A Bar May Be the Place to Understand Markets

How many of you have ever heard of Game Theory?  You might be a little more familiar with one of it's founding fathers John Nash who was the person behind the likely more famous movie "A Beautiful Mind" staring Russel Crowe.


I really never studied game theory much until I started pursing the CFA charter.  Part of the curriculum briefly touches on this subject and John Nash.  Game Theory in essence tries to explain strategic interactions.  In this Bloomberg story by  Mark Buchanan the writer uses a unique example and situation in explaining how the theory works and how it can relate to the markets.


Via Bloomberg

• The idea comes by way of a silly thought experiment invented in 1994 by Brian Arthur, an economist then at Stanford University. Imagine a college bar with music and cheap drinks every Thursday night. Naturally, lots of students want to go. Trouble is, it’s a tiny place, and they will enjoy it only if 60 percent or fewer of them go. Otherwise, they will suffer miserably in the cramped heat. Hence, each week, every student faces a tricky decision: How to do what most other people will not do. (No cheating -- everyone has to decide at the same time.)
• Drawing on psychology, Arthur argued that people might make decisions in more practical terms using simple theories or hypotheses. For example, a person might think, “crowded last week, should be less crowded this week,” and choose to go. Another might think differently, “crowded two weeks in a row, likely to be crowded again,” and stay at home. Psychologists have shown that people often make decisions by holding a handful of such theories in their minds, using whichever one seems recently to be working best.
• Looking at the bar puzzle this way, Arthur found, you can quickly see how what happens at popular nightspots might fluctuate quite randomly from night to night. He used a computer to simulate a group of people using various theories about whether to go to the bar, and learning by trial and error. Quite quickly, the weekly attendance settled at an average of about 60 percent. But -- and this is the significant point -- the number didn’t settle down to 60. Rather, it kept fluctuating above and below in a random way, as people changed their tactics from week to week, responding to others who were also changing theirs.
• Notice that there’s no “equilibrium” here of the kind that economists often like and expect. There’s no state of unchanging balance into which things settle. Lots of surprises emerge from a completely static situation: people just trying to solve the same problem week after week.

• With a few small adjustments, this game can be used to describe the stock market. Replace “go” with “buy” and “stay at home” with “sell,” and suppose the difference in the number buying and selling drives a price change up or down. The bar game then takes a step toward the kind of thing that John Maynard Keynes had in mind when he suggested that markets resemble a beauty contest in which people guess whom they think most others will choose as the most beautiful. In the markets, Keynes suggested, we must “devote our intelligences to anticipating what average opinion expects the average opinion to be.”
• Two decades later, the bar game now looks more profound than anyone would have imagined it could. Step by step, a handful of physicists, computer scientists and economists have transformed this curiosity into what are now arguably the most realistic models of markets. Such models treat markets as ever- evolving ecologies of investors who aim to profit on the basis of strategies they keep updating as they learn, or at least try to learn, from the past. Among other things, these ecological models reproduce the same kind of “excess” price fluctuations and sporadic upheavals we see in real markets.