A New Perspective on Market Actor Behavior, Motivations and Beliefs

In my article Tribes and Temperaments: Two Underappreciated Determinants of Market Actor Behavior, Motivations and Beliefs, prepared for a volume on Hidden Fallacies in Corporate Law and Financial Regulation, I make two arguments, one narrow and one very broad.

The narrow argument is that law and economics does not take tribes or temperaments, as I define them, into account in its analyses of markets and market activity, and that it should. That it does not is easy to demonstrate, as is that it can; the chapter contains many examples, some of which are mentioned below, of market behavior that is far better explained with reference to tribes and temperament than it is without them. The greater challenge is to show that it should—that the increase in realism can be accomplished without too much sacrifice to parsimony. My broader argument is directed to that end: that law and economics’ underlying assumptions, notably as to what rationality entails, are too restrictive, and that a broader conception of rationality can be articulated parsimoniously. Rationality reconceived in this fashion yields explanations that are, in words perhaps mistakenly attributed to Albert Einstein, “as simple as possible, but no simpler.”

By tribes, I mean communities with their own norms, rituals, and institutions. Deal makers, for instance, inhabit a community with norms as to the contents of their contracts, such as “what’s market.” “What’s market” is discernible not only in the contracts themselves, but also in various databases and law firm memos. There are norms and rituals as to how negotiations proceed and when they end. For instance, the initial contract offered to the other party is one sided but not “too” one sided. And, whatever else dictates when the deal document is signed, the signing is not preceded by a close reading of the deal document by well-rested people.  Orthodox theory doesn’t explain any of this nearly as well as does an explanation making use of tribes. The lack of a close reading reflects parties’ interests in bonding themselves not to sue precipitously. Norms ensure that there are reputational costs for the party “taking advantage” of something a close reading would have caught. All this complements the orthodox explanation, that parties who think they have concluded negotiations are concerned that their agreement is fragile and might fall apart if they don’t sign immediately.

Norms and rituals also strongly inform what information is sought and from who. As to the former, there are norms, mostly set forth in “forms,” as to what one would ask; confident market actors will feel free to add, and, less often, subtract from what the form provides. As to the latter, the obvious party (typically, the seller) may lack credibility or may simply lack the information sought. The answer may be to go to an expert, but who? The assessment in many contexts is not straightforward—after all, if one could appraise an expert’s expertise, one might not need the expert. Thus, the community anoints certain parties who pass muster as experts for purposes of community judgments. Interestingly, and consistent with the importance of tribes, the status as anointed expert can be sticky notwithstanding significant disconfirming evidence, as demonstrated by the continuing high market shares of the major rating agencies. (Among their other “misratings,” the agencies did not downgrade Enron below investment grade until just before it declared bankruptcy, and they gave highly inflated AAA ratings to subprime securities.)

Knowing and abiding by a community’s norms and rituals conveys information about a person’s willingness and ability to function as a member of the community. These particular norms and rituals are not inevitable, and they are not necessarily the best way to proceed—but they are good enough to have persisted.

What about temperament? Temperament figures in when a less confident investor, even a “sophisticated” institutional investor, rushes to buy “a hot new issue” because it is hot, notwithstanding ample cautionary disclosure. Temperament also figures in when a banker designs a financial instrument or sales strategy that honors the letter of the law while arguably violating its spirit. The chapter discusses temperament on two different dimensions. One is greater or lesser degrees of confidence in one’s own judgments, including, at the extremes, the least confident and the contrarians. The other is “motivational focus,” a concept developed by psychologist and business school professor Tory Higgins. One type is “prevention” focus (more vigilant, hate to lose) and the other is “promotion” focus (less vigilant, love to win). Some people are very much one or the other, while others are more malleable, amenable to influence in one or the other direction, including by the culture around them.

What follows? First, better explanations are worthwhile for their own sake. Second, there is a pedagogical payoff, as phenomena that don’t seem like the product of “rational” processes as that term has been understood can nevertheless be explained intuitively. Third, the approach can profitably inform policy. While many of the dynamics at issue are not normatively undesirable, some are. Examples include sophisticated investor herding of the sort we saw in the 2008 financial crisis, and relatedly, their continuing “reliance” on the rating agencies notwithstanding the agencies’ deeply flawed track record, including the then-recent Enron debacle. This is puzzling under orthodox theory: These investors surely had the incentive, and should have had the ability, to be more critically minded. Tribes and temperament fill in the missing pieces, as they do in understanding how and on who incentives might work to yield letter-honoring-but-spirit-violative behavior, including end-runs around regulation.

The narrow argument is thus that tribes and temperaments matter, yielding better explanations of market behavior than the orthodox account alone. This is to some extent a plea for more realism. The usual response to such pleas has been behavioral law and economics. My broader argument is that behavioral law and economics, with its emphasis on irrationality, is not the answer. Rather, the answer is to modify some of the orthodox account’s assumptions. The assumptions yield a worldview that (mistakenly) treats uncertainty as risk, people as largely atomistic and homogeneous, and rational people as maximizers rather than, in Herbert Simon’s parlance, satisficers. Uncertainty; a more nuanced view of people that appreciates the extent to which behavior, beliefs, and motivation are importantly social and influenced by temperament; and an acknowledgment that one need only be “good enough,” and not “the fittest” to survive; can ground a worldview that yields far more realism than do orthodox accounts.

Claire A. Hill is a Professor at the University of Minnesota Law School

This post is adapted from her paper, “Tribes and Temperament: Two Underappreciated Determinants of Market Actor Behavior, Motivations and Beliefs” available on SSRN.

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