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Posts Tagged ‘behavioral economics’

Michael Sandel has a fascinating new book out called What Money Can’t Buy: The Moral Limits of MarketsSandel makes an old argument, that economics cannot be divorced from its roots in moral philosophy, but he makes it in a fresh light from the perspective of the 21st century. Two transformations, he writes, have made this argument more compelling and important than ever before: our world has changed towards a market orientation, and the boundaries of the economics discipline have expanded.

I do not intend to provide a summary, but want to point out one argument of the book that I found particularly fascinating and persuasive. Sandel describes the commercialization effect – which refers to when markets change the character of the good and the social practices they govern. That is, a good’s characteristics will change depending on how it is exchanged/provided, whether through market exchange or another form such as through gift, informal exchange, altruism, love, or feeling of responsibility or loyalty. Thus, the value of a commodity will depend on how it was provided. The exact same commodity may have one value if I buy it commercially and another if it is given as a gift by a friend.

Though it seems very obvious, the vast majority of economics ignores this commercialization effect. (Some behavioral experimenters such as Dan Ariely have found evidence of this effect, no surprise, and have commented on it.) This highlights how mainstream economics is an analysis of a very special case of economic activity, that done through market exchange, and this theory falls apart with respect to other forms of economic activity. A truly general theory of economic behavior of humans must recognize and deal with these aspects of human psychology and moral philosophy which give rise to the commercialization effect and throw a wrench into the standard microeconomic theory of choice and exchange.

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The blog Sleepykid posts an essay from a 2007 issue of Harper’s, by David Graeber, an anthropologist. I found the following section striking:

PROPOSITION I: NEITHER EGOISM NOR ALTRUISM IS A NATURAL URGE; THEY IN FACT ARISE IN RELATION TO EACH OTHER AND NEITHER WOULD BE CONCEIVABLE WITHOUT THE MARKET

First of all, I should make clear that I do not believe that either egoism or altruism is somehow inherent in human nature. Human motives are rarely that simple. Rather, egoism and altruism are ideas we have about human nature. Historically, one has tended to arise in response to the other…

Even today, when we operate outside the domain of the market or of religion, very few of our actions could be said to be motivated by anything so simple as untrammeled greed or utterly selfless generosity. When we are dealing not with strangers but with friends, relatives, or enemies, a much more complicated set of motivations will generally come into play: envy, solidarity, pride, self-destructive grief, loyalty, romantic obsession, resentment, spite, shame, conviviality, the anticipation of shared enjoyment, the desire to show up a rival, and so on, These are the motivations impelling the major dramas of our lives that great novelists like Tolstoy and Dostoevsky immortalize but that social theorists, for some reason, tend to ignore, if one travels to parts of the world where money and markets do not exist–say, to certain parts of New Guinea or Amazonia–such complicated webs of motivation are precisely what one still finds. In societies based around small communities, where almost everyone is either a friend, a relative, or an enemy of everyone else, the languages spoken tend even to lack words that correspond to “self-interest” or “altruism” but include very subtle vocabularies for describing envy, solidarity, pride, and the like. Their economic dealings with one another likewise tend to he based on much more subtle principles. Anthropologists have created a vast literature to try to fathom the dynamics of these apparently exotic “gift economies,” but if it seems odd to us to see, for instance, important men conniving with their cousins to finagle vast wealth, which they then present as gifts to bitter enemies in order to publicly humiliate them, it is because we are so used to operating inside impersonal markets that it never occurs to us to think how we would act if we had an economic system in which we treated people based on how we actually felt about them.

The sentence in bold particularly resonates with me. I feel like I’ve written this same thing before, but no matter. I think a lot of neoclassical economists have a creation story that starts, “in the beginning there were markets and market-oriented people.” This attitude has become the norm, and thus any activity that deviates from it is considered extra-normal. Behaviors that are altruistic or charitable are considered to be less economic in character. But what is an economy, if not a confluence of decisions on how to allocate resources, and the social substrate that binds these decisions together? If alternative economies arise, one would naturally expect behavior to change, because we are not simply hard-wired to behave as we do in a market economy.

It’s good to keep these alternative interpretations in mind as we think about what our economy is and what it could be.

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David Brooks was interviewed on National Public Radio this week, not for the usual political commentary, but to discuss his new book, The Social Animal, which in fact does look worth checking out. When asked by Robert Siegel what sparked his interest in probing the human mind, he responded:

Mr. BROOKS: Failure. I covered a bunch of policy failures, so in – and when the Soviet Union fell, we sent all these economists into Russia, when what they really lacked was social trust. We invaded Iraq totally oblivious to the psychological trauma and the cultural realities of Iraq. We had financial regulatory policies based on the idea that bankers were sort of rational creatures who would make smart decisions.

And I’ve covered education for 20 years, and we’ve reorganized all the boxes to very little effect. And the reality of education is that people learn from people they love. But if you mention the word love at a congressional hearing, they look at you like you’re Oprah.

And so all these policy failures were more or less based on a false view of human nature: that we’re cold, rationalistic individuals who respond to incentives. And so while all these failures based on this bad view of human nature were over in one side of my life, all these scientists, philosophers and others were developing a more accurate view of human nature, which is that emotion is more important than reason, that we’re not individuals, we’re deeply interconnected. And most importantly, that most of our thinking happens below the level of awareness.

This cold, rationalistic, atomistic agent is exactly the agent that inhabits economic models and plays game theory. It is because this is the type of agent that can be modeled neatly using the techniques borrowed from physics and engineering. In order to theorize about a more useful economic agent, the neoclassical economists standard tools of dynamic optimization and dynamic programming would have to be thrown out the window; economists are most unwilling to throw their entire toolkit out the window, for fear of being reduced to level of other, “soft” and “non-rigorous” social sciences.

Brooks also makes an interesting point about how this research has changed his view of markets:

And it’s made me much more suspicious, actually, of the free market, because we have to have – you know, the free market produces a lot of wealth, but it’s embedded. It’s embedded in a series of understandings. And if you don’t have those relationships, then people can’t thrive in that free market.

Do they have an ability to control their impulses? Do they have an ability to work in groups?

Groups are much smarter than individuals. And the groups that do well, it’s not shaped by how smart the people are in the group, it’s shaped by how well they signal each other. Do they take turns when they’re having a conversation? And so, even when you see something like the free market, you don’t see like Ayn Rand rationale individuals. You see groups and competing groups and collaborating groups deeply intertwined with one another.

It is becoming increasingly clear that a more useful economic theory will be one that is holistic, rather than atomistic, and more humbly interdisciplinary, rather than disdainful of other fields of study.

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Tim Harford had a great column in the FT last weekend in which he discussed some of the limits of what I’ll call micro-behavioural economics (in general I think micro/macro splits are problematic, but this branch is operating as such). Basically, Harford describes the Thaler-Sunstein policy nexus, wherein minor policies will have large impacts because humans behave in ways violating assumptions of neoclassical economics:

Behavioural economists point out cases in which our decisions don’t match neoclassical theory, and thus the “as if” defence fails…

Consider the human response to risk. Neoclassical economics says that we act as if considering all possible outcomes, figuring out the probability and utility of each outcome, multiplying the probabilities with the utilities, and maximising expected utility. Clearly we do not in fact do this – nor do we act as if we do.

Behavioural economics offers prospect theory instead, which gives more weight to losses than gains and provides a better fit for the choices observed in the laboratory…

But, say Berg and Gigerenzer, it is even more unrealistic as a description of the decision-making progress, because it still requires weighing up every possible outcome, but then deploys even harder sums to produce a decision. It may describe what we choose, but not how we choose…

This is tough on behavioural economists, because in order to be taken seriously by other economists they have had to play the optimising game. Switching to Gigerenzer’s rules would mean the end of economics as we know it.

Yet the critique is sobering. If behavioural economists do not really understand why we do what we do, there are surely limits and dangers to the project of nudging us to do it better.

Indeed, it’s unlikely if behavioral economics will ever get at the “why” (perhaps neuroeconomics will some day, but it’s hard to envision how that branch will unfold). The whole nudge policy nexus aims for low-hanging fruit- policies that, for a variety of reasons, will likely work in getting whatever goal is sought. However, this type of behavioral economics will not help us better model an economy, predict crises, et al. In part, it’s because decision-making is fluid, and changes in interaction with other agents in the world. And in part, it’s because decision-making doesn’t necessarily tend to maximize anything in particular.

Indeed, I think we’re better off looking in a direction that Daniel Little points to, wherein real, macro-level complexity reigns supreme.

Axelrod and Cohen make use of three high-level concepts to describe the development of complex adaptive systems: variation, interaction, and selection.  Variation is critical here, as it is in evolutionary biology, because it provides a source of potentially successful innovation — in strategies, in organizations, in rules of action.  The idea of adaptation is central to their analysis — in this case, adaptation and modification of strategies by agents in light of current and past success.  Interaction occurs when agents and organizations intersect in the application of their strategies — often producing unforeseen consequences.

It’s likely that models of the real-world economy with these characteristics will be unsolvable, because these features are difficult to turn into datapoints. Nevertheless, the more ambitious project of seeing how real, unpredictable behavior aggregates into a socially-embedded, uncertain economy, is far more interesting than 401(k) nudges.

 

 

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There’s been a bit of discussion on a Rajiv Sethi post about Duncan Foley’s attempts to bring strong microfoundations into macro. Mark Thoma first had comment and then Leigh Caldwell chimed in. If you have time, start with Rajiv’s post. Thoma sums up a key problem well:

That is, you need to make the representative agent assumption in order to aggregate individuals up to the macroeconomic level and still be able to guarantee uniqueness, stability, or many other properties we need to have a reasonable model.

Caldwell goes a little bit deeper into smoothing out the problem. He argues that we should abstract models of the economy into systems of agents and goods, mediated by beliefs and values. I think the problem is that Caldwell over-abstracts, though. He seems most excited that, “the model has the potential to be simple enough to be tractable.” Even though he acknowledges that, “the actual mathematics of this theory will look like is not yet obvious,” I don’t think Caldwell moves the ball forward much. What he wants boils down to:

But a simple model of choice arising from values, mediated by beliefs, under constraints on attention, accuracy and myopia provides a parsimonious and expressive description of reality. By implementing a realistic theory of decision-making into the model, we will have a closer match to the real world than current theories.

However, he eschews agent-based models which require too many assumptions. However, I think we have two choices if we want to formally model the economy. We either observe behavior on measurables and fit the model, or we make abstract assumptions about how agents behaves on squishier concepts like beliefs and values and then apply them throughout. I don’t think, though, we can get by based on observing these hard-to-measure concepts. Even if we can measure beliefs and values in some dimensions, I’m not sure how we implement them in these models without making further assumptions. And finally, if we want micro-foundations, they have to be agent-based, with a full slew of interactions. For now I side with Thoma’s third option:

give up the idea of providing microeconomic foundations for macroeconomic models and begin modeling the aggregate level directly (e.g. see Kirman’s discussion of network models)

And of course, in modeling this aggregated activity, we should be mindful that there are a variety of questions we can ask besides “what will GDP growth look like?”

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I love these RSA animated lectures. This one by Dan Pink on his new book, Drive: the surprising truth about what motivates us.

I especially like the idea of the purpose motive, and the caveat about unmooring the profit motive from it. If someone does come up with a way to keep organizations anchored in the purpose motive, I think that would make the world a better place.

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Stephanie Rosenbloom at the New York Times challenges the foundational economic assumption that more is always better in a recent article, “But Will It Make You Happy?” Research has shown that people are happier when they spend money on experiences rather than on acquiring more stuff:

On the bright side, the practices that consumers have adopted in response to the economic crisis ultimately could — as a raft of new research suggests — make them happier. New studies of consumption and happiness show, for instance, that people are happier when they spend money on experiences instead of material objects, when they relish what they plan to buy long before they buy it, and when they stop trying to outdo the Joneses.

If consumers end up sticking with their newfound spending habits, some tactics that retailers and marketers began deploying during the recession could become lasting business strategies. Among those strategies are proffering merchandise that makes being at home more entertaining and trying to make consumers feel special by giving them access to exclusive events and more personal customer service.

As a response to these trends, business have been trying to sell more “experiences” than just stuff. For example, Wal-Mart has responded by grouping items that families can use to share experiences at home: cooking out, home theaters, and games. They are really selling experiences. Research shows that other experiences such as vacations and sporting events yield a better “bang for the buck” than buying stuff.

Some argue that this is because we can reminisce about experiences, while new things quickly lose their allure. Also, it might be due to competing for status:

Alternatively, spending money on an event, like camping or a wine tasting with friends, leaves people less likely to compare their experiences with those of others — and, therefore, happier.

Conspicuous consumption certainly does seem to have a huge effect on happiness. However, the commodification of leisure and experiences can lead them to be vehicles for comparison also. How close are your seats to the stage or to the field? Which exotic beaches did you vacation to? How expensive was that wine you tasted?

In the film Happy, Roko Belic shows that “the one single trait that’s common among every single person who is happy is strong relationships.” Does building strong relationships require the commodification of leisure and “experiences” that we have to buy at Wal-Mart? Perhaps not.  But it can help.

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I think James Kwak makes some great points on applying behavioural economics to the current crisis. We must not let that approach excuse the worst of corporate excesses:

First, it doesn’t do to say that ordinary people are irrational in making ordinary everyday decisions, and therefore we have to accept that companies will be irrational in making big decisions — like, say, whether to drill holes in the Earth’s crust a mile under the ocean. As they say, people make big bucks to make these decisions, and we expect them to use a little more reasoning than the kind we evolved on the African grasslands…

The problem is that there is a systematic bias within these companies against certain assessments and in favor of others. That is, the guy who shouts, “Danger! Danger!” will be ignored (or fired), and the guy who says, “Everything’s fine, the model says disaster can strike only happen once every hundred million years” will get the promotion — because the people in charge make more money listening to the latter guy. This is why banks don’t accidentally hold too much capital…

On top of that, it isn’t even true, as a matter of fact, that the companies involved failed to estimate the risk of disaster…

This isn’t inability to quantify the likelihood of unlikely events; this is willfully looking the other way.

Thaler also wants to make the point that regulators are incapable of understanding the complex technologies involved, whether in finance or in oil exploration. But while this is undoubtedly true to an extent, it also misses the main point.

The most frightening part of Lustgarten’s interview has nothing to do with BP. It’s about the use of hydraulic fracturing (or “fracking,” apparently with no intended reference to Battlestar Galactica) to drill for natural gas. In fracking, a mixture of water and chemicals is injected underground under extremely high pressure to break up rock formations and release trapped natural gas bubbles. According to Lustgarten, there is no scientific understanding of what happens to those chemicals — many of which are toxic — and whether they end up in our drinking water. Yet the Energy Policy Act of 2005 forbids the EPA from regulating fracking under the Safe Drinking Water Act — by simply stipulating, without proof, that the chemicals are removed after being used, and therefore there is nothing to regulate.

If this reminds you of the Commodity Futures Modernization Act, it probably should…

This is what happens when you have a weak regulatory agency crippled by pressure from above (and political appointees who are opposed to regulation) and a private sector that simply does whatever it pleases in pursuit of profits. It’s not individual irrationality; it’s power, pure and simple. Free market economics has already whitewashed enough egregious corporate behavior. Let’s not repeat that mistake with behavioral economics.

Combining behaviorial economics with power analysis would be an excellent step towards making it a form of real-world economics. Power analysis would help provide some of the “why?”, not as in “why do people make certain decisions,” but “why are certain people in position to make those decisions?” The preferences that are behind decision-making are not merely exogenous either. I think behavioral economists understand these concepts at an intuitive level, but I don’t think they sufficiently incorporate them into their formal models.

 

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I want to draw attention to three mostly unrelated points. The first (which was in the friday links) is that Ben Bernanke devoted a commencement address to the economics of happiness. Here’s a notable excerpt:

Easterlin’s own view, taking an economic perspective, is that people’s happiness depends less on their absolute wealth than on their wealth compared with others around them…

Human adaptability, which I mentioned earlier, also helps to explain the Easterlin paradox. Rich or poor, you tend to get used to your circumstances. Lottery winners get used to being wealthier, and their psychological state may ultimately be not much different than it was before buying the winning ticket…

life satisfaction requires an ethical framework. Everyone needs such a framework. In the short run, it is possible that doing the ethical thing will make you feel, well, unhappy. In the long run, though, it is essential for a well-balanced and satisfying life.

Second, I thought David Ruccio had a keen response to Akerlof and Kranton’s Identity Economics piece:

I certainly don’t want to argue against the importance of social identities and norms within organizations, large and small…But Akerlof and Kranton’s is an impoverished notion of how social identities and norms work, and how they are reproduced over time.

First, they forget all about notions of fairness and justice, as frames of reference for organizational identities. If the existing norms are considered unfair or unjust, why should they be followed?

Second, they write nothing about power, much less notions of ideology, propaganda, or exploitation. For example, the panopticon works—it keeps people aligned with the correct functioning of the organization—because it induces a sense of permanent visibility that ensures the functioning of power.

Third, from the profile of Cass Sunstein, we see some wrong-headed discount rate thinking. At least the author brings up the ethical point:

In OIRA’s cost-benefit calculations, the government’s willingness to spend depends on…the social cost of carbon…All else being equal, if given a choice between paying $1 million now and $1 million five years from now, economists will choose to pay later…

The problem, Sunstein says, is that we might do irreversible damage to the planet while blithely waiting for the price of action to drop just enough…

The debates over the discount rate are less mathematical than moral. Spending money now to prevent climate damage that won’t appear for decades is a tax on present generations; declining to spend now is a tax on the future. The British government several years ago assigned the economist Nicholas Stern to value the cost of climate change. Stern’s vision was nightmarish…

As an academic, Sunstein seemed to side with economists like William Nordhaus at Yale, who set the discount rate at about 5 percent, which would counsel patience. “It’s not clear what direction the risk of error cuts in,” he told me. “If we err, 7 percent could be bad,” he said, but “if we err, 1 percent could be bad also.” A low a discount rate might protect the environment by spurring us to sacrifice now — while damaging the economy, increasing poverty and putting more people out of work…

So the strategy is too find a price that sounds right, and back the discount rate out? Seems so unrigorous.

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Maxine Udall, whose eponymous blog is quite excellent, responds to my post from last Wednesday.

Foreword: This is a response to Nick Kraftt at Open Economics, where he follows up on his blog in which he “attacks” U Max or “old fashioned economics” by Parsing the Comments that resulted. For non-economists reading this, what follows is my attempt to draw a distinction between utility maximization, which is what economists have tended to assume best describes consumer behavior, and preference maximization, which is more likely to be what consumers are actually doing when markets fail, information is faulty, prices are distorted away from marginal social cost, or uncertainty (i.e., risk) cannot be or is not managed efficiently. We have tended to use the two terms as synonymous. I think the distinction is important. If preferences do not map accurately to something that can objectively be called utility, there is no guarantee that market allocations are efficient in any meaningful sense of that term. (Obey, if you’re out there, this one’s for you. :-))

Uncertainty, norms, institutions all matter and will shape consumer  preferences (more about this later). The real issue IMHO is whether or not individual preferences map accurately to something that could plausibly and objectively be regarded as individual utility. It’s JS Mill’s “better to be a human dissatisfied than a pig satisfied” problem. Mill implies that there is some objective state of the world that corresponds or “should” correspond to human happiness. Were we rational, it is the state of the world we would prefer to that characterized by satisfaction of irrational, short-term pleasures.

We economists have tended to ignore the normative aspect and assume that if someone is a “pig satisfied,” his/her preferences correspond to the highest utility that person can or would want to attain subject to the constraints of their income and prevailing prices (even if there is another feasible to attain (with a little rearranging of resources) state of the world in which the person could have health insurance, retirement security, and better nutrition). We also assume that in forming those preferences, the individual is 1) rational (defined rather narrowly as having preferences that don’t change or switch around at least in the short run and that are characterized by more always and everywhere being preferred to less); 2) self-interested (maximizing his/her own idea of what is best for him/her); and 3) fully-informed (s/he knows everything (and I mean everything) about the good and bad effects of consuming some good, the side effects to others of consuming or producing the good, and the future states of the world that will result from consuming or producing the good. And, finally, the prices s/he faces are assumed to reflect the marginal social cost of the goods and services s/he purchases. If any of these assumptions do not hold, then the consumer’s preferences most likely do not map directly and accurately to a state that could be characterized by JS Mill as a “human satisfied”, i.e., a state in which individual utility by some objective standard is being maximized.

When the assumptions do not hold, the consumer is a preference maximizer, not a utility maximizer. The effect will be to distort demand for things that maximize (uninformed, possibly irrational, maybe even bad in the long run) preferences (e.g., granite counter tops and large homes with en suite baths purchased with no money down and pick-your-payment mortgages) at the expense (opportunity cost) of things that would actually improve the long-term prospects and lives of both individual consumers, the economy, and society generally. In the extreme, we have a world of “pigs satisfied” and an economy with significant (inefficient) distortions in investments in and stocks of financial, human, and health capital.

Norms and institutions are important aspects of market exchange and individual behavior that should (there’s that normative word again) act to align individual preferences with plausibly objective individual and societal utility. In so-called “free markets,” they will embody and reinforce the “social” virtues of generosity, beneficence, fairness or justice as well as individual virtues such as prudence and temperance that lead individuals to take  broader and longer-term views of their own behavior and its impact on their own long-term objectives as well as on their community and the larger society.The result is that norms and institutions provide a moral counterweight to greed and other strong incentives to pursue short-term hedonistic “self-interested” objectives.

All policy solutions aimed at remedying or minimizing the divergence of preferences from utility will necessarily involve “paternalism” to a greater or lesser extent. The solution that is least paternalistic and that allows the most consumer autonomy is preferred. To minimize paternalism, it must include improved (and state-funded) education, improved consumer information, increased market transparency, some regulation, and some “nudging” in circumstances where uncertainty makes rationally, informed choice difficult. The more effective are societal norms and institutions at reinforcing virtues that promote long-term individual and societal well-being, i.e., at aligning individual preferences with individual and societal utility, the less paternalism will be required. For this reason alone, prevailing norms and beliefs in support of unfettered self-interest that are derived from misunderstanding the metaphor of Adam Smith’s “invisible hand” and “self-interest” must be corrected.

Assuming virtue in economic models of individual decision making is much the same as assuming full-information. If the assumption is true, revealed preference probably approximates utility maximization. If it is false, then I believe we’re in a second best world.

If individual virtue tempers our “piggy” desires and conditions our choices to something that is both individually and socially better, then the economic rewards of virtue as embodied in and promoted by societal norms and institutions are far greater than we have ever suspected. As economists, we would do well to recognize this when we teach U max.

At an operational/policy level, I think Maxine pretty much nails it. At the theoretical level, I’d hedge a bit on the preference maximization piece, referring you to Sandwichman’s comments that I reposted here.

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