Sunday, February 15, 2009

Is behavioral economics your friend?

The NYT reports on a couple of interesting papers from the American Economic Association meetings last month in SF.

I am of several minds (pun fully intended) about behavioral economics. First, the name irritates me; all economics is properly about behavior. Second, I think some of theoretical work that transpires under the heading of behavioral economics, such as the development of new choice axioms, is largely wheel-spinning. Third, I think that in some quarters behavioral economics has induced a sort of looseness of thought. Instead of thinking very hard about a phenomenon in order to come up with a non-obvious rational choice explanation, someone simply blurts out "framing" or "hyperbolic discounting" and the thinking stops there. Fourth, it irritates me when people equate rational behavior with an assumption of costless information processing. It seems to me that the correct way to proceed is to incorporate a cognitive budget constraint into the optimization problem. It is hardly rational to spend huge amounts of costly cognitive resources to solve some problem when a quick, cheap but slightly wrong heuristic is available Our models should reflect this and, more broadly, we should not treat clearly irrational behavior as the benchmark of rationality. This requires learning a bit of psychology and/or neuroscience in order to get the budget constraint right. Fifth, I think that people who dismiss the entire behavioral economic enterprise ("wackonomics") based on the failings of some of its practitioners are being careless and making a serious mistake. There is important, policy relevant behavior to be explained that does not fit will with traditional models that assume costless information processing. I think economists have much to add in coming up with new and useful explanations of these behaviors.

Without blaming him for my current views in any way, I should note my major intellectual debt in this area to my graduate school colleague Nat Wilcox, now at the University of Houston, who introduced me to the literature on the boundary of psychology and economics long before it became fashionable.

Oh, and I must point out the glaring error by the NYT reporter:
Lotteries, for example, are the bane of many economists’ existence. People exhibit totally irrational behavior when it comes to such gambling, generally overvaluing the likelihood of winning. For example, let’s say you give a person two options: 1) a one-in-10 chance of receiving $100, or 2) a guaranteed payout of $10. He is much more likely to choose the first option, even though the two options have the exact same expected value (10 percent of $100 = $10). To economists, this makes little sense — both options should be equally appealing.
The two options are equally appealing only if the individual is risk neutral. Economists generally assume that individuals are risk averse, in which case the certain payment should be preferred. This is probably a very reasonable assumption in general but does poorly, as this example suggests, at explaining gambling.

Hat tip: Sarah Turner