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

Conclusions

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:

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.

Lowenstein:

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.

Camerer:

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. ...

Finally,

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.