Sunday, September 17, 2006

Neuroeconomics

Very nice article in the New Yorker summarizing recent research. Your inner lizard brain is loss averse and reacts emotionally to unfair bargains. Monkey brains are good at mathematical optimization in the face of uncertainty, despite not "understanding" probability. Economists and psychologists have rediscovered the age old observation that reason and emotion compete within the brain, but now they know where the various activities occur.

The article is quite long, and worth readng in full. I only excerpt a few things below. Given pieces like this, and the big scoop on Perelman, why would anyone not subscribe to the New Yorker? :-)

...When people make investments, they weigh the possible outcomes of their decisions and select a portfolio of stocks and bonds that offer the highest possible return at an acceptable level of risk. That is what mainstream economic says, anyway. In fact, people often have only vague idea of the risks they face. ...

As imaging technology gets more sophisticated and easier to use, it may become possible to monitor investors’ brains while they trade stocks at their offices. ... In one study, Camerer and several colleagues performed brain scans on a group of volunteers while they placed bets on whether the next card drawn from a deck would be red or black. In an initial set of trials, the players were told how many red cards and black cards were in the deck, so that they could calculate the probability of the next card’s being a certain color. Then a second set of trials was held, in which the participants were told only the total number of cards in the deck.

The first scenario corresponds to the theoretical ideal: investors facing a set of known risks. The second setup was more like the real world: the players knew something about what might happen, but not very much. As the researchers expected, the players’ brains reacted to the two scenarios differently. With less information to go on, the players exhibited substantially more activity in the amygdala and in the orbitofrontal cortex, which is believed to modulate activity in the amygdala. “The brain doesn’t like ambiguous situations,” Camerer said to me. “When it can’t figure out what is happening, the amygdala transmits fear to the orbitofrontal cortex.”

The results of the experiment suggested that when people are confronted with ambiguity their emotions can overpower their reasoning, leading them to reject risky propositions. This raises the intriguing possibility that people who are less fearful than others might make better investors, which is precisely what George Loewenstein and four other researchers found when they carried out a series of experiments with a group of patients who had suffered brain damage.

Each of the patients had a lesion in one of three regions of the brain that are central to the processing of emotions: the amygdala, the orbitofrontal cortex, or the right insular cortex. The researchers presented the patients with a series of fifty-fifty gambles, in which they stood to win a dollar-fifty or lose a dollar. This is the type of gamble that people often reject, owing to loss aversion, but the patients with lesions accepted the bets more than eighty per cent of the time, and they ended up making significantly more money than a control group made up of people who had no brain damage. “Clearly, having frontal damage undermines the over-all quality of decision-making,” Loewenstein, Camerer, and Drazen Prelec, a psychologist at M.I.T.’s Sloan School of Management, wrote in the March, 2005, issue of the Journal of Economic Literature. “But there are situations in which frontal damage can result in superior decisions.”

...A good way to illustrate Cohen’s point is to imagine that you and a stranger are sitting on a park bench, when an economist approaches and offers both of you ten dollars. He asks the stranger to suggest how the ten dollars should be divided, and he gives you the right to approve or reject the division. If you accept the stranger’s proposal, the money will be divided between you accordingly; if you refuse it, neither of you gets anything.

How would you react to this situation, which economists refer to as an “ultimatum game,” because one player effectively gives the other an ultimatum? Game theorists say that you should accept any positive offer you receive, even one as low as a dollar, or you will end up with nothing. But most people reject offers of less than three dollars, and some turn down anything less than five dollars.

Cohen and several colleagues organized a series of ultimatum games in which half the players—the respondents—were put in MRI machines. At the beginning of a round, each respondent was shown a photograph of another player, who would make the respondent an offer. The offer then appeared on a screen inside the MRI machine, and the respondent had twelve seconds in which to accept or reject it. The results were the same as in other, similar experiments—low offers were usually vetoed—but the respondents’ brain scans were revealing.

When respondents received stingy offers—two dollars for them, say, and eight dollars for the other player—they exhibited substantially more activity in the dorsolateral prefrontal cortex, an area associated with reasoning, and in the bilateral anterior insula, part of the limbic region that is active when people are angry or in distress. The more activity there was in the limbic structure, the more likely the person was to reject the offer. To the researchers, it looked as though the two regions of the brain might be competing to decide what to do, with the prefrontal cortex wanting to accept the offer and the insula wanting to reject it. “These findings suggest that when participants reject an unfair offer, it is not the result of a deliberative thought process,” Cohen wrote in a recent article. “Rather, it appears to be the product of a strong (seemingly negative) emotional response.”

Several explanations have been proposed for people’s visceral reaction to unfair offers. Maybe human beings have an intrinsic preference for fairness, and we get angry when that preference is violated—so angry that we punish the other player even at a cost to ourselves. Or perhaps people reject low offers because they don’t want to appear weak. “We evolved in small communities, where there was a lot of repeated interaction with the same people,” Cohen said. “In such an environment, it makes sense to build up a reputation for toughness, because people will treat you better next time they see you.”

.... Today most economists agree that, left alone, people will act in their own best interest, and that the market will co├Ârdinate their actions to produce outcomes beneficial to all.

Neuroeconomics potentially challenges both parts of this argument. If emotional responses often trump reason, there can be no presumption that people act in their own best interest. And if markets reflect the decisions that people make when their limbic structures are particularly active, there is little reason to suppose that market outcomes can’t be improved upon.

Consider saving for retirement. Surveys show that up to half of all families end their working lives with almost no financial assets, other than their entitlement to Social Security benefits. Saving money is difficult, because it involves giving up things that we value now—a new car, a vacation, fancy dinners—in order to secure our welfare in the future. All too often, the desire for immediate gratification prevails. “We humans are very committed to our long-term goals, such as eating healthy food and saving for retirement, and yet, in the moment, temptations arise that often trip up our long-term plans,” David Laibson, the Harvard economist, said. “I was planning to give up smoking, but I couldn’t resist another cigarette. I was planning to be faithful to my wife, but I found myself in an adulterous relationship. I was planning to save for retirement, but I spent all my earnings. Understanding this tendency stands at the heart of a lot of big policy debates.”

...There is also a more fundamental objection to neuroeconomics and the Platonic view of decision-making. “There is no evidence that hidden inside the brain are two fully independent systems, one rational and one irrational,” Paul W. Glimcher, a neuroscientist who is the director of N.Y.U.’s Center for Neuroeconomics, and two of his colleagues, Michael C. Dorris and Hannah M. Bayer, wrote in a recent paper. “There is, for example, no evidence that there is an emotional system, per se, and a rational system, per se, for decision making at the neurobiological level.”

In place of the reason-versus-passion model, Glimcher and his colleagues have adopted a view of decision-making that, paradoxically, bears a striking resemblance to orthodox economics. In one experiment, Glimcher and a colleague trained thirsty monkeys to direct their eyes to one of two illuminated targets, which earned them differing chances of getting juice rewards—a fifty-per-cent chance of getting a full cup of juice for looking right, say, versus a seventy-per-cent chance of getting half a cup of juice for looking left. The game was repeated many times, with the probabilities changing periodically.

The monkeys’ task was to consume as much juice as possible, and they proved very adept at it. Before long, they were dividing their time between the illuminated targets in a way that roughly maximized their payoffs. When the odds favored looking right, they looked right; when the odds favored looking left, they looked left. Glimcher also used electrodes to track neural firing in part of the posterior parietal cortex, an area that is thought to organize signals transmitted by the retina. He discovered that the firing rate was closely related to the rewards the monkeys were likely to receive. “Specifically,” he and his colleagues reported, “the firing rate of a neuron associated with a leftward movement was a linear function of the probability that the leftward movement would yield the juice reward.”

Clearly, monkeys can’t do probability sums. (Many humans struggle with them!) But Glimcher’s experiment implies that their brains act as if they were solving a mathematical problem, which is what economists assume when they depict people as rational agents trying to maximize their well-being, or “utility.” “What seems to be emerging from these early studies is a remarkably economic view of the primate brain,” Glimcher and his colleagues wrote. “The final stages of decision-making seem to reflect something very much like a utility calculation.”

If Glimcher’s results could be demonstrated in human brains, they might undermine a lot of neuroeconomics, and many in the field tend to downplay his work. “Well, monkeys are very interesting, but they are not nearly as rich in their behavior as humans,” George Loewenstein said to me. “Humans have this very well-developed prefrontal cortex, which allows us to look ahead a number of stages, rather than just behaving in a reflexive fashion. Still, it’s wonderful that we have these controversies. Most of us are friends, and we debate these issues. I’ve learned a lot from talking to Paul.”

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