Behavioral Economics - Sp 11
1. Introduction
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 Post Keynesian economics, as it was in the economic thinking of John Maynard Keynes. While risk can be quantified, uncertainty simply cannot. By investigating literature on behavioral economics, uncertainty and risk can be addressed with the use of two different theories; non-expected utility and the utility choice theory. 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
3.Indecision and Inefficiencies in the market
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.
