1. No category

Behavioral economics: Introduction
Colin Camerer, Caltech
RES Easter School 22-25 Mar 2015
• What is it?
•Use facts about natural [biological] limits on
computation, willpower and self-interest to improve
economics
•History:
•Why was psychology ignored?
• Questions to eventually answer
–What happens in equilibrium?
–Welfare and policy
This deck is for personal scholarly use only. Do not quote, circulate, or use for
teaching.
Precursor: What is economics?
• Consumer theory
– Maximize utility given preferences and information, subject to
constraint
Max u(x1,x2,…xn|θ) s.t. Σi pixi <y (income)
• Demand
– From consumer theory
– Complicated by risk, time, probability judgment (given θ)
– Assume social independence of demand (no “fashion”)
• Supply
– Firms combine capital and hired labor to produce output
– Sorting of different workers into ideal jobs (Becker: “That takes
care of 90% of it”)
Allowing imperfection always
improves economics
Perfect competition (∞ firms)
Useful special case, helpful to relax
(product differentiation, oligopoly)
Perfect information (θ = truth)
Useful special case, helpful to relax
(costly hidden information & action, signaling)
Perfect rationality (max u(x))
Useful special case, helpful to relax
(costly information processing, heterogeneity)
What do economists study?
AER March 07
•
The Missing Motivation in Macroeconomics
George A. Akerlof
Competence Implies Credibility
Giuseppe Moscarini
Modeling the Transition to a New Economy:
Lessons from Two Technological Revolutions
Andrew Atkeson and Patrick J. Kehoe
The Cross Section of Foreign Currency Risk
Premia and Consumption Growth Risk
Hanno Lustig and Adrien Verdelhan
Inefficiency in Legislative Policymaking: A
Dynamic Analysis
Marco Battaglini and Stephen Coate
Decision Making in Committees:
Transparency, Reputation, and Voting Rules
Gilat Levy
Bureaucrats or Politicians? Part I: A Single
Policy Task
Alberto Alesina and Guido Tabellini
The Motivation and Bias of Bureaucrats
Canice Prendergast
Urban Evolutions: The Fast, the Slow, and the
Still
Gilles Duranton
Market Share Dynamics and the "Persistence
of Leadership" Debate
John Sutton
•
Internet Advertising and the Generalized
Second-Price Auction: Selling Billions of
Dollars Worth of Keywords
Benjamin Edelman, Michael Ostrovsky and
Michael Schwarz
Credible Sales Mechanisms and
Intermediaries
David McAdams and Michael Schwarz
Imprecision as an Account of the
Preference Reversal Phenomenon
David J. Butler and Graham C. Loomes
Do Workers Work More if Wages Are High?
Evidence from a Randomized Field
Experiment
Ernst Fehr and Lorenz Goette
The Effect of Court-Ordered Hiring Quotas
on the Composition and Quality of Police
Justin McCrary
The Economic Impacts of Climate Change:
Evidence from Agricultural Output and
Random Fluctuations in Weather
Olivier Deschênes and Michael Greenstone
What Are Stock Investors’ Actual Historical
Returns? Evidence from Dollar-Weighted
Returns
Ilia D. Dichev
What model features are useful?
• Neoclassical economics:
– Generality– applies to many domains
– Precision– produces clear predictions
– Accuracy– predictions are tested by field data
• Behavioral economics:
– All of above
+ psychological plausibility– fit data on how
individuals think, perceive etc.
Why psychology was ignored:
Milton Friedman, Methodology of
Positive Economics (1953)
• “The abstract methodological issues we have
been discussing have a direct bearing on the
perennial criticism of “orthodox” economic
theory as “unrealistic” as well as on the attempts
that have been made to reformulate theory to
meet this charge. Economics is a “dismal”
science because it assumes man to be selfish
and money-grubbing, “a lightning calculator of
pleasures and pains, who oscillates like a
homogeneous globule of desire of happiness
under the impulse of stimuli that shift him about
the area, but leave him intact”; it rests on
outmoded psychology and must be
reconstructed in line with each new development
in psychology;…”
Forgotten passage…
• “As we have seen, criticism of this type [about
accuracy of assumptions] is largely beside the point
unless supplemented by evidence that a
hypothesis differing in one or another of these
respects from the theory being criticised yields
better predictions for as wide a range of
phenomena. (mytalics)”
• That is precisely what behavioral economics
tries to do…
precisely
precisely
Claim: Many important economic decisions
will not necessarily be‘computed’ correctly
•
•
•
•
•
•
Housing
Marriage/divorce
Children
Education & career choices
Violence (crime, war)
Health
Claim: Many important economic decisions
will not necessarily be‘computed’ correctly
• Why not?
– Many are political decisions (median voter
theorem)
– Evolution did not face these challenges
– Learning from experience is difficult
– Advice markets may or may not work well
– Imitation of successful people may or may not
work well
Examples
• Computation
– Chess, consumer choice
• Willpower
– Hyperbolic discounting
• Greed
– Ultimatum games
Do markets correct mistakes?
•
Tug-of-war:
– Firms sort to limit rationality mistakes from
workers…and to better exploit consumer
mistakes
– Example: Pathological gambling
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Heterogeneity in economics
• Not everyone is the same
– Differences create division of labor,
specialization
– Interactions are interesting: Is the effect of
limitedly-rational agents multiplied or erased?
(Fehr Camerer Sci 07)
• Individual differences
• Gender, lifecycle, IQ, patience
• Example: Aging and credit (Laibson et al 07)
Pareto believed optimization was
due to learning…
• [W]e are concerned only with certain relations between
objective facts and subjective facts, principally the tastes
of men. Moreover, we will simplify the problem still more
by assuming that the subjective fact conforms perfectly
to the objective fact. This can be done because we will
consider only repeated actions to be a basis for claiming
that there is a logical connection uniting such actions.
• A man who buys a certain food for the first time may buy
more of it than is necessary to satisfy his tastes, price
taken into account. But in a second purchase he will
correct his error, in part at least, and thus, little by little,
will end up by procuring exactly what he needs. We will
examine this action at the time when he has reached this
state.
History and sociology
• Herbert Simon
– 1954 JASA/OR/Econometrica/PoliSci
– “bounded”, “procedural” rationality (a/k/a Aumann
“rule rationality)
– Inspired by cognitive revolution in psych, AI
• Thaler 1980 “Toward a theory of consumer
choice” (JEBO, first article, first issue)
– Met Kahneman, Tversky in 1970’s
• KT, Slovic, Fischhoff, Lichtenstein
– Used deviations from Bayesian judgment, EU to
understand psychological principles
– Analogy to visual illusions in study of perception
Optical illusions: Decomposition is
unnatural…except for autists!
Modern history …
• Second wave empirics & psychology
– Camerer, Loewenstein, Shafir, Shefrin (c. 1985+), Shiller (1981)
• Third wave formalists
– Rabin (1993 AER), Laibson (1997 QJE)
• Koszegi, O’Donoghue
• Empirics: Malmendier, Della Vigna, D. Silverman et al, +++
• Nobel prize (Kahneman-Smith 02)
– Thaler: “Did you ever think we would be here?” CFC: ______
• Converts
– Benabou-Tirole (03?), Fudenberg-Levine (06), Benhabib-Bisin
(05), many more…
• 2005+ Fundamentalist backlash
– Shaked “pamphlet” on social prefs, Rubinstein, Gul and
Pesendorfer (05) (echo of Pareto-Friedman argument), Levine
(“Is behavioral economics doomed?”)
– Relatively easy to publish ‘ refutations’ of behavioral economics
findings (Plott-Zeiler AER, Manaiadis AEJ, AER, Sprenger
AER…)
Trends: Franchising
• Finance (Shiller-Thaler, Shleifer, Barberis, Odean)
– Rationality limits influence pricing, corporate
• Game theory (Crawford, Camerer…)
– Formal models of cognitive hierarchy, learning
• Labor (Fehr…)
– Reciprocity/crowding out overturns many conclusions
• Law (Sunstein)
– Influence of framing, norms, tackle paternalism
• Public finance (Slemrod et al )
– What is welfare?
• Poverty (Shafir, Mullainathan)
Trends: Formal theory & field data
• ‘New’ psychology & sociology
– Attention, motivated cognition, self-image, social
networks + peer effects
• Formal theory
– Deriving bounds on rationality from familiar primitives
(beliefs, preferences, rational attention)
– Dual-process models (planner-doer, controlledauto…)
– My view: Theories that fit the most data and make
sharp, bold predictions are preferred
• Field data
– Friedman’s desideratum– what new effects are
predicted & explained?
Conclusions
• Behavioral economics is now well-established
– Should cease to be a distinct subfield around 2015
• Grounds economics in psychology and biology
• Imperfect rationality is as natural as
– Imperfect competition
– Imperfect information
• Interesting questions about market equilibrium
• Controversies are healthy (normal science)
– E.g. reference points are fragile
• Frontiers:
– Field data, careful theory, “new” psychology…
Some critique
• “The conclusion of so-called behavioral
economics is that people don’t behave in a
rational way, that they don’t respond as
expected to economic incentives. Empirical
economics shows that people do respond very
precisely to economic incentives.” (Robert
Aumann interview 9/04
http://www.ma.huji.ac.il/~hart/papers/mdaumann.pdf?. )
• Not quite: People respond imprecisely (perhaps
slowly) to incentives. And they respond to
variables which are not incentives (not prices,
income, or information)
Conscious computation and “as if”
• “The thesis that behavioral economics attacks is that
people behave rationally in a conscious way—that they
consciously calculate and make an optimal decision based,
in each case, on rational calculations. [Ed. : False] Perhaps
behavioral economists are right that that is not so. Because
their experiments or polls show that people, when faced
with certain kinds of decisions, do not make the rational
decision. However, nobody ever claimed that; they are
attacking a straw man, a dead horse. What is claimed is
that economic agents behave in a way that could be
described as derived from rationality considerations; not
that they actually are derived that way, that they actually go
through a process of optimization each time they make a
decision.” (Aumann interview)
• Not so: We are questioning predictions of the “as if” view
and attempting to construct models which make better
predictions. Read Friedman carefully...