Question
Two factors that played important roles in the 2008 crisis were (a) the representativeness heuristic in encouraging potential home buyers' responses to rising housing prices,
Two factors that played important roles in the 2008 crisis were (a) the representativeness heuristic in encouraging potential home buyers' responses to rising housing prices, and (b) the systematic over-rating of CDOs, CDSs, and similar securities by credit rating agencies. These practices by homebuyers and by the ratings agencies seemed inconsistent with the competitive market model. That model assumes utility-maximizing consumers making well informed decisions, and profit-maximizing sellers providing goods and services of good quality or losing customers to other sellers. Of course, the market model does not claim that behavior such as described in (a) and (b) cannot ever happen. But it does predict that such behavior will not persist or win out since other buyers or sellers will gain by acting more rationally. They will displace (and the market will penalize) those who behave as in (a) or (b), thereby bringing the market back on track. With respect to each phenomenon--(a) the influence of the representative heuristic for home buyers and also for (b) credit rating agencies' tendency to over-rate--explain whether and why the process of market self-correction did not seem to work; or if it did work, worked only with a very long lag; or worked only in some cases or for some of those involved. Then explain what specific public policy or policies, if any, might have helped improve market performance without causing more problems than it solved.
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