"A century ago, Albert Einstein revolutionized physics with his theory of relativity, which suggested that while the fundamental laws of Newtonian physics were useful for many purposes, they broke down under certain extreme conditions.

Now, I'm wondering if we need a new theory of relativity for economics, where the standard models are unable to explain a growing number of situations where highly competitive markets are delivering less-than-optimal results.

The recent credit bubble is one example of a very big market failure for which we all will pay a serious price. But other, smaller failures also come to mind.

Think of skyrocketing tuitions among elite colleges and universities that spend lavishly on winning sports teams, rock-climbing walls and scholarships for those who don't even need them, all to attract top students.

Or the runaway compensation for chief executives who would be willing to take the job for half of what they are being paid.

Or the ridiculous prices paid for "it" handbags, fancy watches or houses in the Hamptons.

How do we explain why cities are still tripping over themselves to offer subsidies for baseball stadiums and convention centers in the face of overwhelming evidence that these diminish economic efficiency and welfare rather than enhance them?

And how is it rational that first-year associates at top law firms are paid more than federal judges?

One thread that runs through all these "market failures" is that they involve a kind of competition in which "winning" is more a relative concept than an absolute one -- that the goal is not so much to maximize profits, income or welfare, as economic models assume, but to beat the competitors. In the process, perfectly rational investors, businesses or consumers wind up doing things that are irrational, leaving them no better off than before.

The intellectual roots of this economic theory of relativity go back to Adam Smith, Alfred Marshall and Thorstein Veblen. It got a big boost from game theorists, among them University of Maryland's Thomas C. Schelling, who won a Nobel Prize for his work on unproductive arms races, both economic and military. More recently, the hot new area of behavioral economics has focused considerable light on the seemingly irrational side of homo economus.

Perhaps nobody has done more to expand our understanding of relative competition than Robert H. Frank of Cornell University. Frank's particular focus has been on the importance of status in consumer choices. His point is that the desire for ever-bigger homes, ever-fancier gas grilles, ever-more powerful SUVs is based not on some absolute notion of what is good or sufficient, but rather on the relative basis of what everyone else has.

It is this compulsion to keep up with the Joneses, Frank argues, which leads us to over-spend on status goods that, in the end, make us no happier. Meanwhile, we wind up under-investing in leisure time or "public goods," such as better schools and parks, that would give us more satisfaction.

The same type of arms race that has us constantly upping the ante on kitchen stoves is also at work when companies or sports teams compete for top talent, paying huge premiums to lure reputed superstars who, in reality, are only slightly better than the next-best candidates.

In private, college presidents will acknowledge that they are trapped in a wasteful, educationally bankrupt and socially damaging competition to attract top students and improve their score in the annual U.S. News & World Report rankings.

And how many law firms have sacrificed the quality of their work and the collegiality of their culture to improve their profit-per-partner, the all-important metric in the annual American Lawyer rankings?

Three business school professors have just completed a study that suggests that the powerful desire to keep up with the Joneses is also to blame for the size and persistence of investment bubbles.

Traditional finance theory would suggest that sophisticated investors and money managers are simply out to deliver the highest risk-adjusted returns they can get. But Peter DeMarzo and Ilan Kremer of Stanford, and Ron Kaniel of Duke, reason that if that were true, everyone wouldn't so reliably pile into the same investments every few years, paying too much and taking too much risk.

Rather, what explains the herd behavior by Wall Street's money managers is the fear that they might not do as well as their peers. By that logic, it's okay to lose money as long as everyone else does. What's not okay is to turn in mediocre returns when everyone else does spectacularly.

Part of this motivation has to do with the human desire to be respected and avoid embarrassment, the authors explain. But just as important is the fear by money managers that they will be priced out of the market for the things they value at the margin -- a nicer co-op on the Upper East Side, a fancier school for their kids -- if their wealth is out of sync with everyone else in their cohort. By that logic, they may wind up losing a lot of money on exotic securities backed by subprime mortgages, but if everyone else is in the same boat, they won't be at a financial disadvantage in the competition for "status goods."

In their paper, DeMarzo, Kaniel and Kremer create a fancy mathematical model that purports to prove this theory. But they might have simply checked in with Chuck Prince, the former Citigroup chairman, who famously gave this explanation last July for why Citi was continuing to lend aggressively into what everyone could see was a credit bubble: "As long as the music is playing, you've got to get up and dance."

The challenge for economics now is to reconcile the theoretical magic of Adam Smith's "invisible hand" with the disastrous reality of Prince's two left feet." (Steven Pearlstein, The Washington Post, February 8, 2008)