Professor Birdthistle has a very thoughtful reply to my earlier post over at the Conglomerate on Jones v. Harris and behavioral economics. I thank Professor Birdthistle for his reply. I’ve learned a great deal about Jones v. Harris from reading his posts at the Conglomerate and have no doubt that I’ll learn more from this exchange. The thrust of my original post was that, in general, my view was that behavioral law and economics has been too quick to rely on findings in the behavioral/ experimental literature demonstrating systematic deviations from rationality to justify paternalistic regulation.
The criticism was both theoretical and empirical. I noted that these scholars often incorrectly specify the burden of demonstrating that, even assuming a rock solid empirical case for market failure deriving from cognitive quirks, the regulation is warranted and cost justified including the potential for deterring learning, efficiency explanations for the phenomenon at issue, unintended consequences, magnitude of the social costs imposed by the market failure, administrative costs, etc. The empirical component was what amounts to playing fast and loose with the appropriate empirical burden to be assigned to these regulatory proposals and selective cherry-picking of relevant evidence. This is a problem in the behavioral law and economics literature, and particularly among consumers of this literature rather than its producers. For example, I noted the case of the endowment effect literature:
Indeed, one classic example of this is the reaction of the behavioral law and economics community to the Zeiler & Plott (2005, American Economic Review) analysis demonstrating that the common asymmetry between people’s valuation of gains and losses can be made to grow or to disappear by manipulating the context or circumstances under which the valuations are made. I blogged about what I described as the Endowment Effect’s Disappearing Act here. In the meantime, I noted back at the end of 2005 a search of the JLR database had 541 hits for “endowment effect.” Post-2006, that number is already 255, with 210 of those also including the word “regulation.” How many of those cite (much less discuss) Zeiler & Plott (2005)? Sixteen. Sixteen out of 255! That’s an incredibly disappointing figure and, at a minimum, suggests that taking empirical evidence seriously is not a top priority in the portion of this literature appearing in JLR.
Professor Birdthistle endorses my criticism that the behaviorists might be ” too quick to convert findings of investor irrationality or unsophistication into calls for regulatory intervention” but argues that I’ve missed nuances that are important in the context of this specific Jones v. Harris litigation and the mutual fund industry more specifically.
Birdthistle makes two points: (1) that I rely on the same argument as Easterbrook (echoing Schwartz & Wilde) that the presence of irrational investors does not mean that we get inefficient outcomes because competition for the sophisticates on the margin protects the naifs — an argument that is wrong because in the mutual fund industry there is a “uniquely rigid segregation of sophisticated investors from unsophisticated — with the former buying one set of investments and the latter buying a very differently priced one — which neutralizes the possibility that sophisticated sentinels will protectively police for all”; and (2) that I’m the one playing fast and loose with burdens here since 36(b) of the Investment Company Act already exists, and so the burden lies on the price theorists to present evidence sufficient to override it.
Now, I started my first post with a note that I was no expert in either this particular litigation nor the mutual fund industry. So I hesitate to take this too much further, but I think that my points survive Professor Birdthistle’s critique and are actually fairly general points of economic theory rather than specific to the mutual fund industry. I do think, however, that I expressed this particular economic point a bit inartfully in the first post so thought I’d take this opportunity to clarify a bit. Besides, blogging isn’t for intellectual hesitation, is it
Birdthistle makes two points: (1) that I rely on the same argument as Easterbrook (echoing Schwartz & Wilde) that the presence of irrational investors does not mean that we get inefficient outcomes because competition for the sophisticates on the margin protects the naifs — an argument that is wrong because in the mutual fund industry there is a “uniquely rigid segregation of sophisticated investors from unsophisticated — with the former buying one set of investments and the latter buying a very differently priced one — which neutralizes the possibility that sophisticated sentinels will protectively police for all”; and (2) that I’m the one playing fast and loose with burdens here since 36(b) of the Investment Company Act already exists, and so the burden lies on the price theorists to present evidence sufficient to override it.
I’m going to defer to the experts on the Investment Company Act and appropriate burden of proof as I have no relevant expertise with this piece of legislation — I lumped the burden-shifting point in the first post into the Jones v. Harris discussion, so Professor Birdthistle’s response is fair game —- but will simultaneously defend my broader point that the style of invocation of the behavioral literature that I’ve seen in some corners of the behavioral law and economics literature is methodologically unsound to the point of eschewing serious economic analysis.
But let’s talk about the second point about the competitive effects analysis when you’ve got ex post holdup opportunities deriving from switching costs, behavioral and cognitive biases, or other sources. Professor Birdthistle writes that neither Wright nor Easterbrook discusses that:
the mutual fund industry features a uniquely rigid segregation of sophisticated investors from unsophisticated — with the former buying one set of investments and the latter buying a very differently priced one — which neutralizes the possibility that sophisticated sentinels will protectively police for all” — I believe you’re mistaken but I don’t think I was clear enough in my post about the point I was inarticulately making.
Let me offer an important clarification here. Specifically, note that the point I’m making on the economics is different than the ex ante competition point argued by Easterbrook and responded to by Litan et al that competition for sophisticated investors on the margin will protect the unsophisticated investors. To the contrary, my point is that sufficient ex ante competition can prevent anti-competitive outcomes EVEN WHEN the entire market consists of naive consumers. In other words, I think the features Birdthistle assigns to the mutual fund industry cut the other way. Let me explain with an example.
Imagine a world where the fraction of investors exhibiting these biases is 1. Or a more complicated world like the one Birdthistle contemplates with two different markets without interaction where the fraction of investors with biases in one market is 1 (the naive market) and 0 in the other (sophisticated market). What happens to the naifs in these markets? It still depends on ex ante competition. Imagine that each seller knows ex ante that he can extract an extra 10% profit out of the buyer ex post (after lock-in) because of switching costs related to behavioral biases. Indeed, sellers will in fact hold up the buyers ex post and extract those rents. But a complete competitive analysis must also consider what happens to the ex ante competition for these naifs. Some elements of competition occur ex ante and others ex post. If competition between mutual funds is sufficiently vigorous then we will still get a zero profit equilibrium. How will that occur? Given that sellers know that they will increase profits 10% ex post, one expects competition between sellers to dissipate that 10% profits in various forms of ex ante competition.
One cannot focus on the ex post effects that derive from cognitive biases alone and claim to have done a complete analysis. The key is that, as I wrote:
“If sellers anticipate this ex post profitability, and there is competition among sellers, one expects these rents to be dissipated by ex ante competition across these different dimensions. This is a key point about switching costs or other ex post holdup (or in this case the presence of behavioral quirks that make for opportunities to holdup consumers).”
I was a bit inartful about this distinction in the post — but it really is a different point that Easterbrook is making (relying on Schwartz & Wilde).
But this is why I believe that the structural evidence of low barriers to entry, shifting shares, low concentration, etc., are as important as I do. Evidence that there vigorous competition between sellers (and nobody here claims that sellers here are irrational or unaware of any cognitive biases that are relevant) changes the predicted outcome of competition. To be sure, its true that in this equilibrium you get difference prices and quality ex ante and ex post than you would if the biases didn’t exist, i.e. you get better consumer outcomes on dimensions of competition that are pre-lock-in and worse post. But you do get zero profit, competitive outcomes. They don’t resemble perfect competition — but hey, what does in the real world?
The economic point that I’m suggesting Litan et al and Posner and others do not respond to in claiming that we are getting inefficient and anticompetitive outcomes by pointing to behavioral biases and impact on single dimensions of competition is described above — and pointing to the existing of naifs doesn’t address it.
I do really appreciate the response. Its been a lot of fun to think about this issue for an outsider…