… because today the Science journal published a short commentary [subscription required] written by myself and John List, on the topic of behavioral economics. Our piece begins like this:
The discipline of economics is built on the shoulders of the mythical species Homo economicus. Unlike his uncle, Homo sapiens, H. economicus is unswervingly rational, completely selfish, and can effortlessly solve even the most difficult optimization problems. This rational paradigm has served economics well, providing a coherent framework for modeling human behavior. However, a small but vocal movement in economics has sought to dethrone H. economicus, replacing him with someone who acts “more human.” This insurgent branch, commonly referred to as behavioral economics, argues that actual human behavior deviates from the rational model in predictable ways. Incorporating these features into economic models, proponents argue, should improve our ability to explain observed behavior.
But we remain somewhat skeptical:
Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets. We have recently discussed several factors, ranging from the properties of the situation — such as the nature and extent of scrutiny — to individual expectations and the type of actor involved. For example, the competitive nature of markets encourages individualistic behavior and selects for participants with those tendencies. Compared to lab behavior, therefore, the combination of market forces and experience might lessen the importance of these qualities in everyday markets.
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Responding to Rob:
The homo economicus camp generally allows that observed individual behavior will deviate from the predicted rational decision. However, they believe that those deviations will be non-biased, thus cancelling out on average as you suggest. (E.g. some firms at an auction for oil rights bid more than they rationally should while others bid less.)
The behavioralists look for deviations that are systematically biased in one direction. In the auction context, several studies show that participants tend to bid higher than they “should” because they fail to account for a phenomenon sometimes called the “winner’s curse.” Thus, the deviations don’t average out to zero.
To my knowledge, this phenomenon occurs in many real-world auctions for common-value goods (such as oil rights), not just in lab experiments.
Free Time (or lack there of) to choose is the economic variable that is missing outside of the lab. How much time does the individual have? Do they think and act based on a balance of short and long-term goals, or are they in a hurry to decide and therefore forced to think and act irrationally. If we can afford the ultimate luxury of taking our time to choose, our ability to think and act rationally increases.
As a non-economist, I like to give my take on the jam issue. More isn’t necessarily better. Given 21 different jams, what exactly are the variables that change…flavor, jar size, brand name? Or can those 21 really be categorized into fewer sets? Is the variety of jam really just commoditized and the average consumer really can’t tell the difference?
As for the lab vs real world discussion, isn’t by definition lab experiments only focus on a finite set of factors? It’s not feasible to examine all of the factors and as such, people can always look back to the real world and throw another factor in. If lab experiments could incorporate all factors, then why use labs…just look at the real world.
Speaking of irrationality vs. rationality, maybe we should look at systems more closely. If you create a system (in the lab or market), and people consistently respond in an “rational” or “irrational” way, then wouldn’t it just all be rational? Then would we say that irrational is just very unpredictable. So we’re saying there are systems where people sometimes respond rationally and sometimes irrationally? Or is it systems where a percentage of people respond rationally and the rest otherwise? Are there systems out there where everybody behaves rationally? Going back to the jam experiment, if we can establish that when people are given a relatively higher choice, that they are less likely to buy, then we can now predict how consumers will behave and that’s not so irrational of them.
On a lighter side of things, homo economicus and psychologist try to understand the behavior of homo sapiens but is it ever the other way around. Despite years of research, the experts still haven’t gotten it down pat yet. How useful is the “rationality” model then? I think you would have to convert all homo sapiens into homo economicus and then we won’t even have to discuss this topic of behavioral economics. Can you imagine a world where everybody acts rationally? Is there such a thing as a rationality index? Has anybody tried to measure the world’s rationality?
such.ire, Jacob B:
You could argue that we should readjust the utility curve, but I think that doing so has the potential to lead you to seemingly absurd arguments.
Jacob, you hypothesize, for instance, that the opportunity cost of buying the “wrong” jam is higher than the cost of not buying any jam. That strikes me as one such absurd argument; surely in both cases the opportunity cost is defined solely by the value the buyer would have gained from buying the “right” jam, no? In other words, in both the case where we buy jam and the one we don’t, we run the risk of failing to buy the better jam–the opportunity cost. The only difference I see, rationally, between the two cases is whether there was a marginal gain by buying the jam we did buy. This shouldn’t change based on how many other possible jams there were.
So this brings us to the subjective experience of the buyer. Yes, there’s a utility cost, in some sense, for feeling bad (overwhelmed by how many choices, perhaps). But isn’t it simpler, and more reasonable, to simply say that the buyer estimates, inaccurately, the potential opportunity cost (as Jacob described) by using the number of jams available? In other words, the buyer uses this as a rough heuristic and, seeing how many jams there are, decides (irrationally) that the risk of making the “wrong” choice has increased (it hasn’t, since he is guaranteed to miss the better jam if he never buys jam at all).
So it doesn’t strike me that this example is so easily reconciled. Rationally, the possible opportunity cost hasn’t increased. But the best we can say about the buyer is that he estimated that the opportunity cost went up.
(As a side note, my personal view was always that the buyer feels a compulsion–nonrationally–to inspect every possible jam before buying. If he’s presented with enough jams as to make that costlier than the value of the jam he wants, he won’t buy. This, I should guess, is why we aren’t put off by the number of possible cars, computers, or houses–these are all expensive items, so the cost of looking at all the options is comparatively negligable–but we are put off by doing so for something worth a lot less, like jam.)
Kevin L:
I wanted to just address one thing you said–having already rambled on about the jam thing myself for far too long.
“Going back to the jam experiment, if we can establish that when people are given a relatively higher choice, that they are less likely to buy, then we can now predict how consumers will behave and that’s not so irrational of them.”
I don’t think you can conflate rationality with consistency. A group of people might be consistently irrational–in the sense that their actions do not maximize their utility. They might be consistent, but wrong.
(For that matter, there might be situations where rationality demands unpredictability, so that the rational actors are the ones who appear to act inconsistently. For example, if the stock market were perfectly efficient, a rational actor would do well to pick stocks purely by flipping a coin. He’d be unpredictable, but rational.)
Dan wrote: “Jacob, you hypothesize, for instance, that the opportunity cost of buying the “wrong” jam is higher than the cost of not buying any jam. That strikes me as one such absurd argument; surely in both cases the opportunity cost is defined solely by the value the buyer would have gained from buying the “right” jam, no?”
and Dan also wrote: “In other words, the buyer uses this as a rough heuristic and, seeing how many jams there are, decides (irrationally) that the risk of making the “wrong” choice has increased (it hasn’t, since he is guaranteed to miss the better jam if he never buys jam at all).”
The buyer is committed to having missed the better jam once he makes a purchase, but until then he leaves himself the opportunity of nabbing it later. The opportunity cost is not the value of the best jam in the case where he doesn’t buy any, since he has not given up that opportunity, only delayed it. The non-purchasing shopper only has to pay the opportunity cost of not having the best jam immediately (but a friend’s recommendation could clarify things and allow him to return to the store tomorrow not worried about making the wrong choice) whereas the purchaser who has expended his jam budget has to wait for an entire budget/jam cycle and is stuck with a lesser jam.
My suspicion is that Homo economus evolved, as I suggested yesterday on my blog: http://zatavu.blogspot.com/2008/02/on-rise-of-irrationalism.html
I offered my own take on the “Ultimatum Game” earlier this month.
http://justenjoytheshow.blogspot.com/2008/02/ultimatum-game.html