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. 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.

At one end of the spectrum we have mathematical economists and pure theorists which form deductions from a controlled setting with a very small number of assumed as universal laws. This is in attempt to create the ability to regard economics as scientific in which their are exact laws and variables can be controlled. At the other extreme there is tendency to remove abstraction and deduction. This form relies on a descriptive science. This leaves every other opinion and form in between to counter and weigh the different measurements and theories.

Therefore, the study of economics stands as a science of human activities under a given form of organization. This rationalistic view of activity in search theory boils down to the search for the satisfaction of wants and desires of the given entities.

We will use the writings of authors such as:

• Camerer
  • Advances in Behavioral Economics
• Knight
  • Risk and Uncertainty
• Zak
  • Moral Markets: The Critical Role of Values in the Economy

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)

The application of the analytic method in any class of problems is always very incomplete. It is never possible to deal in this way with a very large proportion, numerically speaking, of the vast complexity of factors entering into a normal real situation such as we must cope with in practical life. The value of the method depends on the fact that in large groups of problem situations certain elements are common and are not merely present in each single case, but in addition are both few in number and important enough largely to dominate the situations. The laws of these few elements, therefore, enable us to reach an approximation to the law of the situation as a whole. They give us statements of what "tends" to hold true or "would" hold true under "ideal" conditions, meaning merely in a situation where the numerous and variable but less important "other things" which our laws do not take into account were entirely absent.

In a similar way, but for various reasons not so completely and satisfactorily, we have developed a historic body of theoretical economics which deals with "tendencies"; i.e., with what "would" happen under simplified conditions never realized, but always more or less closely approached in practice. But theoretical economics has been much less successful than theoretical physics in making the procedure useful, largely because it has failed to make its nature and limitations explicit and clear. It studies what would happen under "perfect competition," noting betimes respects in which competition is not perfect; but much remains to be done to establish a systematic and coherent view of what is necessary to perfect competition, just how far and in what ways its conditions deviate from those of real life and what "corrections" have accordingly to be made in applying its conclusions to actual situations

Economics is a human science; its foundations are laid in the principles of human behavior, and consequently we must begin with some observations on the psychology of human conduct which controls economic life. Economic analysis may be truly said to deal with acts adapted to ends, or of the adaptation of acts to ends, in contrast with the broader category of "behavior" in general. It assumes that men's acts are ruled by conscious motives; that, as it is more ordinarily expressed, they are directed toward the "satisfaction of wants." At the very outset the science is thus subjected to notable restrictions, since it is only to a limited extent that our behavior, even our economic behavior, is of this character. Much of it is more or less impulsive and capricious. The conclusions of economic theory must in general be admitted subject to the qualification, in so far as men's economic activities are rational or planned.

It appears that a relatively small fraction of the activities of civilized man are devoted to the gratification of needs or desires having any foundation beyond the mere fact that an impulse exists at the moment in the mind of the subject. Most human motives tend on scrutiny to assimilate themselves to the game spirit. It is little matter, if any, what we set ourselves to do; it is imperative to have some objective in view, and we seize upon and set up for ourselves objectives more or less at random—getting an education, acquiring skill at some art, making money, or what-not. But once having set ourselves to achieve some goal it becomes an absolute value, weaving itself into and absorbing life itself. It is just as in a game where the concrete objective—capturing our opponents' pieces, carrying a ball across a mark, or whatever it may be—is a matter of accident, but to achieve it is for the moment the end and aim of being. And, as in a game again, so with life generally, the social situation furnishes much of the driving power, though again there are many who can become intensely interested in solitaire.

Allais Paradox

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 Bias

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

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).

Heuristics

From a psychological standpoint, heuristics are much more straightforward. Characterized by efficient rules and evolutionary processes, heuristics are used to explain why people make certain decisions, form judgments, and solve problems that are usually void of certain information making them more complex (Tversky and Kahneman). Although these rules work well under most condition, certain variables or instances can cause systematic errors and cognitive biases that create anomalies that can be unexplainable and unpredictable. Amos Tversky, Daniel Kahneman, and Gerd Gigerenzer have accomplished the majority of the work concerning human decision-making and judgment. Kahneman proposed that heuristics work through a process known as attribute substitution, which occurs completely void of conscious awareness. Under this pretense, a judgment is made by an individual that is computationally intense and complex, and the individual substitutes this complex variable for an easier calculated heuristic attribute. This allows for the individual to cognitively developing a simpler problem to answer without the individual realize this strategy is even occurring, as he is consciously unaware of this substitution. This theory shows why cases of judgment are unable to show regression towards the mean. This is one of the reasons heuristics are considered to reduce the level of complexity of clinical judgments in the business world as well as why heuristic algorithms are used as they appear to work without have ever been proven mathematically or meet a predetermined set of requirements (Gigerenzer). A common pitfall can occur in which an engineer employs a model but fails to recognize that the data being used does not necessarily represent future system outputs. Although the algorithm can process the data over and over, one must realize that it is much more important to make sure the date being projected is concurrent with the data input. The engineer must understand the requirements of the data to insure the output data is not solely reflective of the input data but the output data as well. Statistical analysis is often used when employing these techniques in the form of p-values to measure the probability of incorrect outcomes. Another function of behavioral economics includes the use of framing. Framing relates itself to heuristics, as it is a social theory consisting of the concept of interpretation of a collection of anecdotes and stereotypes that individuals use to understand and respond to events. (Druckman 2001A) Through the use of framing, people develop emotional mental filters that are used to make sense of the world and in turn make choices that are influenced from this frame of reference. This social construction is a selective influence over someone’s perception, which deals directly with the meaning attributed to specific words or phrases that invoke certain emotions or rationalizations. This frame can encourage or discourage certain decisions depending on the individual’s history and preference. Due to framing being a heuristic and subconscious shortcut, humans are “cognitive misers” meaning they prefer to do as little as thinking as possible and rely heavily on these subconscious decision formulas that allow them to make split second decisions in multitudes of different scenarios (Druckman 2001A). Framing allows for quick and easy decisions to be obtained and to understand incoming stimuli. This gives the sender and framer of the information enormous power to use these schemas to influence how the receivers will interpret the message (Druckman 2001B)

Reciprocity

Reciprocity is a form of social psychology in reference to responding to a positive action with another positive action in return as well as responding with a negative action when a negative action precedes this action (Gigerenzer). This reciprocal action differs from altruistic behavior due to they only follow from receiving positive actions. These actions only occur with the expectation that they initial action will receive positive responses at some point in the future. These actions of reciprocity help explain social norms and are an important fundamental of social psychology (Zak). Must human societies consider breaking a social norm as an act of hostility and usually respond with an action to punish this disruption even when it costs the person to administer this punishment, Punishments range from verbal warnings to complete exclusion from society depending on the level and frequency of the infraction. In public good experiments, behavioral economists have demonstrated that the potential for reciprocal actions by players increases the rate of contribution to the public good, providing evidence for the importance of reciprocity in social situations (Druckman 2001A). In mathematics, game theory describes reciprocity as a highly effective strategy for the classic prisoner's dilemma. In this case, cooperating is dominated by selling the other prisoner out, as no matter what the other prisoner does, the other will always be better off by confessing the other person is guilty. Due to in any situation the defector is better off; all rational players will always defect. However, if the simulation can be repeated, it would benefit the players to cooperate with each other so that they could both benefit from reciprocity. But the biggest problem with this simulation is in the final simulation round, one player will no longer reciprocate and someone will end up losing everything. This brings the next idea to light in the form of bounded rationality in which individuals are limited to only the information privy to them at a given time.

5.Critics of Keynes

John Maynard Keynes once wrote to friend George Bernard Shaw: “I believe myself to be writing a book on economic theory which will largely revolutionize—not I suppose at once but in the course of the next ten years—the way the world thinks about economic problems. (John Keynes, 1935)”

Keynes made this statement while writing his well known piece titled The General Theory, and though some will argue, it seems as if his predictions made to Shaw were indeed true. After the completion of The General Theory, governments began implementing the policies put forth by Keynes and schools worldwide started to include his writings into the curriculum. Yet, with all of the praise that Keynesian economics received, came criticisms as well. For example, economic success after World War II has generally been connected with the adoption of the types of policies seen in Keynes’ writings. However, some insist that factors such as improved international economic relations and advancements in technology funded by private investors were what fueled the economy. Some scholars even claim that The General Theory is an attempt by Keynes to merely save capitalism (most of these critics are those who believe strongly in communism).

7. References

Works Cited Akerlof, George A., and Robert J. Shiller. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton: Princeton UP, 2009. Print. Cassidy, John. How Markets Fail: the Logic of Economic Calamities. New York: Farrar, Straus and Giroux, 2009. Print. Druckman, J. “ Evaluating Framing Effects.” Journal of Economic Psychology; 2001A, 22: 96-101 Druckman J. “Using Credible Advice to Overcome Framing Effects.” Journal of Law, Economics, and Organization: 2001B, 17: 62-82 Gigerenzer, Gerd. Rationality for Mortals: How People Cope with Uncertainty. Oxford: Oxford UP, 2008. Print. Knight, Jack. Institutions and Social Conflict. Cambridge [England: Cambridge UP, 1992. Print. Plous, Scott. The Psychology of Judgment and Decision Making. Philadelphia: Temple UP, 1993. Print. Tversky, A., and D. Kahneman. The Framing of Decisions and the Psychology of Choice. 1981. Print. Zak, Paul J. Moral Markets: the Critical Role of Values in the Economy. Princeton: Princeton UP, 2008. Print.