Market Competition and Selection for the New Palgrave Dictionary of Economics, 2nd ed..pdf

Market Competition and Selection for the New Palgrave Dictionary of Economics, 2nd ed. Lawrence Blume?? and David Easley? June 2007 Realized profits, not maximum profits, are the mark of success and viability. It does not matter through what process of rea- soning or motivation such success was achieved. The fact of its accomplishment is sufficient. This is the criterion by which the economic system selects survivors: those who realize positive prof- its are the survivors; those who suffer losses disappear. Alchian (1950) 1 Introduction Most economic models make use of extreme rationality hypotheses: firms maximize profits with full knowledge of their technology and prices, and, investors are subjective expected utility maximizers whose beliefs are correct. Surely, some firms and some investors do not always behave as these models hypothesize. But does this matter for predictions of market outcomes? It could be that the aggregation that takes place in supply and demand results Cross references: general equilibrium, rational expectations, rationality ? Cornell University. ? The Santa Fe Institute. 1 2in prices and market quantites that agree with the predictions of models using extreme verions of rationality. It could be that over time, firms and investors learn to behave as these models predict and so over time market outcomes converge to those predicted by the models. Finally, it could be that markets select for firms and investors who behave ’as if’ they are rational. This last defense of the use of rationality is the essence of the quote from Alchian (1950). There is a long history in economics of using market selection argu- ments in defense of rationality hypotheses. The early literature focused on selection for profit maximizing firms. Among its best known proponents is Friedman (1953): ‘The process of natural selection thus helps to validate the hypothesis (of profit maximization) or, rather, given natural selection, acceptance of the hypothesis can be based