Perfect knowledge

There’s nothing like blogging on a 6 hour delayed flight with the only TV on the plane that doesn’t work. Mind you, it’s JetBlue – I’ve sat on the plan an hour and a half before it took off.

This lends great time to actually getting some work done. Finally – can sit down and thoroughly think through what I’ve been wanting to write for a while.

In continuing this Friendman talk in his Selected Papers, there maintains this prudent versus reckless utility in the next chapter. He describes a person’s marginal utility to, in essence, gamble. Whether it be purchasing homeowner’s insurance, or buying a lottery ticket. A person is being charged a premium for the opportunity to ‘cash in.’ Unfortunately odds are against most.

But I’d like to take this a step in a different direction along with the perception of ‘prudent’ and ‘reckless’ behaviors, particularly pertaining to the financial markets. It is a strong belief of mine that going to Vegas and working in the stock exchange is one in the same. Granted, odds are different, but buying or shorting stock is placing your bets on personal profitability from a loss of the dealer (or company, security, or …government…). But there is a gamble, as there is a chance to profit, and a possibility of loss. Why is stock trading as a profession okay, but weekly trips to a casino seen as a personal problem?

Anyways – drawing that back with utility. Friedman quotes Vickrey saying:
“There is abundant evidence that individual decisions in situations involving risk are not always made in ways that are compatible with the assumption that the decisions are made rationally with a view to maximize the mathematical expectation of a utility function” (Friedman 28).
Individual decisions of risk are not exactly rational. Yeah we get that. Why pay a dollar every day for two weeks for the impossible chance of winning millions of dollars (only to be grossly over taxed)? Why not save that dollar and buy some hot tamales. That’s some utility I could actually enjoy. And it’s a safe bet – I will enjoy it. (I know – not apples to apples). My point is the dollar could be invested in something with guaranteed return, or at least return of more favorable odds.

But what if irrationality of the decision making wasn’t known to the decision maker? What if the gambler, or investor, believes that he’s making a sound decision based on his rationality?

One assumption that capitalism is based on is perfect knowledge. The markets are ‘perfect’ since knowledge is free flowing (granted if you lose based on stupidity and lack of research, that’s you’re own damned fault) and available. But not all knowledge is out there, not everything is known. Hence the purpose of the SEC, laws of insider trading, the growing graduate degree market for quantitative finance.

But seriously, if all entities acted perfectly – how could there possibly be perfection in knowledge? Seeing the current state of the markets, really, is there even the ability to fully research and anticipate investments? Who knew that you’d be paying the government to hold their debt?

Is there really rationality to analyzing a person’s own marginal utility curve towards gambling or investments? I don’t think so.

~ by roguelynn on December 19, 2008.