Friday, September 14, 2007

An economic model for the surge

Economics professors have a game called a dollar auction which they use to demonstrate how apparently rational decisions can create a disastrous result.
The professor offers a dollar for sale to the highest bidder, with only one wrinkle: the second-highest bidder has to pay up on their losing bid as well...

The problem surfaces when the bidders get up close to a dollar. After 99 cents the last vestige of profitability disappears, but the bidding continues between the two highest players. They now realize that they stand to lose no matter what, but that they can still buffer their losses by winning the dollar...

Following this strategy, the two hapless students usually run the bid up several dollars, turning the apparent shot at easy money into a ghastly battle of spiraling disaster...

Theoretically, there is no stable outcome once the dynamic gets going. The only clear limit is the exhaustion of one of the player's total funds. In the classroom, the auction generally ends with the grudging decision of one player to "irrationally" accept the larger loss and get out of the terrible spiral. Economists call the dollar auction pattern an irrational escalation of commitment. We might also call it the war in Iraq...

In the bigger game of democratic politics, the dollar auction scenario has a particularly dangerous power. Politicians fear that voters will unfairly punish the realist who cuts off the escalation early, in the process also clearly "losing" the ever-diminishing prize...

...there is one other way out of the spiral — in the classroom, if you allow some kind of negotiated settlement between the two sides, they can sometimes agree to split the dollar and halt the contest.

2 comments:

K T Cat said...

Hey, I've got some good ones, too.

How about if you auctioned off a lollipop and everyone bidding was a devout Unitarian?

Or maybe if you auctioned off a loaded handgun and one of the bidders was a homicidal lunatic?

How much would you pay in each of those circumstances?

The problem with games based on rational behavior is that Man is not a rational animal, he's a rationalizing animal.

Kelly the little black dog said...

The problem with games based on rational behavior is that Man is not a rational animal this is in fact the problem with all of economics. Its strongly influenced by human psychology - and it unfortunately makes assumptions like perfect knowledge and rational decisions on the part of the population.