to more than discovering that the behavioral
how difficult it is to find; if there is none or if it is pretty
hard to uncover, it suggests abandonment in the presci-
entific womb.
266 THE AMERICAN ECONOMIC
properties of our own creations are con-
sistent with controlled experimental evi-
dence, although the attempt to falsify these
creations may be a necessary step in acquir-
ing the conditional knowledge that can
improve our theorizing ability. This is why
empirical investigations of all aspects of
parallelism between laboratory and field
behavior are important. Similarly, our ex-
perimental and other investigations should
not be confined to testing formal theory (for
example, nomothetic experiments) since this
objective requires us to impose more struc-
ture on the free play of decision making than
ultimately may be justified. Finally, our re-
search methodology should not be too rigid
in testing only the market implications of a
theory (or in testing only the assumptions of
a theory).
Thus, John Kagel et al. (1981) have ad-
dressed direct tests of the observable impli-
cations of preference theory. This literature
reports results consistent with standard pref-
erence theory (i.e., with Hicks-Slutzky in-
come-compensated demand theory), but also
with the ad hoc widely assumed law of de-
mand, which Heiner (1983) is able to deduce
from his model of adaptive uncertain choice.2
As noted by Kagel et al., the convergence
tendency reported in auction market experi-
2Since it seems that no one has ever produced any
rigorous evidence for the existence of a price inferior
good (Sir Giffen was just speculating, and had no con-
trols on his "experiment"), its prediction by textbook
theory is a curiosity (which was recognized as such by
Alfred Marshall who started it all), that should have
counted against the theory, just as the failure to find a
planet "Vulcan" between Mercury and the sun (there
was no shortage of claimed sightings), that would accountCharles Plott, 1979; and especially the survey
for the advance of Mercury's perihelion, ultimately
counted against Newtonian theory (David DeVorkin,
1983, p. 1058). In more mature sciences this might have
sparked analytical interest in producing a theory con-
sistent with the law of demand, but having other falsifi- respects inconsistent with controlled evi-
able implications. Contrarily, in economics such a the-
ory might even be considered unpublishable because of
its "lack of generality," and the Giffen good curiosity
has sparked an endless preoccupation with examples of
" multiple" and " unstable" equilibria based on the
Walrasian adjustment mechanism, which is itself devoid
of any institutional evidence. These have been good
analytical exercises, but so far as I can see all this
self-knowledge is good only for teaching the defenseless
and uninitiated students who will form the next genera-
tion of automata.
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REVIEW MARCH 1985
ments "depends critically on the fact that
subjects behave in a way which is consistent
with utility-maximizing principles underlying
consumer demand theory and that negatively
sloped demand curves have been induced in
the market" (p. 13). I do not wish to suggest
that these studies have put to rest the issues
raised by Heiner whose emphasis is on the
inadequacy of standard theory when prefer-
ences are uncertain. Indeed, both the animal
and especially the human preference studies
of Kagel et al. exhibit "dynamic" effects or
lagged responses that are not even supposed
to exist in received preference theory, and
which may reflect the "insecure preference
beliefs" suggested by Heiner (1983). It would
seem that lagged responses are inconsistent
with a cognitive, calculating interpretation of
preference theory, but consistent with some
sort of adaptive response interpretation. Even
if preference theory accounts for many
agents' stationary state choices in certain
experimental situations, it tells us nothing
about the processes that yield these "good"
predictions or why some agents' behavior is
not consistent with the theory. The failure of
animal studies to falsify demand theory can
be interpreted as lending support to Heiner's
(1983) emphasis on rule-governed behavior
although here the "rules" are apparently
programmed into the instincts (genes), unless
we are prepared to accept the proposition
that species other than ours have cognitive
decision-making powers.
Furthermore, the numerous direct studies
of individual decision making under uncer-
tainty, over the past 25 years (see the recent
papers by David Grether, 1980; Grether and
and evaluation by Paul Slovic and Sarah
Lichtenstein, 1983), suggest that our theories
of decision under uncertainty are in several
dence. The results of these experiments are
robust under replication, and various arti-
factual explanations of the results (that might
have rescued the theory) have been sys-
tematically eliminated. The results are not to
be idly dismissed by anyone with the slight-
est interest in evidence. What I want to
suggest is that (so far as we are able to tell)
experimental methods are entirely competent
VOL. 75 NO. I SMITH: EXPERIMENTAL ECONOMICS 267
to examine these important issues. New the-
ory, such as that proposed by Heiner (1983)
and Soo Hong Chew (1983) (also see Don
Coursey, 1982) are particularly welcome at
this stage in research programs using, or
directly concerned with testing, preference
theory under uncertainty.
However, among those who take these ex-
perimental results as a serious challenge to
existing theory, not all may interpret them
in
the same way. In the following I will try to
state some of my interpretations, and relate
them, where it seems appropriate, to Heiner's
work.
1) The state of experimental research on
decision under uncertainty has produced
many unresolved anomalies. Experimental
tests of market theories, which explicitly
assume expected utility (or value) maximiza-
tion, have not falsified many of these theo-
ries (for example, James Cox, Bruce Rober-
son and myself, 1982; Plott and Louis Wilde,
1982). Yet, as indicated above, the results of
direct tests are inconsistent with the expected
utility hypothesis (EUH). Some, but not
all (for example, violation of simple domi-
nance), of these anomalies are resolved by
Chew's weighted expected utility hypothesis
(WEUH). Although at this stage I think it
would be premature to abandon EUH, and
especially its extensions, it is not premature
to work on the resolution of these anomalies.
(One did not reject Newton's inverse square
law of attraction because the planets failed
to move in perfect ellipses, nor because of
the highly inconsistent observed advance in
the perihelion of Mercury.)
2) One route to such a resolution may
be to recognize, and to elaborate more for-
mally, the hypothesis that subjects are more
rational (in the sense of received decision
theory under uncertainty) in the context of
laboratory markets, than when responding
to questionnaire choices among prospects,
because of Heiner's conjecture that " Ex-
change environments also enable agents to
interact with each other in an organized and
often repeated fashion. Markets thus provide
agents with additional feedback that may
help guide their behavior" (1985, p. 263).
From the study of experimental markets, I
have long thought that markets may induce
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greater " rationality" in behavior because they
force or promote a response to, or discovery
of, opportunity cost conditions, that need
not be readily forthcoming when agents
merely think about the choices they make.
What I have in mind may be close to Armen
Alchian's (1977, pp. 27-32) imitative and
trial-and-error forms of conscious adaptive
behavior, except that I would deemphasize
the "conscious" element.3
Different forms of market organization
have been found to differ in their power to
induce or extract neoclassical rational behav-
ior. Thus the English auction is slightly more
efficient (97 percent of the allocations are
Pareto optimal), and prices are consistently
closer to the predicted second highest value
among the bidders, than is the Second price
sealed-bid auction (94 percent Pareto opti-
mal allocations) (see Cox, Mark Isaac, and
myself, 1983, pp. 73-75). An explanation is
simple. In the English auction it is a domi-
nant strategy to raise the standing bid if it is
less than your value, and to never raise your
own bid. Behaviorally, the temptation to use
this strategy is irresistable, and made trans-
parent (without thinking) by the sequential
complete bid information properties of the
process. In terms of Heiner's model (1983),
subjects easily (I would say at low cost)
3In writing this reply, I found myself reminiscing that
Adam Smith did not begin his economic analysis, as
does mainstream economics, with preferences as the
primeval cause of the phenomena we study. He began
with a deeply insightful observation qua axiom, which
states that man is unique among all animal species in
exhibiting " the propensity to truck, barter and exchange
one thing for another." (Man is not unique in revealing
preferences.) After some speculation that this might be a
consequence of man's ability to use language (I would
speculate that man's development of language may have
been in part due to the specialization and affluence
made possible by markets), Smith deduced the im-
portant result that it is this power of exchanging that
gives rise to wealth creating specialization, which in turn
is limited by the extent of the market. Markets thus lead
agents to promote ends which are no part of their
intention. Except for modern scholars such as Hayek,
the idea that we are studying processes that contain
major elements that are not consciously or cognitively
purposive has been lost in the pyrotechnics of straight-
ening out Smith's little paradoxes of value. No wonder
that Kenneth Boulding will tell you flat out that Smith
was the first great post-Newtonian scientist.
268 THE A MERICA N ECONOMIC RE VIE W MA RCH 1985
perceive, perhaps quite unconsciously, the
opportunity cost of "nonoptimal" behavior.
In the Second price sealed-bid auction it is a
dominant strategy to submit a bid equal to
your value. But this requires reasoning which
is in fact very subtle, although, as with all
puzzles, it is obvious or "trivial" once you
understand it.4 One must perceive that if
one's own bid is the highest, the price paid is
the amount of the next highest bid, and
therefore one's surplus to be gained is inde-
pendent of the amount bid. So the "rational"
bid is to maximize your chance of winning
by bidding your value. About a third of the
subjects recruited out of campus classrooms
to participate in a sequence of Second price
auctions (with values assigned independently
from a distribution to all bidders in each
auction), bid "as if" they perceive the im-
plied dominant strategy from the beginning.
About one-third appear to "learn" asymptot-
ically from their success-failure experience
that this is the "best" strategy. Another third
do not clearly converge to the dominant
strategy- some hit it irratically, some rarely,
if ever, and some bid just below value. An
examination of the bids that are less than
value reveals that many occur at values so
low that the prospect of having the winning
bid is remote. These can be interpreted as
"throw-away" bids, and if in the strict sense
they are "irrational," at least they are only
marginally so.5
4Richard Thaler once reported in a seminar that,
informally, he had gone around polling economists as to
how they would bid, after describing the Second price
auction procedure. This was before William Vickrey's
discussion of this auction had become so well-known.
He reported that very few got it "right." Most thought
one should bid at least a "little" under value. The early
polling of economists on Allais, Ellsberg, Second price,
and other such " paradoxes" makes it clear that
economists will get it "wrong" about as often as the
sophomore subject (who of course we pay a monetary
reward) until he or she has had considerable time to
think and analyze. Incidentally, this observation pro-
vides an answer for that somewhat mythical business-
man who asks, " If you're so smart why ain't you rich?"
My classmate, Otto Eckstein, didn't get rich by equating
price to marginal cost.
'An outstanding young economist once asked me
why I was bothering to do Second price sealed-bid
auction experiments since the dominant strategy prop-
erty was so trivial. I encounter statements in this spirit
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3) The wide variety of different experi-
mental studies of decision making under un-
certainty, yielding results inconsistent with
EUH, are subject to different interpretations
in terms of the damage they inflict on EUH.
I think a key element in these interpretations
is what Jacob Marschak (1968) long ago
called the cost of thinking, calculating, decid-
ing, and acting, which are all part of what I
have called the subjective cost of transacting
(SCT) (see my 1982 article, p. 934 and pas-
sim). Of course, one could argue that EUH
and its Chew-Machina-type extensions are
on the face of it inadequate theories because
they leave SCT out of the formal apparatus.
But this is much too harsh. Considerations of
SCT are hard to formalize within a frame-
work as general as that attempted in EUH
and WEUH, that allow the latter to be de-
duced as limiting cases when SCT goes to
zero, or when outcome values get large rela-
tive to a fixed SCT. But the modification of
standard EUH theory by introducing SCT
elements in particular decision-making con-
texts (Sydney Siegel, 1961), or in illustrative
examples (my 1982 article, p. 934), point to
the untapped potential of imbedding stan-
dard theories in larger (and more "rational")
frameworks. How important are the SCT
elements in the various decision contexts
which yield violations of EUH?
(a) I think the class of violations which
are due to Kahneman-Tversky framing effects
(see Slovic and Lichtenstein, and the refer-
ences therein), do relatively low level damage
to EUH. The typical case here is that the
options are identical in two situations except
that in one the outcomes are stated in terms
of what will be lost (deaths), the other in
terms of what will be gained (lives saved). It
seems to me that these are like elementary
optimal illusions, which the individual, at
comparatively low cost, can learn to recog-
so regularly that it has become a permanent way of life.
They reveal two things: 1) how quickly, easily and
matter of factly as economists we are prepared to be-
lieve our own propaganda (theorems), and to use these
beliefs to insulate ourselves from evidence; and 2) how
the use of experimental methods leads one to think
about the world of economic knowledge in a fundamen-
tally different way.
 VOL. 75 NO. 1 SMITH: EXPERIMENTAL ECONOMICS 269
nize as such (for example, the individual can
be taught that the death rate is one minus
the survival rate. If it is hard to teach this, as
it may be, then I am wrong in interpreting it
as a low-cost recognition problem). We all
learn that when the sun is low, the pond in
the highway ahead is just a reflection, and we
do not risk a rear-end collision by jamming
on the brakes. In saying this, I do not mean
to suggest that the study of framing effects is
of no interest. On the contrary, these exam-
ples show how bad we can be at intuitive
problem solving, and why it is important to
examine a decision from alternative perspec-
tives. Also, these examples vary in trans-
parency. I find the second example cited by
Slovic and Lichtenstein (p. 597) to involve
more SCT than the first. I think the equiv-
alence of the two situations in the first exam-
ple could be conveyed to the uninitiated
much more easily than the second. So some
of these "optical" illusions may be more
costly to expose than others.6 Note that this
SCT interpretation blurs the distinction
often made between positive and normative
economic theory, but I have never been
convinced that such a distinction was very
helpful.
(b) The preference reversal examples
may represent still more sophisticated "opti-
6In studies of science learning it is found that bothparallel. There is first a question of the com-
weak and strong learners come to their first science
classes with extensive "naive" theories about how the
world works. They use these naive theories to explain
physical events and tend, even after instruction in the
new concepts and the scientific support for them, to
resort to their prior theories to solve problems that differ laboratory experiments, the situations are
from the textbook examples (Lauren Resnik, 1983). Of
course with EUH we have the difficult problem of
deciding when the subject is making a "mistake" (an
"optical" illusion) which she can at more-or-less cost
recognize as such, and when the theory is a mistake, or more clearly interpretable as inconsistent
not relevant to the actual problem faced by the subject
(which, for example, might be better represented by
WEUH than EUH). The fact that about one-third of
the subjects in sequential Second price sealed-bid auc-
tions "learn" to make dominant strategy choices has
been interpreted as analogous to learning that a certain
mirage is an optimal illusion and the self-interest is not
served by taking such a phenomenon at its face value
(Vicki Coppinger et al., 1980, p. 20). Also see Thaler
(1983) for a discussion of cognitive illusions and mirages and EUH is considered to be just a limiting
in decision making.
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cal" illusions, and may require rather more
SCT to yield consistency of choice. How-
ever, the fact that they seem to be moderated
(although they do not disappear) when the
motivation is increased (Werner Pom-
merehne et al., 1982) is consistent with the
hypothesis that subjects do seek to increase
benefits net of SCT, even where the latter are
relatively large. A preference reverser is of
course vulnerable to a con game (money
pump) in which a sequence of decisions will
produce a loss in assets. Will a person dis-
cover his decision inconsistencies and learn
the appropriate corrections in a money pump
sequence? In this context EUH is being
tested in a more market-like framework. J. E.
Berg et al. (1984) report results showing that
although the frequency of preference rever-
sals is not reduced, the total value (dollar
magnitude) of preference reversals is re-
duced. Apparently, there is positive interac-
tion between the stakes, and the money pump
treatment. They also report that the prefer-
ence reversal phenomena tends to decline
across experiments with the same subjects.
4) The results of direct laboratory tests
of EUH have been used to explain the ap-
parent failure of EUH in insurance, securi-
ties and futures markets (see Kenneth Arrow,
1982; Heiner, 1983). Although this appears
to be evidence of parallelism in behavior
between laboratory and field, I think we have
to be particularly careful in drawing this
parability of the quality of the evidence in
the two environments, and second a question
of whether EUH is failing for the same
reason in the two environments. In the
carefully controlled and structured, the states
of nature are well-defined, and so are the
outcomes. Consequently, the results are much
with EUH, even if the cause of the incon-
sistency is an inappropriate carryover to the
laboratory of Heiner's rule-governed agent
whose habits have been developed in the
more unstructured uncertainty environments
of the field; or if, as I have suggested, the
results can be interpreted in terms of SCT,
case of a more general economic problem.
270 THE AMERICAN ECONOMIC REVIEW MARCH 1985
An example may help to clarify one type
of ambiguity in interpreting field observa-
tions in terms of EUH. Suppose you have
had a sore rib for many weeks that hasn't
healed. Your doctor sends you to the lab for
an x-ray to "see if it is fractured." It is not
fractured, and she tells you, "Well, a hairline
fracture might not show, but it doesn't much
matter since the treatment is the same
whether it is a fracture or a contusion." You
think, "This violates the Savage axioms!"
Does it? How do you (or does she) know that
there are only two states of nature, rib frac-
tured or rib bruised, given that it is sore?
Could a carcinoma behind the rib make it
sore? There may be hundreds of causes of
sore ribs, and it may not be worth anyone's
trouble to list them all, or even to invest time
in thinking about any significant fraction of
them. A host of past experiences may have
programmed your doctor to acquire informa-
tion that appears to be redundant in this
particular case, and she may be unable to
organize these experiences into an articulate
case for her actions because such a detailed
cognitive treatment of every decision is
neither a necessary nor a desirable feature of
her modus operandi.
As a second example, take the reported
reluctance of people to insure against rare
disasters even though, since 1969, the
government has offered subsidized flood in-
surance rates that are below actuarial value.
Is it a fact that this violates EUH? If it is a
fact, then I like Heiner's explanation that
there is a tradeoff between the greater setup
costs (these are part of what I call SCT) of
insuring against more events of small prob-
ability, and the expected loss from failing to
insure, and it is hardly economical to insure
against everything. Hence, in the field situa-
tion EUH is failing because it formulates the
wrong economic choice problem, by leaving
out SCT. But it is not clear from the evi-
dence that this is an example of the violation
of EUH. Arrow tells us that the reason the
government offered the subsidized insurance
"was to relieve the pressure for the govern-
ment to offer relief when floods occurred"
(p. 2). If I have built a house on a flood
plane, if flood planes sometimes flood (we
call them 100-year floods in Arizona), and if
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it is standard political procedure for the
governor to declare it a disaster area, and the
federal government to respond with relief
when a flood occurs, then I might not buy
insurance even at rates below actuarial value.
(This need not be a conscious decision with
people able to state that the failure to buy
insurance was due to the expectation of
government relief.) Without better controls
on the experimental treatment variable, I
don't know how to interpret the observa-
tions. This problem does not reflect on the
quality of these excellent studies cited by
Arrow, but on the difficulty of doing field
experiments with the most desirable controls.
Similar considerations apply when asking
whether interest rates or stock prices vary
"too much" (see the studies by Cagan and
Shiller cited in Arrow). It is unclear what is
to be concluded when the falsifying "facts"
are no more than "an impression which many
students of these markets and practitioners
in them seem to have" (Arrow, p. 4).
But Stewart's finding that unprofessional
speculators lose money in grain futures is
cited by Arrow as "especially surprising,"
and he asks "why did they enter the market
at all?" (p. 3). I would suggest that they do it
for the same reason that people go to Las
Vegas to play roulette, buy tickets in the
Arizona Lottery, and play bingo at the local
church on Thursdays. I don't see any way to
understand these phenomena with EUH (it
is well known that convex, risk-preferring,
utility doesn't explain repetitive small stakes
wagering) nor any way to understand them
with Heiner's theory. I find it necessary, if
not entirely satisfactory in terms of seeking a
universal theory, to accept the idea that some
people just simply like to gamble (ancient
hunter cultures did it) and that it has com-
modity value, or perhaps that some people
have "pathological" expectations, whether it
is roulette, grain futures or stock investment.
(See my 1971 article.)7
71f in all markets with uncertainty there is a subclass
of participants with these "irrational" characteristics,
this lowers the insurance cost of hedging and lowers the
cost of capital to firms. The gamblers lose money volun-
 VOL. 75 NO. 1 SMITH: EXPERIMENTAL ECONOMICS 271
I have no disagreement with Heiner's cri-
tique of classical preference theory, which is
among the roots that should be reexamined.
However, I would register disagreement with
Heiner's interpretation of "privacy" as an
experimental condition. As noted in my
article (1982, p. 933, fn. 13; p. 935) the
purpose of privacy is to maintain control
over preferences. Privacy does not deny the
existence of interpersonal externalities. The
latter is achieved under controlled conditions
by simply inducing the appropriate interde-
pendent preferences if that is the topic of
investigation. If one wishes to study the effect
of " utility information" on behavior, one
publicizes information on commodity alloca-
tions, or token earnings (which is analogous
to income in the field), but not subject cash
payoffs since these are to induce utility on
allocations and indirectly on token income.
The idea is to preserve the natural uncer-
tainty about other's subjective value of allo-
cations, and of the exchange medium.
tarily, the economy benefits and perhaps only EUH
suffers as a predictive theory for some types of agents.
But the existence of such agents in futures, stock, and
option markets will cause such markets to appear to be
irrational by our definitions, whereas actually these
markets may be performing with high allocative
efficiency, given the environment, by taking wealth away
from the gamblers and giving it to the hedgers, inves-
tors, and rational expectationists. Isn't Las Vegas an
exchange market between gamblers (customers) and ra-
tional expectationists (casinos)? The question may be
not "Why are certain markets inefficient?," but "What
is wrong with our interpretation of markets?" An im-
portant technical difference between casinos and finan-
cial markets is that in the former the agent learns
immediately the outcome of her investment. But the
more variable are the prices of financial instruments, the
more will they have this casino characteristic, and the
more attractive they will be to this type of investor.
Hence, the alleged "fact" that security prices vary " too
much" may be both the effect and the cause of its
appeal to these kinds of investors.
I suspect that Adam Smith would wonder why there
is so much modem professional interest in the internal
efficiency or "perfection" of particular markets, and so
little interest in what determines the extent of markets,
and how this in turn may create social gains that are
more important and significant than the " imperfections"
in particular markets that are suggested by our theory of
" rational" preferences.
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