Irrationality is the focus of behavioral economists, who appear to be gaining greater credibility in macroeconomic circles since the housing bubble of 2008 and the ensuing global financial meltdown. They are also at the center of an age-old debate recently reignited by columnist and Nobel laureate Paul Krugman in a September 6 New York Times Magazine article titled, "How Did Economists Get It So Wrong?," which fires a salvo at the assumption underlying neoclassical economics -- namely, that free markets are inherently rational and efficient.

Krugman's article heaps scorn on so-called "freshwater economists" -- as typified by the University of Chicago economics faculty, whose ideas have dominated government policymaking since the early 1980s. In contrast, "saltwater economics" exhibits more openness to the ideas promulgated in the 1930s by Britain's John Maynard Keynes -- that free markets often behave inefficiently, are self-destructive and at times need corrective policy actions such as government stimulus spending. Rather than ascribing perfect rationality to markets, these economists say people and institutions often behave irrationally and often in ways contrary to their own interests.

While the debate between the freshwater and saltwater viewpoints in macroeconomics may sound academic, it has a significant impact far outside the ivory towers of universities.

Universities can help boost a mature industrial economy by reinvigorating the flow of new ideas in the community. But universities can approach this task in different ways, each leading to vastly different outcomes.

Employment growth is strongly predicted by smaller average establishment size, both across cities and across industries within cities, but there is little consensus on why this relationship exists. Traditional economic explanations emphasize factors that reduce entry costs or raise entrepreneurial returns, thereby increasing net returns and attracting entrepreneurs. A second class of theories hypothesizes that some places are endowed with a greater supply of entrepreneurship. Evidence on sales per worker does not support the higher returns for entrepreneurship rationale. Our evidence suggests that entrepreneurship is higher when fixed costs are lower and when there are more entrepreneurial people.

The Mises Institute plays the role of free market defender in a response piece to a person who does not favor free market responses. [Hat tip to FinanceProfessor.com]

The previous round of wealth in this economy was built on selling precious copies, so the free flow of free copies tends to undermine the established order. If reproductions of our best efforts are free, how can we keep going? To put it simply, how does one make money selling free copies? Kevin Kelly has an answer: When copies are free, you need to sell things which can not be copied. Well, what can't be copied? From a study of the network economy there he sees roughly eight categories of intangible value that we buy when we pay for something that could be free.

Differing beliefs lead to price drift: The standard view of how stock prices move—that investors act rationally on information and that markets are efficient—does not account for price drift. Snehal Banerjee explains that price drift may occur because investors agree to disagree about the average valuation of an asset.

Chris Anderson’s book, “Free: The Future of a Radical Price,” is essentially an extended elaboration of Stewart Brand’s famous declaration that “information wants to be free.” The digital age, Anderson argues, is exerting an inexorable downward pressure on the prices of all things “made of ideas.” Anderson does not consider this a passing trend. Rather, he seems to think of it as an iron law: “In the digital realm you can try to keep Free at bay with laws and locks, but eventually the force of economic gravity will win.” In this article, Malcolm Gladwell challenges the core assertions underlying the book.

Findings from behavioral organization theory, behavioral decision theory, survey research, and experimental economics leave no doubt about the failure of rational choice as a descriptive model of human behavior. But this does not mean that people and their politics are irrational. Bounded rationality asserts that decision makers are intendedly rational; that is, they are goal oriented and adaptive, but because of human cognitive and emotional architecture, they sometimes fail,occasionally in important decisions. Limits on rational adaptation are of two types: procedural limits, which limit how we go about making decisions, and substantive limits, which affect particular choices directly. [Hat tip to FinanceProfessor.com]

One of the root problems with business schools is that too many are infected with assumptions that reinforce and bring out the worst in human-beings. In particular, the logic and discipline of economics usually rules the roost at business schools.

Editor's Note: The comments add as much or more value as the article itself.

New research from Arvind Krishnamurthy argues that the rapid adoption of financial innovations—in this case, subprime mortgage-backed securities—set the stage for crisis. His report with coauthor Ricardo J. Caballero found that when popular new financial instruments behave unexpectedly, investors flee the market. The liquidity supply tightens, making it hard for market participants to get the capital they need.

Venkat Rao has started an exploration of the changing nature of careers with a micro-level view of its archetypal figure, the cloudworker. In this second part in the series, let’s take a look at how the cloudworker fits within the economy. The main argument of this article is that the dominant distinction in labor economics, unemployed vs. employed, is slowly getting displaced by a more fundamental one: default vs. exceptional career paths.

It doesn’t matter where scientific discoveries and breakthrough technologies originate—for national prosperity, the important thing is who commercializes them. The United States is not behind in that race.

The financial crisis—which almost no one predicted—has only heightened disagreement among experts claiming to know what makes the world go round.

In one of a series of interactive presentations, McKinsey director Rob Latoff offers insight into the industry cost curve, a business school classic for understanding pricing. By bringing discipline and a practical set of definitions to bear, this framework can be applied to real-world, competitive markets.

The U.S. system of security law was designed more than 70 years ago to regain investors' trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors had been defrauded by offerings of dubious quality securities, in the new millennium, investors' perception is that they have been defrauded by managers who are not accountable to anyone. For this reason, I propose a series of reforms that center around corporate governance, while shifting the focus from the protection of unsophisticated investors in the purchasing of new securities issues to the investment in mutual funds, pension funds, and other forms of asset management. [Hat tip to FinanceProfessor.com]

Editor's Note: According to the FinanceProfessor (Jim Mahar), "even if you are not interested in regulation, the figures at the back of the paper are excellent and could/should be included in many classes from Investments to Macroeconomics, Money and Banking, Financial Institutions, and even Corporate Finance."

Unscientific assumptions in economic theory are undermining efforts to solve environmental problems.

Editor's Note: you may or may not agree with this short article, but it is thought provoking and thus I think worth reading (including the comments)...

Amartya Sen takes on free-market orthodoxy by looking at what its patron saint, Adam Smith, had to say. In Capitalism Beyond the Crisis, Sen uses a Smithian prism to look at three big questions:

1. Do we need a new capitalism?
2. What kind of economics institutions and priorities do we need?
3. How can we get out of our current crisis with as little damage as possible?
[BNET Annotation]

The era that defined Wall Street is finally, officially over. Michael Lewis, who chronicled its excess in Liar’s Poker, returns to his old haunt to figure out what went wrong.

Contrarians act against the market mood. “Buy when others are fearful, sell when they are greedy,” Warren Buffett has advised. The historical evidence for buying on the dips, however, is rather mixed.

A study of interactions reveals how pervasive they are. As they increase in number, answers to fundamental questions about integration, scale, and scope will change. But what will happen when workers can carry out their jobs in half the time?

Editor's Note: written in 1997 and it shows in a few spots, but still a good read...

Last year, on the 100th anniversary of their book's subject, Robert F. Bruner and Sean D. Carr published The Panic of 1907: Lessons Learned from the Market's Perfect Storm (John Wiley & Sons). A year later, as we weather a far greater financial storm, the book's lessons are more relevant than ever. From their analysis of one of the worst banking panics in U.S. history, when dozens of banks and trust companies failed, Bruner and Carr conclude that financial crises typically result from the convergence of certain elements into a "perfect storm." The book is an engrossing read, featuring characters such as Augustus Heinze, the brash entrepreneur; Charles Barney, the tragic trust president; and, above all, J.P. Morgan, Wall Street's indispensable man. Bruner, who is Dean and Distinguished Professor at the University of Virginia's Darden Graduate School of Business Admi

Why asset bubbles are a part of the human condition that regulation can’t cure

"Fishbowl" economics once provided the basis of corporate strategy, but no longer. New theories show that markets are "complex adaptive systems." Can managers be more than blind players in an evolutionary business game?

There are a number of qualities that can’t be copied. consider “trust.” Trust cannot be copied. you can’t purchase it. Trust must be earned, over time. It cannot be downloaded. or faked. or counterfeited (at least for long). If everything else is equal, you’ll always prefer to deal with someone you can trust. so trust is an intangible that has increasing value in a copy-saturated world.

There are a number of other qualities similar to trust that are difficult to copy, and thus become valuable in this network economy. I think the best way to examine them is not from the eye of the producer, manufacturer, or creator, but from the eye of the user. We can start with a simple user question: why would we ever pay for anything that we could get for free? When anyone buys a version of something they could get for free, what are they purchasing? From my study of the network economy, I see roughly eight categories of intangible value that we buy when we pay for something that could be free.

Financial bubbles are like epidemics— and we should treat them both the same way.