Wednesday, December 22, 2010

The Future of Behavioral Economics: A Conjecture

Conventional economic theory is based on the assumption that individuals act rationally. Behavioral economics modifies that by trying to take account of various observed patterns of predictable irrationality. A recent post of mine on a different blog discussed my somewhat mixed views of the project. Thinking further on the subject, a conjecture about the future of behavioral economics occurred to me.

Most of the applications of the theory that I have seen concern decisions by individuals, employees, firms in the general area covered by price theory, more commonly and misleadingly labeled "microeconomics." My conjecture is that where behavioral economics will actually matter, if it matters, will be in disequilibrium theory, more commonly labeled "macroeconomics."

Price theory is a reasonably well understood structure of ideas that works reasonably well. Markets are observed to successfully solve the complicated coordination problem underlying any but the simplest economy; steel mills don't shut down because nobody is mining enough ore, or car companies because nobody is producing enough steel. Obvious predictions of the theory—surpluses when price is fixed above the market level, shortages when it is fixed below, increases in price when supply is restricted, market prices responding to (estimates of) future as well as present supply and demand—are routinely observed. The theory is not, of course, a perfect description of reality, and behavioral economics might improve it a little. But, at the fundamental level, there is no need to fix something that isn't broken.

Disequilibrium theory, the theory that is supposed to explain business cycles, involuntary unemployment, and similar observed phenomena, is much more of a problem. If you simply take the tools of price theory and turn the crank, you get clear answers to the relevant questions. The price of labor equates supply and demand on the labor market as on other markets, so there is no involuntary unemployment, save when minimum wage laws prevent wages from moving to their equilibrium level. Firms and employees make their decisions taking account of rational predictions of future as well as present conditions, so there is no business cycle. The analysis is straightforward. And the conclusions are wrong.

There have been a variety of attempts to solve this problem over the past century or so. Fifty years back, the Keynesian version of macroeconomics was pretty general accepted. It turned out that it too gave incorrect predictions, and academic economists largely abandoned it, although it retained its popularity with journalists, politicians, and much of the general public and was revived with great confidence in response to recent problems. A variety of other attempts to solve these problems have been made. So far as I can tell—it is not my field, so I am judging as an observer, not a participant—none of them has combined a clear, convincing analysis with a correct prediction of real world observations.

If the rational model gives, for this set of questions, the wrong answer, perhaps the solution is a model that incorporates irrational behavior. That is what behavioral economics attempts to provide. If it succeeds, that will be an important contribution to economic theory, a much more important contribution than a collection of observations about particular mistakes made by individual economic actors.

17 Comments:

At 1:06 PM, December 22, 2010, Blogger Julien Couvreur said...

What bothers me about the notion of "predictable irrationality" is the failure to define rationality in the first place and explain why we'd expect humans to behave that way.

In contrast, Mises does provide a definition for rationality (although admittedly somewhat tautological). As long as individuals act in ways they think will achieve the ends they aim for, that action is rational.

 
At 4:05 PM, December 22, 2010, Anonymous Anonymous said...

One man's irrationality is another man's rational preference.

 
At 7:39 PM, December 22, 2010, Anonymous Ricardo Cruz said...

David, do you not find plausible the generally accepted Keynesian idea of downwardly sticky wages?

That's a point that could have came out from the minds of behavioural economists.

 
At 7:40 PM, December 22, 2010, Anonymous Nicholas D. Rosen said...

Are you familiar with Professor Mason Gaffney's updating of Henry George's explanation of the boom-bust cycle and unemployment? It seems to explain the facts without assuming irrationality. Basically, when the economy booms, land rents rise; land selling prices rise to an even greater degree, to reflect expected future increases in land rents; people invest in land with leverage, because they have to, in order to afford land, and because it looks like a safe bet. The easy availability of mortgages helps pump up land prices further.

This can't go on forever, so sooner or later it doesn't. Once land prices stop rising, they can't stabilize, since they were based on expected further increases, not value for current use, so they crash. This brings down land speculators and the financial institutions that got in over their heads, and creates awave of business failures and unemployment.

It does seem to explain the eents of the past few years.

 
At 9:18 PM, December 22, 2010, Anonymous Anonymous said...

What behavioral economics hasn't incorporated yet are the distortions created by the system of central banking worldwide. These interwoven distortions are fundamental to the unleashing of 'irrational behavior' found in business cycles. Some great economists with some 'cohones' to challenge the status quo will need to integrate this model into their research (of course I would do the research myself but I have to mow the lawn of my underwater home I bought and refi-ed 'irrationally' thanks to the low interest rate policy of the Federal Reserve).

 
At 10:09 AM, December 23, 2010, Anonymous Kid said...

The "macroeconomy" is so unbelievably complex v_v

The previous commentator makes a point about the banking system, which influences everything, but everything influences everything.

How can you make sense out of it? Rational people or not.

 
At 10:12 AM, December 23, 2010, Anonymous Kid said...

Humans that have been made aware of their own irrationalities can, to a large extent, compensate by thinking in a structured way. I expect that with a lot of money on the line, firms will still attempt to make rational decisions, even if actors involved in those decisions are irrational for a large part of their lives.

What of the prisoner's dilemma analysis of boom and bust cycles? That seems to be another way to explain perceived irrationality without requiring irrational actors.

 
At 12:41 PM, December 23, 2010, Blogger Purgatus said...

This is no different than the challenges facing all social sciences which attempt to predict future behavior. My own field is International Relations and I have long been interested in Realist theory and the Unified Rational Actor assumptions that underpin it.

Modelling or envisioning a state as a unified rational actor is a useful but not truthful act. It is reductionist in the way that all such models are reductionist.

I am a believer in subjective rationality and flawed rationality. Actors pursue their ends to their best of their means, though their ends may seem irrational to an outside observer, and their means may seem flawed to those with superior access to information or better reasoning skills. For a state actor you can presume a Hobbesian imperitive of self-preservation and you can further presume a solid reasoning ability provided by the conglomerate of the state.

What you cannot presume is that the ends of the state beyond self preservation are completely known to you, or that the state has access to the same information you do.

 
At 12:59 AM, December 24, 2010, Blogger Maciek said...

I wonder, in what sense behavioral economists can speak about irrational behavior, when it is predictable. Maybe it depends on the notion of rationality? We can have to deal with a different models of rationality, not only with game-theoretic, strategic (or “conventional economic”), but f. e. with a communicative rationality, which is connected with a debate on abstract values and goods in society (Habermas). Taking this into account we can see f. e. participation in elections as economically and individually irrational, because a participant can’t be elected personally, and his transaction costs are bigger than his benefits from participation. The same behavior we can see as rational from a communicative rationality’s point of view, because the participation in public debate as such can be something valuable for participant (this kind of rationalization of group behavior is often presented before election campaign by mass media). Apart from that, we have a lot of other possibilities to explain the sense of participation in elections, none of them could be call “irrational” (irrationality can be at least also a question of lack of our information about motivations of person). Isn’t it only a verbal question? And another question: I am not an economist (I deal with theory of law and politics) and I don’t know a relationship between behavioral and institutional economy, but it seems to me that an institutional economy deal with something similar.

 
At 3:51 PM, December 24, 2010, Blogger Jonathan said...

Io, Saturnalia! No-one behaves rationally at this time of year.

 
At 3:50 AM, December 25, 2010, Anonymous Ricardo Cruz said...

Maciek writes:
Taking this into account we can see f. e. participation in elections as economically and individually irrational, because a participant can’t be elected personally, and his transaction costs are bigger than his benefits from participation.

So, if you are a member of some board, you won't vote unless you can be elected chairman?!

What economists tend to say is that making an _informed_ vote in an electorate of a few thousand is not rational (rational ignorance). That property is not exclusive of democratic government btw.

--

Anyhow, I still think the idea of downwardly sticky wages is pretty much a behavioral economics point, and serves to explain much of macro behavior (or misbehavior). For those who don't know: the sticky wages thesis says that workers assign an irrational importance to nominal wages versus real wages. If prices increase by 100%, then workers won't blame their employers and their productivity stays immaculate. However, if the employer is forced to cut wages by 50% (which should have the equivalent income effect), then workers will resent, will strike, etc: hence why employers will fire workers rather than cut wages on a downturn.
Wages are not the only prices that expose such a property btw: consider for instance house prices too. People won't sell their house "unless I can sell by the amount I bought it", and by amount they mean the nominal number, not the real price. Keynesians therefore suggests recessions can be averted by some inflation, and recommend deflation be absolutely avoided. How to do that is when it gets messier: fiscal stimulus (money velocity) or monetary stimulus (money quantity).

 
At 9:38 AM, December 25, 2010, Blogger Julien Couvreur said...

The idea of sticky wages is intuitively plausible, but is it true?
How is it defined, and was it ever validated?

 
At 10:32 AM, December 25, 2010, Blogger John Lott said...

My guess is that when the rational model gives "the wrong result" it is often because the economist got the model wrong. When I was at the Univ of Chicago Thaler and Sunstein gave a paper on Behavioral Economics. In one example after another the audience would point out alternative rational explanations for the claimed results. Indeed, it frequently seemed as if Thaler had set up a strawman to illustrate the failure of the rational model. Finally in frustration Dick Posner asked Thaler for his best example illustrating irrationality. Thaler's pointed out that for years he had started the beginning of each term asking students what grades they expected to get in the class, with all the students expecting to get the average grade or higher. The obvious problems were quickly raised. Even if the questions were given so as to protect the identity of the student if there was even the tiniest probability that the professor would learn that you expected to get a "D" in the class, why provide that information. Also what was the gain to accurately predicting what the student's grade would be. There was no reward for correctly stating what one expected to get. Possibly Thaler would point to another example now.

I think that behavioral economics risks what monopoly power has become for economists. That whenever they see something that they can't instantly explain, they call it a result of monopoly power. Behavioral economics is also a way for those who practice it to have more variations on existing models.

 
At 11:37 AM, December 28, 2010, Anonymous Rick Pulito said...

I believe that most traditional viewpoints on economic decision-making presume that humans seek to maximize their individual economic benefit.
Studies by Ariely, Thaler/Sundstein, and Ran Kivetz (Columbia Univ), as well as considerable "real world" studies done by our firm, BI Worldwide (a global behavior change agency), indicate that there is significant divergence from this traditional rational/economic model.
Rational thought processes are often used to "legitimize" decisions that would otherwise appear to be purely emotionally driven. However, the fact is that people are emotional creatures, not always rational...
Is there a place for behavioral economics? Absolutely. Do we understand sufficiently how people make decisions? Not nearly. As such, neither traditional economic theory nor the concepts of behavioral economics will entirely suffice.
Why, for instance, do you see a higher percentage of participants in a loyalty program that requires increased numbers of purchases to receive an identical payoff as a parallel offer which requires a lesser number of purchases? Clearly not a matter of rational thought going on there. But it is a replicable study that has borne similar results in a number of test environments.
It would be foolish to dismiss behavioral economics as being "faddish" because it flies in the face of traditional beliefs.
I would invite you to come visit my blog, http://ideationz.wordpress.com for additional discussions on change. Interesting post. Thank you. Rick S. Pulito

 
At 8:52 PM, December 30, 2010, Anonymous SheetWise said...

In all market trades, half of the parties are irrational. We just don't which half until the market tells us.

 
At 2:17 PM, January 04, 2011, Anonymous Anonymous said...

What about the fact that Austrian business cycle theory has gained popularity? Though largely outside of mainstream academia, its growing surge through all facets of society is undeniable. Most interesting is how it provides a "microeconomic" foundation for what is now traditional macro phenomenon. The results are obvious in basic price theory, its amazing how widely the theory is denied. This is mostly because people lack the skill of identifying the variables appropriately in economic events in order to "verify" parts of the theory or design falsifiability tests. It also takes just ignoring basic theory that we already know to be true (via pure logic or via or other empirical measures like those outlined in your post). Verifying money supply, for example, is not a simple task when virtually no single number currently provided by government or major private sources addresses what the money supply truly is. although all measures have some purpose this is almost always misinterpreted. The whole structured theory around most monetary based economics misunderstands fundamental facts and has built their analysis incorrectly as a result.

i'd really suggest you start focusing on macro given its current popularity and how much the field is corrupted. Its in a huge deficit of economists who can reground the theories in some sensible manner.

 
At 7:10 PM, January 16, 2011, Blogger Roger said...

"The Keynesian version of macroeconomics...was revived..."

I'm sorry, but I'd like some explanation of how any reasonably informed person could hold this belief. The initial stimulus proposed by the Obama administration in 2009 was widely predicted (by Keynesian macroeconomists)to be too small (about one-third of what was needed). Since then President Obama has embraced all the right-wing myths about the economy, including the idea that the problem is with the deficit, and he looks ready to destroy the Social Security program in pursuit of that delusion.

 

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