Saturday, July 14, 2007

Behavioral economics

I found this overview and intellectual history of behavioral economics via a link from Economist's View.

By now I think anyone who has looked at the data knows that the agents -- i.e., humans -- participating in markets are limited in many ways. (Only a mathematics-fetishizing autistic, completely disconnected from empiricism, could have thought otherwise.) If the agents aren't reliable or even particularly good processors of information, how does the system find its neoclassical equilibrium? (Can one even define the equilibrium if there are not individual and aggregate utility functions?)

The next stage of the argument is whether the market magically aggregates the decisions of the individual agents in such a way that their errors cancel. In some simple cases (see Wisdom of Crowds for examples) this may be the case, but in more complicated markets I suspect (and the data apparently show; see below) that cancellation does not occur and outcomes are suboptimal. Where does this leave neoclassical economics? You be the judge!

Related posts here (Mirowski) and here (irrational voters and rational agents?).

The paper (PDF) is here. Some excerpts below.

Opening quote from Samuelson and Conclusions:

I wonder how much economic theory would be changed if [..] found to be empirically untrue. I suspect, very little.
--Paul Samuelson


Samuelson’s claim at the beginning of this paper that a falsification would have little effect on his economics remains largely an open question. On the basis of the overview provided in this paper, however, two developments can be observed. With respect to the first branch of behavioral economics, Samuelson is probably right. Although the first branch proposes some radical changes to traditional economics, it protects Samuelson’s economics by labeling it a normative theory. Kahneman, Tversky, and Thaler propose a research agenda that sets economics off in a different direction, but at the same time saves traditional economics as the objective anchor by which to stay on course.

The second branch in behavioral economics is potentially much more destructive. It rejects Samuelson’s economics both as a positive and as a normative theory. By doubting the validity of the exogeneity of preference assumption, introducing the social environment as an explanatory factor, and promoting neuroscience as a basis for economics, it offers a range of alternatives for traditional economics. With game theory it furthermore possesses a powerful tool that is increasingly used in a number of related other sciences. ...

Kahneman and Tversky:

Over the past ten years Kahneman has gone one step beyond showing how traditional economics descriptively fails. Especially prominent, both in the number of publications Kahneman devotes to it and in the attention it receives, is his reinterpretation of the notion of utility.13 For Kahneman, the main reason that people do not make their decisions in accordance with the normative theory is that their valuation and perception of the factors of these choices systematically differ from the objective valuation of these factors. This is what amongst many articles Kahneman and Tversky (1979) shows. People’s subjective perception of probabilities and their subjective valuation of utility differ from their objective values. A theory that attempts to describe people’s decision behavior in the real world should thus start by measuring these subjective values of utility and probability. ...


Thaler distinguishes his work, and behavioral economics generally, from experimental economics of for instance Vernon Smith and Charles Plott. Although Thaler’s remarks in this respect are scattered and mostly made in passing, two recurring arguments can be observed. Firstly, Thaler rejects experimental economics’ suggestion that the market (institutions) will correct the quasi-rational behavior of the individual. Simply put, if one extends the coffee-mug experiment described above with an (experimental) market in which subjects can trade their mugs, the endowment effect doesn’t change one single bit. Furthermore, there is no way in which a rational individual could use the market system to exploit quasi-rational individuals in the case of this endowment effect36. The implication is that quasi-rational behavior can survive. As rational agents cannot exploit quasi-rational behavior, and as there seems in most cases to be no ‘survival penalty’ on quasi-rational behavior, the evolutionary argument doesn’t work either.

Secondly, experimental economics’ market experiments are not convincing according to Thaler. It makes two wrong assumptions. First of all, it assumes that individuals will quickly learn from their mistakes and discover the right solution. Thaler recounts how this has been falsified in numerous experiments. On the contrary, it is often the case that even when the correct solution has been repeatedly explained to them, individuals still persist in making the wrong decision. A second false assumption of experimental economics is to suppose that in the real world there exist ample opportunity to learn. This is labeled the Ground Hog Day argument37, in reference to a well-known movie starring Bill Murray. ... Subjects in (market) experiments who have to play the exact same game for tens or hundreds of rounds may perhaps be observed to (slowly) adjust to the rational solution. But real life is more like a constant sequence of the first few round of an experiment. The learning assumption of experimental economics is thus not valid.


But perhaps even more destructive for economics is the fact that individuals’ intertemporal choices can be shown to be fundamentally inconsistent49. People who prefer A now over B now also prefer A in one month over B in two months. However, at the same time they also prefer B in one month and A in two months over A in one month and B in two months.


The ultimatum game (player one proposes a division of a fixed sum of money, player two either accepts (the money is divided according to the proposed division), or rejects (both players get nothing)) has been played all over the world and leads always to the result that individuals do not play the ‘optimum’ (player one proposes the smallest amount possible to player two and player two accepts), but typically divide the money about half-half. The phenomenon is remarkably stable around the globe. However, the experiments have only been done with university students in advanced capitalist economies. The question is thus whether the results hold when tested in other environments.

The surprising result is not so much that the average proposed and accepted divisions in the small-scale societies differ from those of university students, but how they differ. Roughly, the average proposed and accepted divisions go from [80%,20%] to [40%,60%]. The members of the different societies thus show a remarkable difference in the division they propose and accept.

...“preferences over economic choices are not exogenous as the canonical model would have it, but rather are shaped by the economic and social interactions of everyday life. ..."

Camerer’s critique is similar to Loewenstein’s and can perhaps best be summed up with the conclusion that for Camerer there is no invisible hand. That is, for Camerer nothing mysterious happens between the behavior of the individual and the behavior of the market. If you know the behavior of the individuals, you can add up these behaviors to obtain the behavior of the market. In Anderson and Camerer (2000), for instance, it is shown that even when one allows learning to take place, a key issue for experimental economics, the game does not necessarily go to the global optimum, but as a result of path-dependency may easily get stuck in a sub-optimum. Camerer (1987) shows that, contrary to the common belief in experimental economics, decision biases persist in markets. In a laboratory experiment Camerer finds that a market institution does not reduce biases but may even increase them. ...


The second branch of behavioral economics is organized around Camerer, Loewenstein, and Laibson. It considers the uncertainty of the decision behavior to be of an endogenous or strategic nature. That is, the uncertainty depends upon the fact that, like the individual, also the rest of the world tries to make the best decision. The most important theory to investigate individual decision behavior under endogenous uncertainty is game theory. The second branch of behavioral economics draws less on Kahneman and Tversky. What it takes from them is the idea that traditional Samuelson economics is plainly false. It argues, however, that traditional economics is both positively/descriptively and normatively wrong. Except for a few special cases, it neither tells how the individuals behave, nor how they should behave. The main project of the second branch is hence to build new positive theories of rational individual economic behavior under endogenous uncertainty. And here the race is basically still open.


Anonymous said...

I think Samuelson's quote could also be applied to certain theories currently fashionable in the theoretical physics community.

Steve Hsu said...

The situation in, e.g., string theory is not quite as bad as you suggest. Everyone *wants* falsifiability, and will abandon a model that is falsified (after a bitter fight), but the problem is that the experiments are not yet capable of testing quantum gravity.

In economics you could argue that the standard neoclassical assumptions (at the agent level) have been tested and falsified many times. There's always the magical market assumption that aggregating many agents will fix the problem of faulty individuals, but it appears even *that* has been falsified in certain settings.

Anonymous said...

Behavioral economists have YET to offer us more than a catalog of situations where individuals make what we would refer to as sub optimal choices. They have NOT presented any unified theory of choice to displace the current rational model. Our friends K&T and their legions have produced many models that like the classical models need to be tweaked on a one-by-one basis to explain choices. For example Prospect theory suffers from the same set of limitations and misses as the more classical models.

Next the assertion that their is no individual to market level problem is simply not true. I have yet to read a paper that addresses the levels issue. Markets operate remarkably well.

Now I would like to turn to a more serious set of issues associated with BDT. Firstly , the theory does not adequately address the short comings raised by Simon with his work on bounded rationality. Secondly, the BDT theorists have not yet offered a cognitive foundation for the phenomena that they document. Again I would ask BDT theorists to explore more fully the work of Simon. Simon's work is the cognitive field is much more robust than simple phenomena based studies K&T and Thaler offer to economics or psychology. Third, BDT focus ignore the role of institutions in shaping decision making. Again, Simon, March Cyert introduced cognitive limitations and organization dynamics into decision making. BDT could also learn from North.

In summary, BDT is a simple , young discipline focused on cataloging biases and not addressing real decisions, markets or institutional situations without making them all a question of cognitive bias.

Anonymous said...

One more comment regarding falsification.

The assertion that classical assumptions have been falsified is not as simple as many BDT theorists suggest. The reason is that showing a case or cases where a theory is not correct is not falsification. It is simple showing a case. Popper's model requires that an alternative theory be offered that correctly explains the situations. It is here that BDT has yet to make the case. Yes, we have violations of the received theory, but we do not have a new alternative that can make predictions any more accurately. Please note that the theory must explain the market outcomes not individual level predictions.

Further, anyone who has worked in the field knows that many experiments are run and rerun to get the results that K&T assert to be so robust.

Steve Hsu said...

It is simply not true that an alternative theory has to exist for the original theory to be falsified. If the original theory is *scientific* then it makes predictions (or in this case, assumptions) that are either in accord or not with experiments. In the latter case the theory is falsified.

Yes, the behaviorists may not have something to "take the place of" the neoclassical model. But what, exactly, do you mean by that? Perhaps there does not exist any simple, tractable model that predicts outcomes for the interactions of large numbers of humans. There is never any guarantee that a particular complex system is computationally tractable or reducible to a simpler system.

It may be that one can't predict the outcome of complex interactions among many humans through anything less than an accurate simulation of all or most of the *individual* participants, with their own idiosyncracies and psychologies (i.e., path dependencies). That would be the worst case "chaotic" scenario for social science. But how do you know it's not the case?

If you want to attack the experimental results themselves, by all means please do, That is at least scientific. But you can't attack the behavioral point of view simply because it makes life difficult for economic theorists. Nature works the way it works.

Unknown said...

I think that we have a unique trait among animals... We are unusually good at working with each other. Of course, ants do this too, but I've not seen a study of how ants interact in markets. There's an avenue of research in everything...

An anecdote: I attended a leadership conference last summer in which we were placed in groups. We individually completed a "disaster" scenario by ranking decisions based on the order they should be completed. The last few decisions were decision we opted not to make.

When aggregated in a group and allowed 5 minutes to discuss our rankings, we no doubt increased our score. But it was surprising to all of us that our "synergy" score was about 67%, meaning that roughly, we did 67% better as a group than any individually.

While this is probably uncommon, it leads me to believe that not only do markets correct individually poorly made decisions, but serves as an institution greater than the sum of its parts.

Anonymous said...


The task of a theory is to explain a range of phenomena, not just show case a particular phenomena. I ask that BDT to do what all theory seeks to do explain a range of phenomena. If physics worked like BDT we would argue against Newtonian physics given predictions were not perfect. We would have journals attacking Newtonian physics with examples where an object rolled fewer feet than the theory predicted.

More seriously, BDT must offer a theory of markets if it wants to explain markets. Attacking the classical model because actors are violating transitivity is not an attack of substance. The model is about markets not individuals. I ask BDT to explain market level behavior.

Steve Hsu said...

I think to engage further on this we have to carefully define what you mean by the existing (neoclassical) "theory of markets". If you mean a model which

a) posits rational agents with infinite computing power and well-defined utility functions


b) manages to find global optima of some kind of aggregate (societal) utility function

then I neither believe (a) nor (b). You may say I am being too stringent here, but I believe (a) are the kind of assumptions needed to prove anything approaching a theorem (i.e., (b)) in economics.

I think (a) has been *demonstrated* to be false. You can claim that even though (a) is false that (b) is somehow achieved through aggregation (not even well-defined, since I don't know what the societal utility function is supposed to be), but I think some of the experiments even invalidate that perspective (see quotes in original post).

If your idea of "theory of markets" is "we like markets better than central command economies as they can aggregate information from lots of sources, and, though imperfect, they are the best we can manage, even though the collective opinion of the market at any moment might be way off. And, by the way, we can not in any way make precise quantitative predictions about how these markets will behave -- such as when bubbles, manias, mispricings, etc. will occur. In fact, cultural values and individual psychologies, even IQ distributions, can all affect the detailed outcomes.", well I suppose I can endorse that "theory of markets". I don't see what the word "theory" is doing in there, though. It's about as much a theory as Tolstoy's "theory of history".

Wah! you say. "But we know incentives work!" "People will bend down and pick up $20 from the sidewalk!". I totally agree, but if neoclassical economics boils down to "people respond to incentives" then it's not much of an intellectual triumph.

Anonymous said...


First, no one is saying that the assumption made in classical economics are with out error. They are by definition flawed summaries of reality. The question is whether the flawed summary is better than aletrnatives. Given that BDT does not predict better than the classical assumptions market level behavior I would say that it remains a better flawed summary.

Second, Simon long ago posited the limits of econ theory assumptions - complete information, infinite bandwidth, and constant objective function. The difference is that he recognized that a theoretical explanantion required the "right" level approach. Thus, we see cognitive theory development (with his AI approach) or an organizational explanation (a la March).

Third, markets operate every day with less than perfect information. The theoretically interesting question is how robust markets are given the material violations of the theory.

Forth, I do not discount the catalog of biases that have been found. They require an explanation. The current state of theory is sad at best. Given that the field ha been busy fro a couple of decades I fear it suffers from the same ailments that classical assumptions suffer. The only difference is that economists are not building up assumptions.

Fifth, you comment on incentives is a very good one. Much can be made with that assumption.

Steve Hsu said...

Anonymous 7:37 pm:

I think I agree with all your points, but I'm not sure what you meant by "Given that the field ha been busy fro a couple of decades I fear it suffers from the same ailments that classical assumptions suffer. The only difference is that economists are not building up assumptions. "

Care to elaborate? I get the feeling you are a real economist, so would love to hear your thoughts!

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