Prompted by this post at Cafe Hayek, I recently participated in a web experiment sponsored by NPR’s Planet Money.  I was asked to watch three short animal videos and vote for the animal I found cutest.

The videos were all pretty cute.  One featured a polar bear cub sliding along the ice with its mother.  Another featured a loris — a wide-eyed adorable creature with which I was not familiar — being tickled under its arms.  I voted for the critter in the third video, a tiny kittenthat would throw its arms back in surprise when its handler made a certain noise and motion.  That dang kitten was excruciatingly cute.  I watched the video several times.

Earlier this week, the folks at Planet Money explained their experiment.  They were, they say, testing John Maynard Keynes’s famous “beauty contest” analogy.  In Section V of Chapter 12of the General Theory, Keynes explained that investors picking stocks are a bit like participants in a type of newspaper beauty-picking contest that was apparently common in England in the 1930s:

[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.

So what has this to do with those cute critters?  Unbeknownst to me when I voted for that adorable kitten, I had been placed, along with half of the 12,000 participants, in “Group A.”  We were asked to vote for the cutest animal.  The other experimental subjects, those in Group B, were asked to vote for the animal they thought participants would say is cutest.  They were, in other words, asked to act as a judge in the sort of “beauty contest” (here, “cuteness contest”) to which Keynes analogized.

My kitten prevailed in both polls (go kitten!), but by substantially different margins.  Of the participants asked to vote for the animal they thought cutest (members of Group A), 50 percent voted for the kitten, 27 percent for the loris, and 23 percent for the polar bear.  The participants directed to vote for the animal they thought would generally be perceived as cutest (members of Group B) voted for the kitten about 75 percent of the time, with the loris and the polar bear capturing 15 percent and 10 percent of the vote, respectively.  If we assume an even distribution of preferences among the members of the two randomly segregated 6,000-person groups, then it seems that a great many members of Group B did not vote for the animal they personally deemed cutest.

The folks at Planet Money claim that they were “trying to get a better sense of how the stock market works.”  They say they were trying to “test” Keynes’ observation and its implication, which is that the stock market often fails as a measure of listed firms’ fundamental values (i.e., investor expectations about the future free cash flows the firms will generate), because investors focus not on expectations about actual future earnings but instead on other investors’ sentiments.  In actuality, the experiment in no way confirms the accuracy of Keynes’ analogy or says anything at all about how the stock market actually works.

Keynes’ notable claim was not that participants in newspaper beauty-picking contests tend to disregard their own preferences and pick according to expected majority sentiment.  Of course they do.  That’s how they win.  Keynes, though, asserted something more controversial:  He contended that investors do, in fact, act like participants in a newspaper beauty-picking contest when they make investment decisions.

The Planet Money experiment may “prove” the incontrovertible claim that a person who is rewarded for following herd mentality will tend to disregard his personal preferences when they diverge from his expectations about majority preferences.  But it says nothing about whether investors do, in fact, merely follow the herd when they are making investment decisions.  In the experiment, many members of Group B disregarded their own preferences in selecting the cutest critter, but that’s because they were directed to do so.  They weren’t simply given a sum of money to “invest” in cute creatures and told that they could keep any profits.  Had they been, a great many who voted for the kitten or polar bear cub might instead have invested in the loris, recognizing that kittens and baby polar bears — while cute today and likely to be quite popular in the short-term — will eventually grow into decidedly less cute cats and mama bears, while lorises, with their huge doe-eyes, tend to retain their cuteness over time.  An investor who bought a bunch of now-hot kitten stock and failed to dump it before the kitten turned into a gawky adolescent could lose his shirt.  Long-term investors, especially institutional investors, would be particularly loathe to invest in a critter whose popular appeal was likely to change so quickly and unpredictably.  (As a proud cat owner, I can attest to the fact that the creatures transition from cute kittens to ungainly young cats in a very short period.  A kitten investor would have to be an awfully scrupulous monitor!)

This is not to say that stock market bubbles — and asset bubbles more generally — do not occur.  Of course they do.  And they are frequently occasioned by precisely the sort of thinking Keynes imagined — i.e., investors, spotting a hot area of investment, disregard their own expectations about the investment’s fundamental value and instead assess the likelihood that they will be able to sell the investment, for a profit, to some “greater fool” in the future.  I’ve blogged about this phenomenon several times and believe it was responsible for the recently deflated real estate bubble (especially since the investors who originated loads of bad mortgages knew there were congressionally created greater fools — Fannie Mae and Freddie Mac — standing ready to buy their bad investments!).

The Planet Money discussion, though, was misleading on a couple of fronts.  First, as noted, the cute animal experiment didn’t really test — and therefore cannot “prove” — Keynes’ descriptive claim about how investors make investment decisions.  Second, the discussion suggests that investors generally take the “greater fool” approach when making investment decisions — not simply that asset bubbles occasionally occur — and it therefore insinuates that the stock prices are generally a poor gauge of firms’ fundamental values.  There’s a good deal of empirical evidence suggesting otherwise.  For a wonderfully lucid summary of it, pick up the brand new (2011) edition of Burton Malkiel’s classic, A Random Walk Down Wall Street.  Malkiel acknowledges asset bubbles (colorfully and in great detail!) but recognizes that they are the exception, not the rule.

Behavioralism is mesmerizing.  Ever since I took Cass Sunstein’s outstanding Elements of the Law course as a 1L at the University of Chicago Law School, I’ve been fascinated by studies purporting to show how humans are systematically irrational.

Read the full piece here. 

The Wall Street Journal is reporting that the Feds (the SEC, the FBI, and federal prosecutors in New York) are about to bring a host of insider trading charges “that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation.”  The authorities, which have been investigating the situation for three years, are boasting that their criminal and civil probes “could eclipse the impact on the financial industry of any previous such investigation.”

Read the full piece here. 

My Missouri colleague, Peter Klein, of Organizations and Markets fame (and, like Larry, a proud non-voter), has been asked to contribute a book chapter on the Austrian theory of the firm and the law. Peter, who has written extensively on the Austrian theory of the firm and maintains an online bibliography on the subject, is an expert on the economics. He asked me to give him some thoughts on the law — i.e., which business law doctrines cohere or conflict with Austrian insights on the nature of the firm.

Read the full piece here. 

In a front-page article entitled Congress Staffers Gain from Trading in Stocks, the Wall Street Journal reports that “72 aides on both sides of the aisle traded shares of companies that their bosses help oversee.” That finding was based on an “analysis of more than 3,000 disclosure forms covering trading activity by Capitol Hill staffers for 2008 and 2009.”

Read the full piece here. 

Yesterday, the Wall Street Journal ran an article entitled McDonald’s May Drop Health Plan. The article reported that “McDonald’s Corp. has warned federal regulators that it could drop its health insurance plan for nearly 30,000 hourly restaurant workers unless regulators waive a new requirement of the U.S. health overhaul.” The insurance plan at issue is a so-called “mini-med” plan, which provides limited coverage but at low prices. The Journal reports, for example, that “[a] single worker can pay $14 a week for a plan that caps annual benefits at $2,000, or about $32 a week to get coverage up to $10,000 a year.”

Read the full piece here. 

Last Thursday and Friday, I attended a conference at Case Western Law School on the Roberts Court’s business law decisions. I presented a paper on the Court’s antitrust decisions. Adam Pritchard, Matt Bodie, and Brian Fitzpatrick presented papers considering the Court’s treatment of, respectively, securities law, labor and employment law, and pleading standards.

Read the full piece here. 

Abstract

Antitrust is back in vogue at the U.S. Supreme Court. Whereas the Rehnquist Court decided few antitrust cases in its latter years (only one from 1993 to 1995, one each year from 1996 through 1999, and none from 2000 to 2003), the Roberts Court issued seven antitrust decisions in its first two years alone. Numerous commentators have characterized the Roberts Court’s antitrust decisions as radical departures that betray a pro-business, anti-consumer bias. While some of the decisions do represent significant changes from past practice (see, e.g., Leegin, which overruled the 1911 Dr. Miles rule of per se illegality for minimum resale price maintenance, and Twombly, which abrogated the infamous “no set of facts” pleading standard set forth in the 1957 Conley v. Gibson decision), the “pro-business/anti-consumer” characterization of the Roberts Court’s antitrust decisions is inaccurate. The characterization – caricature, really – fails to appreciate the fundamental limits of antitrust, a body of law that requires judges and juries to make fine distinctions between procompetitive and anticompetitive behaviors that frequently resemble each other. While false acquittals of anticompetitive conduct may harm consumers, so may false convictions of procompetitive actions. And efforts to eliminate errors in liability judgments are themselves costly. Optimal antitrust rules will therefore aim to minimize the sum of decision costs (the costs of reaching a liability decision) and expected error costs (the social losses from false convictions and false acquittals). Each of the Roberts Court’s antitrust decisions can be defended in light of this “decision-theoretic” approach, an approach calculated to maximize the effectiveness of the antitrust enterprise, to the ultimate benefit of consumers. This Article first describes the fundamental limits of antitrust and the decision-theoretic approach such limits inspire. It then analyzes the Roberts Court’s antitrust decisions, explaining how each coheres with the decision-theoretic model. Finally, it predicts how the Court will address three issues likely to come before it in the future: tying, loyalty rebates, and bundled discounts.

One of my summer writing projects is a response to Einer Elhauge’s recent, highly acclaimed article, Tying, Bundled Discounts, and the Death of the Single Monopoly Profit Theory.  In the article, which appeared in the December 2009 Harvard Law Review, Elhauge defends current tying doctrine, which declares tie-ins to be per se illegal when the defendant has market power in the tying product market and the tie-in affects a “not insubstantial” volume of commerce in the tied product market.

Read the full piece here.