Free market and equal rates of investment: no longer beggaring belief Premium

A recent study published in The Economic Journal tries to put an end to the age-old debate between traditional and behavioural economists, of whether a free market economy enables healthy competition or abnormal profits for certain businesses

Leeson, Peter and Hardy, August and Suarez, Paola, “Hobo Economicus,” The Economic Journal, Volume 132, Issue 646, August 2022, Pages 2325–2338

Over many centuries, economists have argued that competition among entrepreneurs would ensure that the rate of return on investment would tend to be equal across industries. So, for example, if the rate of return in the car industry was abnormally high, this would cause investment (and hence resources) to move from other industries, yielding lower returns into the car industry. This, it was believed, would cause the price of cars to drop while that of other goods to rise, thus helping in a way to equalise the rate of return across industries. This widely accepted economic fact was part of the standard response from free market economists whenever critics of the market economy complained about certain businesses enjoying abnormal profits in a market economy. Competition among entrepreneurs, it was argued, would ensure that no business earned abnormally high returns over a long time.

Modern behavioural economists, however, have questioned the above traditional economic wisdom by arguing that the rate of return on investment does not tend to equalise across industries for various reasons.

In particular, they argue that ordinary human beings in the real world are different from the textbook homo economicus in three ways — firstly, they have limited cognitive abilities, secondly, they have limited self control, and thirdly, they possess some degree of altruistic rather than just purely selfish tendencies. In fact, behavioural economists note that even in an industry like finance, in which we might expect participants to be highly rational, people may not be perfectly rational. Therefore, the rates of return might vary significantly across industries even in a competitive market economy.

In “Hobo Economicus,” published in The Economic Journal, Peter T. Leeson, R. August Hardy, and Paola A. Suarez tried to find out if the doubts raised by behavioural economists regarding human rationality are valid. The researchers studied the behaviour of panhandlers, or beggars, in the Metro rail stations in Washington, DC to see if these people exhibit rational economic behaviour. Many beggars tend to suffer from mental disorders and substance abuse problems, which could surprisingly make these people excellent candidates for this study on human rationality.

The authors argue that if even beggars can be shown to behave rationally, then it would bolster the claims of traditional economic theory.

The authors of the paper studied the hourly receipts of beggars in a number of Metro rail stations and also the number of passengers who pass through these stations. If traditional economic theory is right, then beggars would tend to be attracted towards Metro rail stations frequented by the most passengers and desert other stations. This is because beggars are likely to earn more dollars per hour in the busiest Metro rail stations. Eventually, however, the process of entrepreneurial arbitrage — whereby beggars move from stations offering low rate of return to stations offering a higher rate of return — would ensure that the hourly receipts of beggars across Metro rail stations tend to be the same. The tendency of beggars to move towards Metro rail stations that offer the best return on investment is no different from the tendency of investors to invest their capital in industries that offer the highest rate of return.