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Safety in Markets: An Impossibility Theorem for Dutch Books

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  • Leeat Yariv
  • David Laibson

Abstract

This paper explores the extent to which markets constrain intertemporal preferences. First, we show that without transaction costs, agents are immune to exploitation in competitive markets. In particular, a sequence of trades leaving any market participant strictly worse off (termed a money losing Dutch book) is generically impossible. When transaction costs exist in the market, Dutch books are plausible only when agents have inaccurate beliefs about their own future behavior. Thus, markets are appropriate filters of non-standard (time-inconsistent) preferences only when sufficient irrational behavioral expectations are allowed. Second, we show that while non-standard preferences may be sustained in competitive markets, they are generically non-identifiable. Under mild conditions, any profile of demands can be explained with a standard, time-consistent, model. Nonetheless, we demonstrate that such a model will have weak predictive power across markets if non-standard preferences indeed prevail.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 867.

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Date of creation: 2004
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Handle: RePEc:red:sed004:867

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Keywords: Dutch books; money pumps; time inconsistency; markets;

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References

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  1. Erzo Luttmer & Thomas Mariotti, 2006. "Competitive equilibrium when preferences change over time," Economic Theory, Springer, Springer, vol. 27(3), pages 679-690, 04.
  2. Kubler, Felix, 2003. "Observable restrictions of general equilibrium models with financial markets," Journal of Economic Theory, Elsevier, Elsevier, vol. 110(1), pages 137-153, May.
  3. Border, Kim C & Segal, Uzi, 1994. "Dutch Books and Conditional Probability," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 104(422), pages 71-75, January.
  4. Ariel Rubinstein & Rani Spiegler, 2005. "Money Pumps in the Market," Levine's Bibliography 122247000000000941, UCLA Department of Economics.
  5. Kim C. Border & Uzi Segal, 2001. "Coherent Odds and Subjective Probability," Boston College Working Papers in Economics, Boston College Department of Economics 513, Boston College Department of Economics.
  6. Blume, Lawrence & Easley, David, 1992. "Evolution and market behavior," Journal of Economic Theory, Elsevier, Elsevier, vol. 58(1), pages 9-40, October.
  7. Lawrence Blume & David Easley, 2006. "If You're so Smart, why Aren't You Rich? Belief Selection in Complete and Incomplete Markets," Econometrica, Econometric Society, Econometric Society, vol. 74(4), pages 929-966, 07.
  8. Laibson, David I. & Gabaix, Xavier, 2006. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," Scholarly Articles 4554333, Harvard University Department of Economics.
  9. Green, Jerry, 1987. ""Making Book against Oneself," the Independence Axiom, and Nonlinear Utility Theory," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 102(4), pages 785-96, November.
  10. Ran Spiegler, 2005. "Competition over Agents with Boundedly Rational Expectations," Levine's Bibliography 122247000000000535, UCLA Department of Economics.
  11. Aviad Heifetz & Chris Shannon & Yossi Spiegel, 2003. "What to Maximize If You Must," Game Theory and Information, EconWPA 0303002, EconWPA.
  12. Stefano DellaVigna & Ulrike Malmendier, 2006. "Paying Not to Go to the Gym," American Economic Review, American Economic Association, American Economic Association, vol. 96(3), pages 694-719, June.
  13. Laibson, David, 1997. "Golden Eggs and Hyperbolic Discounting," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(2), pages 443-77, May.
  14. Debreu, Gerard, 1993. "Existence of competitive equilibrium," Handbook of Mathematical Economics, Elsevier, in: K. J. Arrow & M.D. Intriligator (ed.), Handbook of Mathematical Economics, edition 4, volume 2, chapter 15, pages 697-743 Elsevier.
  15. Alvaro Sandroni, 2000. "Do Markets Favor Agents Able to Make Accurate Predicitions?," Econometrica, Econometric Society, Econometric Society, vol. 68(6), pages 1303-1342, November.
  16. M.J. Todd & A. Fostel & H.E. Scarf, 2004. "Two New Proofs of Afriat's Theorem," Econometric Society 2004 North American Summer Meetings 632, Econometric Society.
  17. Cubitt, Robin P. & Sugden, Robert, 2001. "On Money Pumps," Games and Economic Behavior, Elsevier, Elsevier, vol. 37(1), pages 121-160, October.
  18. Machina, Mark J, 1989. "Dynamic Consistency and Non-expected Utility Models of Choice under Uncertainty," Journal of Economic Literature, American Economic Association, vol. 27(4), pages 1622-68, December.
  19. Narayana R. Kocherlakota., 2001. "Looking for evidence of time-inconsistent preferences in asset market data," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Sum, pages 13-24.
  20. David Laibson & Xavier Gabaix, 2004. "Competition and Consumer Confusion," Econometric Society 2004 North American Summer Meetings 663, Econometric Society.
  21. Erzo G. J. Luttmer & Thomas Mariotti, 2003. "Subjective Discounting in an Exchange Economy," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 111(5), pages 959-989, October.
  22. Harris, Christopher J, 1985. "Existence and Characterization of Perfect Equilibrium in Games of Perfect Information," Econometrica, Econometric Society, Econometric Society, vol. 53(3), pages 613-28, May.
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Cited by:
  1. Ernst Fehr & Jean-Robert Tyran, 2005. "Individual Irrationality and Aggregate Outcomes," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 19(4), pages 43-66, Fall.
  2. Kfir Eliaz & Ran Spiegler, 2006. "Contracting with Diversely Naive Agents," Review of Economic Studies, Oxford University Press, vol. 73(3), pages 689-714.
  3. Berg, Nathan & Biele, Guido & Gigerenzer, Gerd, 2010. "Does Consistency Predict Accuracy of Beliefs?: Economists Surveyed About PSA," MPRA Paper 24976, University Library of Munich, Germany.
  4. Matthias Lang & Achim Wambach, 2010. "The fog of fraud – mitigating fraud by strategic ambiguity," Working Paper Series of the Max Planck Institute for Research on Collective Goods, Max Planck Institute for Research on Collective Goods 2010_24, Max Planck Institute for Research on Collective Goods.
  5. Xavier Gabaix & David Laibson, 2005. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," NBER Working Papers 11755, National Bureau of Economic Research, Inc.
  6. Ariel Rubinstein & Rani Spiegler, 2005. "Money Pumps in the Market," Levine's Bibliography 122247000000000941, UCLA Department of Economics.
  7. Azevedo, Eduardo M. & Gottlieb, Daniel, 2012. "Risk-neutral firms can extract unbounded profits from consumers with prospect theory preferences," Journal of Economic Theory, Elsevier, Elsevier, vol. 147(3), pages 1291-1299.

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