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Meltdown links

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1) Leonard Lopate interview with Economist editor Greg Ip, formerly of the WSJ. (Scroll down the page to Financial Crisis: What Happens Next?). This is the best 12 minute summary of the current situation I have yet heard. Ip is consistently good at explaining this complicated subject in an accessible manner. If you have a friend who is confused about the credit crisis, have them listen to this interview. (Avoid Terri Gross and pals on this one… 😉

I have been listening to Leonard Lopate’s show for some time and I can tell his grasp of finance has increased dramatically in the last year or so (his strength is interviewing artists, writers, etc.). It’s yet another example of high-g at work. He knew almost nothing a year ago but now asks occasional perceptive questions. (But of course it doesn’t matter how smart our next President is!)

2) Mark Thoma discusses the pros and cons of mark to market accounting. To me it’s rather obvious that M2M accounting is exacerbating this crisis. It has introduced a very significant nonlinearity, both on the upside (bubble), and now in the collapse. If the market for mortgage assets has failed it is crazy to use it as a barometer for value. More discussion at WSJ.

3) This NYTimes Op-Ed written by a former theoretical physicist discusses agent-based simulation, behavioral economics and phase transitions — yes, in an Op-Ed! (Thanks again to reader STS for the pointer.)

Written by infoproc

October 1, 2008 at 7:43 pm

Mortgage securities oversold by 15-25 percent

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Below are some quotes which support the view that mortgage assets are currently undervalued by the market. Yes, the market is inefficient — it overpriced the assets at the peak of the bubble (greed), and is currently underpricing them (fear). Both Buffet and ex-Merrill banker Ricciardi below think the mispricing is about 15-25 percent. That is, the “fear premium” currently demanded by the market is 15-25 percent below a conservative guess as to what the assets are really worth. This is the margin that can be used to recapitalize banks, perhaps without costing the taxpayer any money, simply by providing a rational buyer of last resort and injecting some confidence into the market. Note to traders: yes, this is obvious. Note to academic economists: this is yet another market failure — but of an unprecedented scale and complexity.

(Actually, 15-25 percent is not bad, and just shows that credit markets are generally more rational and data driven than equities. During the Internet bubble and collapse you had mispricings of hundreds of percent, even an order of magnitude.)

Warren Buffet interview from CNBC:

Government intervention necessary to restore confidence in the market.

If I didn’t think the government was going to act, I would not be doing anything this week. I might be trying to undo things this week. I am, to some extent, betting on the fact that the government will do the rational thing here and act promptly.

Mispricing is about 15-20 percent:

…all the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government. And what they’re talking about is leveraging up to the tune of 700 billion, to in effect, offset the deleveraging that’s going on through all the financial institutions. And I might add, if they do it right, and I think they will do it reasonably right, they won’t do it perfectly right, I think they’ll make a lot of money. Because if they don’t — they shouldn’t buy these debt instruments at what the institutions paid. They shouldn’t buy them at what they’re carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments. If the government makes anything over its cost of borrowing, this deal will come out with a profit. And I would bet it will come out with a profit, actually.

Christopher Ricciardi, former head of Merrill’s structured credit business, in an open letter to Paulson. Note his comments illustrate the role that psychology, or animal spirits (Keynes), plays in the market.

The securitization market worked exceptionally well for decades and was the financing tool of choice for large and small institutions alike. As investments, performance for securitized assets typically exceeded corporate and Treasury bond investments for decades.

Where securitization went wrong in recent years was with subprime mortgages. These securitizations performed disastrously, causing people to mistakenly question the practice of securitization itself.

Decades of historical data were ignored, with the subprime experience exclusively driving market perceptions: The entire securitization market was effectively shut down, and this explains the depth and persistence of the ongoing credit crisis.

Government purchases of illiquid mortgage assets from the system will cost taxpayers significant sums and expose them to downside risk, without addressing this fundamental issue. Billions of dollars held by all the major institutional bond managers, hedge funds and distressed funds are already available to purchase mortgage assets.

However, in the absence of a way to finance the purchase of these assets, such funds must bid at prices which represent an attractive absolute return acceptable to their investors (15% to 25% typically), resulting in typical transaction terms that have significantly impeded the sale of mortgage securities to these funds. If these funds could finance their purchases, especially under efficient financing terms, they would still require similar returns, but would be able to buy many more assets, and bid higher prices for the assets.

Our financial system needs the capital markets and the natural power of securitization to get a jumpstart from the government. I propose using the powers granted to Treasury to create “vehicles that are authorized…to purchase troubled assets and issue obligations” under currently contemplated legislation to more efficiently address the crisis and establish a program which we might call the Federal Bond Insurance Corporation (”FBIC”), as an alternative to simply having the government directly purchase assets.

Comment re: behavioral economics. The preceding housing bubble and the current crisis are very good examples of why economics is, at a fundamental level, the study of ape psychology. On the planet Vulcan, Mr. Spock and other rational, super-smart traders and investors would have cleared this market already. But we don’t live on Vulcan. Anyone who wants to model the economy based on rational agents who can process infinite amounts of information without being subject to fear, bounded cognition, herd mentality, etc. is crazy.

When the conventional wisdom is that house prices never go down (people believed this just a couple years ago), you risk little of your reputation or self-image by investing in housing. When the conventional wisdom is that all mortgage backed securities are toxic, you must be extremely independent and strong willed to risk buying in, even if metrics suggest the market is oversold. This is simple psychology. Very few people can resist conventional wisdom, even when it’s wrong.

Written by infoproc

September 26, 2008 at 5:11 pm

Confessions of a car dealer

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Ever wonder what’s behind the horrible experience of buying a car at a dealership? What the negotiation looks like from the other side?

There’s a great podcast up on Econtalk, in which Russ Roberts (econ prof at George Mason) interviews a sales manager at a Honda dealership. Did you know that everyone working on the sales side, including the manager, is on 100% commission-based compensation? The average amount earned by the salesman on the sale of a new car is about $350. Check out the comments as well.

The sales manager adopts a stubbornly behavioral position for why prices of cars are not set in a more transparent manner — that we are culturally conditioned to haggle over car prices. In the comments several more traditional economic (game or information theoretic) arguments are proposed. How does it work in other countries? Are Japanese car salesmen just like their American counterparts?

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June 10, 2008 at 6:54 pm


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If this article by John Cassidy in the New York Review of Books is any guide, Obama’s grasp of economics may be orders of magnitude deeper than that of John McCain. A long exposure to the market-obsessed Chicago School has probably made him at least familiar with the arguments favoring market outcomes over government intervention. The remainder of the article is mainly about behavioral economics, rather than Obama, but well worth reading.

…Should Obama win the nomination, political considerations may well force upon him a more interventionist position, but his first inclination is to seek a path between big government and laissez-faire, a trait that reflects his age—he was born in 1961—and the intellectual milieu he emerged from. Before entering the Illinois state Senate, he spent ten years teaching constitutional law at the University of Chicago, where respect for the free market is a cherished tradition. His senior economic adviser, Austan Goolsbee, is a former colleague of his at Chicago and an expert on the economics of high-tech industries. Goolsbee is not a member of the “Chicago School” of Milton Friedman and Gary Becker, but he is not well known as a critic of American capitalism either. As recently as March 2007, he published an article in The New York Times pointing out the virtues of subprime mortgages. “The three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans,” Goolsbee wrote. “These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital.”

When I spoke to Goolsbee earlier this year, he said that one of the things that distinguished Obama from Clinton was his skepticism about standard Keynesian prescriptions, such as relying on tax policy to stimulate investment and saving. In a recent posting on, Cass Sunstein, who for ten years was a colleague of Obama’s at the University of Chicago Law School—and has said he is “an informal, occasional adviser to him”—made a similar point regarding government oversight of the financial markets: “With respect to the mortgage crisis, credit cards and the broader debate over credit markets,” Sunstein wrote, “Obama rejects heavy-handed regulation and insists above all on disclosure, so that consumers will know exactly what they are getting.”

If Obama isn’t an old-school Keynesian, what is he? One answer is that he is a behavioralist—the term economists use to describe those who subscribe to the tenets of behavioral economics, an increasingly popular discipline that seeks to marry the insights of psychology to the rigor of economics. Although its intellectual roots go back more than thirty years, to the pioneering work of two Israeli psychologists, Amos Tversky and Daniel Kahneman, behavioral economics took off only about ten years ago, and many of its leading lights, among them David Laibson and Andrei Shleifer, of Harvard; Matt Rabin, of Berkeley; and Colin Camerer, of Caltech, are still in their thirties or forties. One of the reasons this approach has proved so popular is that it appears to provide a center ground between the Friedmanites and the Keynesians, whose intellectual jousting dominated economics for most of the twentieth century.

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June 8, 2008 at 2:48 pm

New Yorker on behavioral economics

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Elizabeth Kolbert reviews two recent books on behavioral economics. She even notes the negative consequences of “irrationality” for democracy.

NewYorker: …Over the years, Tversky and Kahneman’s initial discoveries have been confirmed and extended in dozens of experiments. In one example, Ariely and a colleague asked students at M.I.T.’s Sloan School of Management to write the last two digits of their Social Security number at the top of a piece of paper. They then told the students to record, on the same paper, whether they would be willing to pay that many dollars for a fancy bottle of wine, a not-so-fancy bottle of wine, a book, or a box of chocolates. Finally, the students were told to write down the maximum figure they would be willing to spend for each item. Once they had finished, Ariely asked them whether they thought that their Social Security numbers had had any influence on their bids. The students dismissed this idea, but when Ariely tabulated the results he found that they were kidding themselves. The students whose Social Security number ended with the lowest figures—00 to 19—were the lowest bidders. For all the items combined, they were willing to offer, on average, sixty-seven dollars. The students in the second-lowest group—20 to 39—were somewhat more free-spending, offering, on average, a hundred and two dollars. The pattern continued up to the highest group—80 to 99—whose members were willing to spend an average of a hundred and ninety-eight dollars, or three times as much as those in the lowest group, for the same items.

This effect is called “anchoring,” and, as Ariely points out, it punches a pretty big hole in microeconomics. When you walk into Starbucks, the prices on the board are supposed to have been determined by the supply of, say, Double Chocolaty Frappuccinos, on the one hand, and the demand for them, on the other. But what if the numbers on the board are influencing your sense of what a Double Chocolaty Frappuccino is worth? In that case, price is not being determined by the interplay of supply and demand; price is, in a sense, determining itself.

…A few weeks ago, the Bureau of Economic Analysis released its figures for 2007. They showed that Americans had collectively amassed ten trillion one hundred and eighty-four billion dollars in disposable income and spent very nearly all of it—ten trillion one hundred and thirty-two billion dollars. This rate of spending was somewhat lower than the rate in 2006, when Americans spent all but thirty-nine billion dollars of their total disposable income.

According to standard economic theory, the U.S. savings rate also represents rational choice: Americans, having reviewed their options, have collectively resolved to spend virtually all the money that they have. According to behavioral economists, the low savings rate has a more immediate explanation: it proves—yet again—that people have trouble acting in their own best interests. It’s worth noting that Americans, even as they continue to spend, say that they should be putting more money away; one study of participants in 401(k) plans found that more than two-thirds believed their savings rate to be “too low.”

…Like neoclassical economics, much democratic theory rests on the assumption that people are rational. Here, too, empirical evidence suggests otherwise. Voters, it has been demonstrated, are influenced by factors ranging from how names are placed on a ballot to the jut of a politician’s jaw. A 2004 study of New York City primary-election results put the advantage of being listed first on the ballot for a local office at more than three per cent—enough of a boost to turn many races. (For statewide office, the advantage was around two per cent.) A 2005 study, conducted by psychologists at Princeton, showed that it was possible to predict the results of congressional contests by using photographs. Researchers presented subjects with fleeting images of candidates’ faces. Those candidates who, in the subjects’ opinion, looked more “competent” won about seventy per cent of the time.

When it comes to public-policy decisions, people exhibit curious—but, once again, predictable—biases. They value a service (say, upgrading fire equipment) more when it is described in isolation than when it is presented as part of a larger good (say, improving disaster preparedness). They are keen on tax “bonuses” but dislike tax “penalties,” even though the two are functionally equivalent. They are more inclined to favor a public policy when it is labelled the status quo. In assessing a policy’s benefits, they tend to ignore whole orders of magnitude. In an experiment demonstrating this last effect, sometimes called “scope insensitivity,” subjects were told that migrating birds were drowning in ponds of oil. They were then asked how much they would pay to prevent the deaths by erecting nets. To save two thousand birds, the subjects were willing to pay, on average, eighty dollars. To save twenty thousand birds, they were willing to pay only seventy-eight dollars, and to save two hundred thousand birds they were willing to pay eighty-eight dollars.

What is to be done with information like this? We can try to become more aware of the patterns governing our blunders, as “Predictably Irrational” urges. Or we can try to prod people toward more rational choices, as “Nudge” suggests. But if we really are wired to make certain kinds of mistakes, as Thaler and Sunstein and Ariely all argue, we will, it seems safe to predict, keep finding new ways to make them. (Ariely confesses that he recently bought a thirty-thousand-dollar car after reading an ad offering FREE oil changes for the next three years.)

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February 19, 2008 at 6:47 pm

Tyler Cowen and rationality

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I recently came across the paper How economists think about rationality by Tyler Cowen. Highly recommended — a clear and honest overview.

The excerpt below deals with rationality in finance theory and strong and weak versions of efficient markets. I believe the weak version; the strong version is nonsense. (See, e.g, here for a discussion of limits to arbitrage that permit long lasting financial bubbles. In other words, capital markets are demonstrably far from perfect, as defined below by Cowen.)

Although you might think the strong version of EMH is only important to traders and finance specialists, it is also very much related to the idea that markets are good optimizers of resource allocation for society. Do markets accurately reflect the “fundamental value of corporations”? See related discussion here.

Financial economics has one of the most extreme methods in economic theory, and increasingly one of the most prestigious. Finance concerns the pricing of market securities, the determinants of market returns, the operating of trading systems, the valuation of corporations, and the financial policies of corporations, among other topics. Specialists in finance can command very high salaries in the private sector and have helped design many financial markets and instruments. To many economists, this ability to “meet a market test” suggests that financial economists are doing something right. Depending on one’s interpretation, the theory of finance makes either minimal or extreme assumptions about rationality. Let us consider the efficient markets hypothesis (EMH), which holds the status of a central core for finance, though without commanding universal assent. Like most economic claims, EMH comes in many forms, some weaker, others stronger. The weaker versions typically claim that deliberate stock picking does not on average outperform selecting stocks randomly, such as by throwing darts at the financial page. The market already incorporates information about the value of companies into the stock prices, and no one individual can beat this information, other than by random luck, or perhaps by outright insider trading.

Note that the weak version of EMH requires few assumptions about rationality. Many market participants may be grossly irrational or systematically biased in a variety of ways. It must be the case, however, that their irrationalities are unpredictable to the remaining rational investors. If the irrationalities were predictable, rational investors could make systematic extra-normal profits with some trading rule. The data, however, suggest that it is very hard for rational investors to outperform the market averages. This suggests that extant irrationalities are either very small, or very hard to predict, two very different conclusions. The commitment that one of these conclusions must be true does not involve much of a substantive position on the rationality front.

The stronger forms of EMH claim that market prices accurately reflect the fundamental values of corporations and thus cannot be improved upon. This does involve a differing and arguably stronger commitment to a notion of rationality.

Strong EMH still allows that most individuals may be irrational, regardless of how we define that concept. These individuals could literally be behaving on a random basis, or perhaps even deliberately counter to standard rationality assumptions. It is assumed, however, that at least one individual does have rational information about how much stocks are worth. Furthermore, and most importantly, it is assumed that capital markets are perfect or nearly perfect. With perfect capital markets, the one rational individual will overwhelm the influence of the irrational on stock prices. If the stock ought to be worth $30 a share, but irrational “noise traders” push it down to $20 a share, the person who knows better will keep on buying shares until the price has risen to $30. With perfect capital markets, there is no limit to this arbitrage process. Even if the person who knows better has limited wealth, he or she can borrow against the value of the shares and continue to buy, making money in the process and pushing the share price to its proper value.

So the assumptions about rationality in strong EMH are tricky. Only one person need be rational, but through perfect capital markets, this one person will have decisive weight on market prices. As noted above, this can be taken as either an extreme or modest assumption. While no one believes that capital markets are literally perfect, they may be “perfect enough” to allow the rational investors to prevail.

“Behavioral finance” is currently a fad in financial theory, and in the eyes of many it may become the new mainstream. Behavioral finance typically weakens rationality assumptions, usually with a view towards explaining “market anomalies.” Almost always these models assume imperfect capital markets, to prevent a small number of rational investors from dwarfing the influence of behavioral factors. Robert J. Shiller claims that investors overreact to very small pieces of information, causing virtually irrelevant news to have a large impact on market prices. Other economists argue that some fund managers “churn” their portfolios, and trade for no good reason, simply to give their employers the impression that they are working hard. It appears that during the Internet stock boom, simply having the suffix “dot com” in the firm’s name added value on share markets, and that after the bust it subtracted value.11

Behavioral models use looser notions of rationality than does EMH. Rarely do behavioral models postulate outright irrationality, rather the term “quasi-rationality” is popular in the literature. Most frequently, a behavioral model introduces only a single deviation from classical rationality postulates. The assumption of imperfect capital markets then creates the possibility that this quasi-rationality will have a real impact on market phenomena.

The debates between the behavioral theories and EMH now form the central dispute in modern financial theory. In essence, one vision of rationality — the rational overwhelm the influence of the irrational through perfect capital markets — is pitted against another vision — imperfect capital markets give real influence to quasi-rationality. These differing approaches to rationality, combined with assumptions about capital markets, are considered to be eminently testable.

Game theory and the failed quest for a unique basis for rationality:

Game theory has shown economists that the concept of rationality is more problematic than they had previously believed. What is rational depends not only on the objective features of the problem but also depends on what actors believe. This short discussion has only scratched the surface of how beliefs may imply very complex solutions, or multiple solutions. Sometimes the relevant beliefs, for instance, are beliefs about the out-of-equilibrium behavior of other agents. These beliefs are very hard to model, or it is very hard to find agreement among theorists as to how they should be modeled.

In sum, game theorists spend much of their time trying to figure out what rationality means. They are virtually unique amongst economists in this regard. Game theory from twenty years ago pitted various concepts of rationality against each other in purely theoretical terms. Empirical results had some feedback into this process, such as when economists reject Nash equilibrium for some of its counterintuitive predictions, but it remains striking how much of the early literature does not refer to any empirical tests. This enterprise has now become much more empirical, and more closely tied to both computational science and experimental economics.

Computational economics and the failed quest for a unique basis for rationality:

Nonetheless it is easy to see how the emphasis on computability puts rationality assumptions back on center stage, and further breaks down the idea of a monolithic approach to rationality. The choice of computational algorithm is not given a priori, but is continually up for grabs. Furthermore the choice of algorithm will go a long way to determining the results of the model. Given that the algorithm suddenly is rationality, computational economics forces economists to debate which assumptions about procedural rationality are reasonable or useful ones.

The mainstream criticism of computational models, of course, falls right out of these issues. Critics believe that computational models can generate just about “any” result, depending on the assumptions about what is computable. This would move economics away from being a unified science. Furthermore it is not clear how we should evaluate the reasonableness of one set of assumptions about computability as opposed to another set. We might consider whether the assumptions yield plausible results, but if we already know what a plausible result consists of, it is not clear why we need computational theories of rationality.

As you can tell from my comments, I do not believe there is any unique basis for “rationality” in economics. Humans are flawed information processing units produced by the random vagaries of evolution. Not only are we different from each other, but these differences arise both from genes and the individual paths taken through life. Can a complex system comprised of such creatures be modeled through simple equations describing a few coarse grained variables? In some rare cases, perhaps yes, but in most cases, I would guess no. Finance theory already adopts this perspective in insisting on a stochastic (random) component in any model of security prices. Over sufficiently long timescales even the properties of the random component are not constant! (Hence, stochastic volatility, etc.)

Written by infoproc

July 30, 2007 at 4:38 pm

Behavioral economics

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I found this overview and intellectual history of behavioral economics via a link from Economist’s View.

By now I think anyone who has looked at the data knows that the agents — i.e., humans — participating in markets are limited in many ways. (Only a mathematics-fetishizing autistic, completely disconnected from empiricism, could have thought otherwise.) If the agents aren’t reliable or even particularly good processors of information, how does the system find its neoclassical equilibrium? (Can one even define the equilibrium if there are not individual and aggregate utility functions?)

The next stage of the argument is whether the market magically aggregates the decisions of the individual agents in such a way that their errors cancel. In some simple cases (see Wisdom of Crowds for examples) this may be the case, but in more complicated markets I suspect (and the data apparently show; see below) that cancellation does not occur and outcomes are suboptimal. Where does this leave neoclassical economics? You be the judge!

Related posts here (Mirowski) and here (irrational voters and rational agents?).

The paper (PDF) is here. Some excerpts below.

Opening quote from Samuelson and Conclusions:

I wonder how much economic theory would be changed if [..] found to be empirically untrue. I suspect, very little.
–Paul Samuelson


Samuelson’s claim at the beginning of this paper that a falsification would have little effect on his economics remains largely an open question. On the basis of the overview provided in this paper, however, two developments can be observed. With respect to the first branch of behavioral economics, Samuelson is probably right. Although the first branch proposes some radical changes to traditional economics, it protects Samuelson’s economics by labeling it a normative theory. Kahneman, Tversky, and Thaler propose a research agenda that sets economics off in a different direction, but at the same time saves traditional economics as the objective anchor by which to stay on course.

The second branch in behavioral economics is potentially much more destructive. It rejects Samuelson’s economics both as a positive and as a normative theory. By doubting the validity of the exogeneity of preference assumption, introducing the social environment as an explanatory factor, and promoting neuroscience as a basis for economics, it offers a range of alternatives for traditional economics. With game theory it furthermore possesses a powerful tool that is increasingly used in a number of related other sciences. …

Kahneman and Tversky:

Over the past ten years Kahneman has gone one step beyond showing how traditional economics descriptively fails. Especially prominent, both in the number of publications Kahneman devotes to it and in the attention it receives, is his reinterpretation of the notion of utility.13 For Kahneman, the main reason that people do not make their decisions in accordance with the normative theory is that their valuation and perception of the factors of these choices systematically differ from the objective valuation of these factors. This is what amongst many articles Kahneman and Tversky (1979) shows. People’s subjective perception of probabilities and their subjective valuation of utility differ from their objective values. A theory that attempts to describe people’s decision behavior in the real world should thus start by measuring these subjective values of utility and probability. …


Thaler distinguishes his work, and behavioral economics generally, from experimental economics of for instance Vernon Smith and Charles Plott. Although Thaler’s remarks in this respect are scattered and mostly made in passing, two recurring arguments can be observed. Firstly, Thaler rejects experimental economics’ suggestion that the market (institutions) will correct the quasi-rational behavior of the individual. Simply put, if one extends the coffee-mug experiment described above with an (experimental) market in which subjects can trade their mugs, the endowment effect doesn’t change one single bit. Furthermore, there is no way in which a rational individual could use the market system to exploit quasi-rational individuals in the case of this endowment effect36. The implication is that quasi-rational behavior can survive. As rational agents cannot exploit quasi-rational behavior, and as there seems in most cases to be no ‘survival penalty’ on quasi-rational behavior, the evolutionary argument doesn’t work either.

Secondly, experimental economics’ market experiments are not convincing according to Thaler. It makes two wrong assumptions. First of all, it assumes that individuals will quickly learn from their mistakes and discover the right solution. Thaler recounts how this has been falsified in numerous experiments. On the contrary, it is often the case that even when the correct solution has been repeatedly explained to them, individuals still persist in making the wrong decision. A second false assumption of experimental economics is to suppose that in the real world there exist ample opportunity to learn. This is labeled the Ground Hog Day argument37, in reference to a well-known movie starring Bill Murray. … Subjects in (market) experiments who have to play the exact same game for tens or hundreds of rounds may perhaps be observed to (slowly) adjust to the rational solution. But real life is more like a constant sequence of the first few round of an experiment. The learning assumption of experimental economics is thus not valid.


But perhaps even more destructive for economics is the fact that individuals’ intertemporal choices can be shown to be fundamentally inconsistent49. People who prefer A now over B now also prefer A in one month over B in two months. However, at the same time they also prefer B in one month and A in two months over A in one month and B in two months.


The ultimatum game (player one proposes a division of a fixed sum of money, player two either accepts (the money is divided according to the proposed division), or rejects (both players get nothing)) has been played all over the world and leads always to the result that individuals do not play the ‘optimum’ (player one proposes the smallest amount possible to player two and player two accepts), but typically divide the money about half-half. The phenomenon is remarkably stable around the globe. However, the experiments have only been done with university students in advanced capitalist economies. The question is thus whether the results hold when tested in other environments.

The surprising result is not so much that the average proposed and accepted divisions in the small-scale societies differ from those of university students, but how they differ. Roughly, the average proposed and accepted divisions go from [80%,20%] to [40%,60%]. The members of the different societies thus show a remarkable difference in the division they propose and accept.

…“preferences over economic choices are not exogenous as the canonical model would have it, but rather are shaped by the economic and social interactions of everyday life. …”

Camerer’s critique is similar to Loewenstein’s and can perhaps best be summed up with the conclusion that for Camerer there is no invisible hand. That is, for Camerer nothing mysterious happens between the behavior of the individual and the behavior of the market. If you know the behavior of the individuals, you can add up these behaviors to obtain the behavior of the market. In Anderson and Camerer (2000), for instance, it is shown that even when one allows learning to take place, a key issue for experimental economics, the game does not necessarily go to the global optimum, but as a result of path-dependency may easily get stuck in a sub-optimum. Camerer (1987) shows that, contrary to the common belief in experimental economics, decision biases persist in markets. In a laboratory experiment Camerer finds that a market institution does not reduce biases but may even increase them. …


The second branch of behavioral economics is organized around Camerer, Loewenstein, and Laibson. It considers the uncertainty of the decision behavior to be of an endogenous or strategic nature. That is, the uncertainty depends upon the fact that, like the individual, also the rest of the world tries to make the best decision. The most important theory to investigate individual decision behavior under endogenous uncertainty is game theory. The second branch of behavioral economics draws less on Kahneman and Tversky. What it takes from them is the idea that traditional Samuelson economics is plainly false. It argues, however, that traditional economics is both positively/descriptively and normatively wrong. Except for a few special cases, it neither tells how the individuals behave, nor how they should behave. The main project of the second branch is hence to build new positive theories of rational individual economic behavior under endogenous uncertainty. And here the race is basically still open.

Written by infoproc

July 14, 2007 at 7:36 pm