Behavioral Economics - Sp 11

1. Introduction

John Maynard Keynes

Over the years many have questioned exactly what the so-called "correct explanations" are for economic growth and business cycles. These uncertainties remain to exist today, however, it is important to understand that clarifying this debate cannot be done through an aggregative analysis within the Neoclassical framework. Current disputes in theory rest largely on departures from perfect rationality (acting in such a way that utility is always maximized) under uncertainty. The distinction between risk and uncertainty is fundamental in both Classical and Post Keynesian economics. While risk can be quantified, uncertainty simply cannot. By investigating literature on behavioral economics,we will use social, cognitive, and emotional factors to better understand economic decisions of individuals and institutions. We will use the writings of authors such as:

• Keynes
  • The General Theory
• Camerer
  • Advances in Behavioral Economics
• Knight
  • Risk and Uncertainty
• Starmer
• Zak
  • Moral Markets: The Critical Role of Values in the Economy
• Wray
  • Post Keynesian Book Review

2.Risk vs Uncertainty

Risk is defined as the possibility that a chosen decision including the choice of not acting will lead to a decrease in utility and an undesirable outcome. The belief implies that a choice having an influence on the outcome exists or existed. Potential losses themselves may also be called risks.

Uncertainty is simply the condition of having doubts with regard to the market. Uncertainty can have serious affects in the market that lead to both positive and negative outcomes. Due to the different effects uncertainty can cause, it is hard to distinguish whether or not it is good or bad for the market. Uncertainty can cause inflation of prices, excess demand, and liquidity traps. However, the uncertainty ever present in the market fuels investment and growth for the possible potential future return.

Knight argues that there is a fundamental difference between risk and uncertainty. Risk is a state of uncertainty in which some of the possibilities involve a loss, a catastrophe, or other possible negative outcomes.

Uncertainty is the lack of complete knowledge and the existence of more that one possible outcome. The true outcome or result is impossible to know.

Knightian Uncertainty is immeasurable and therefore not possible to calculate while Knightian risk is able to be measured

"Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term "risk," as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. ... The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. ... It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We ... accordingly restrict the term "uncertainty" to cases of the non-quantitive type."(Knight- Risk, Uncertainty and Profit)

3.Indecision and Inefficiencies in the market

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Adam Smith

Throughout the classical period, psychology and economics were closely linked which can be seen in the Theory of Moral Sentiments. Adam Smith proposed explanations using psychology to demonstrate how different individual’s behavior related to their decisions in the market place. However, neo-classical economics tried to reform this discipline into more of a natural science from simple assumptions and developed the concept of homo economicus. This creation was fundamentally rational so that behavior was now assumed rational. Under these presumptions that man are inherently irrational, I will seek to explain from a classical standpoint how people’s decisions are made through the use of the following:

• Heuristics: People often make decisions based on approximate rules of thumb and unbounded logic involving different variables such as perception, effort, and past experiences.

• Framing: The collection of anecdotes and stereotypes that make up the mental emotional filters individuals rely on to understand and respond to events.

• Market inefficiencies: These include herd behavior, panic and non-rational decision making involving stock bubbles.

Cognitive biases may also have strong random effects in the aggregate if there is social contagion of ideas and emotions which can cause collective euphoria or fear causing herding and groupthink. Behavioral finance and economics rests as much on social psychology within large groups as on individual psychology. In some behavioral models, a small deviant group can have substantial market-wide effects which can be quite problematic. The central issue in behavioral finance is explaining why market participants make systematic errors. Such errors affect prices and returns, creating market inefficiencies. This concept investigates how other participants arbitrage such market inefficiencies and use them to their advantage. Behavioral finance highlights inefficiencies such as under or over reactions to information as causes of market trends which can culminate into bubbles and crashes in extreme cases. These cases are usually attributed to limited investor attention, overconfidence, over optimism, and herding. Heuristics refer to a set of techniques related to experiences which all one to solve problems, learn, and discover new things. This technique is used to identify the best solution as fast as possible. There are many different methods, which include “rule of thumb,” intuitive judgment, common sense, and educated guesses (Armstrong). In detail, these heuristics stand as strategies that are easy accessed information used to control problem solving by both human beings and machines as well. One of the most basic heuristics is trial and error, which involves searching for an answer based on a limited number of right answers and applying all solutions until the optimal solution is found (Armstrong). Other heuristics include drawing a picture, working backwards with a possible solution, and trying to examine a concrete example of a problem before a more abstract version.

Herd behavior and panic characteristics cause at times irrational and unexplainable behavior that completely alters the subconscious of its human actors (Knight). Herd behavior describes how individuals in a group can act together without planned direction. The term pertains to the behavior of animals in herds, flocks and schools, and to human behavior during activities such as stock market bubbles and crashes, street demonstrations, sporting events, and even everyday decision making and opinion forming (Zak). Recently an integrated approach to herding has been proposed, describing two key issues, the mechanisms of transmission of thoughts or behavior between individuals and the patterns of connections between them (Knight). It has been proposed that bringing together a multitude of different theoretical approaches of herding behavior allows the applicability of the concept to be applied many domains, ranging from cognitive neuroscience to economics. Asymmetric aggregation of animals under panic conditions has been observed in many species allowing for theoretical models to demonstrate symmetry breaking similar to observations in scientific studies (Cassidy). For example when panicked individuals are trapped to a room with two equal exits, a substantial majority will tend to favor one exit while the minority will favor the other (Cassidy). There are distinct characteristics of a herd in a state of panic. These include individuals moving faster than normal, physical interactions by individuals, exits become clogged, fallen individuals become obstacles, and alternative exits are usually overlooked (Cassidy). In The Theory of the Leisure Class, Thorstein Veblen explained economic behavior in terms of social influences such as "emulation," where some members of a group mimic other members of higher status (Armstrong).