Consumer theory

Consumer theory

• Consumer theory

• Maximize utility given preferences and information, subject to constraint
• Max u(x1,x2,…xn|θ) s.t. Σi pixi <y (income)

• Demand

• From consumer theory
• Complicated by risk, time, probability judgment (given θ)
• Assume social independence of demand (no “fashion”)

• Supply

• Firms combine capital and hired labor to produce output
• Sorting of different workers into ideal jobs (Becker: “That takes care of 90% of it”)

Equilibrium

• Equilibrium

• Walrasian tatonnement
• Prices p* “clear the market” supply(p*)=demand(p*)
• Political + other mechanisms (voting, violence, theft)
• Other mechanisms for equilibration
• Game theoretic equilibrium
• Learning, evolution, imitation

• Welfare

• Choice=true preference (Pareto >> Bentham).
•  Welfare judged by actual choices

Perfect competition (∞ firms)

• Perfect competition (∞ firms)

• Useful special case, helpful to relax

• (product differentiation, oligopoly)

• Perfect information (θ = truth)

• Useful special case, helpful to relax

• (costly hidden information & action, signaling)

• Perfect rationality (max u(x))

• Useful special case, helpful to relax

• (costly information processing, heterogeneity)

The Missing Motivation in Macroeconomics George A. Akerlof Competence Implies Credibility Giuseppe Moscarini Modeling the Transition to a New Economy: Lessons from Two Technological Revolutions Andrew Atkeson and Patrick J. Kehoe The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk Hanno Lustig and Adrien Verdelhan Inefficiency in Legislative Policymaking: A Dynamic Analysis Marco Battaglini and Stephen Coate Decision Making in Committees: Transparency, Reputation, and Voting Rules Gilat Levy Bureaucrats or Politicians? Part I: A Single Policy Task Alberto Alesina and Guido Tabellini The Motivation and Bias of Bureaucrats Canice Prendergast Urban Evolutions: The Fast, the Slow, and the Still Gilles Duranton Market Share Dynamics and the "Persistence of Leadership" Debate John Sutton

• The Missing Motivation in Macroeconomics George A. Akerlof Competence Implies Credibility Giuseppe Moscarini Modeling the Transition to a New Economy: Lessons from Two Technological Revolutions Andrew Atkeson and Patrick J. Kehoe The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk Hanno Lustig and Adrien Verdelhan Inefficiency in Legislative Policymaking: A Dynamic Analysis Marco Battaglini and Stephen Coate Decision Making in Committees: Transparency, Reputation, and Voting Rules Gilat Levy Bureaucrats or Politicians? Part I: A Single Policy Task Alberto Alesina and Guido Tabellini The Motivation and Bias of Bureaucrats Canice Prendergast Urban Evolutions: The Fast, the Slow, and the Still Gilles Duranton Market Share Dynamics and the "Persistence of Leadership" Debate John Sutton

Neoclassical economics:

• Neoclassical economics:

• Generality– applies to many domains
• Precision– produces clear predictions
• Accuracy– predictions are tested by field data

• Behavioral economics:

• All of above
• + psychological plausibility– fit data on how individuals think, perceive etc.

“The abstract methodological issues we have been discussing have a direct bearing on the perennial criticism of “orthodox” economic theory as “unrealistic” as well as on the attempts that have been made to reformulate theory to meet this charge. Economics is a “dismal” science because it assumes man to be selfish and money-grubbing, “a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area, but leave him intact”; it rests on outmoded psychology and must be reconstructed in line with each new development in psychology;…”

• “The abstract methodological issues we have been discussing have a direct bearing on the perennial criticism of “orthodox” economic theory as “unrealistic” as well as on the attempts that have been made to reformulate theory to meet this charge. Economics is a “dismal” science because it assumes man to be selfish and money-grubbing, “a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area, but leave him intact”; it rests on outmoded psychology and must be reconstructed in line with each new development in psychology;…”

“As we have seen, criticism of this type [about accuracy of assumptions] is largely beside the point unless supplemented by evidence that a hypothesis differing in one or another of these respects from the theory being criticised yields better predictions for as wide a range of phenomena. (mytalics)”

• “As we have seen, criticism of this type [about accuracy of assumptions] is largely beside the point unless supplemented by evidence that a hypothesis differing in one or another of these respects from the theory being criticised yields better predictions for as wide a range of phenomena. (mytalics)”

• That is precisely what behavioral economics tries to do…

precisely

• precisely

precisely

• precisely

Pareto (1897)

• Pareto (1897)

• “Pure political economy has therefore a great interest in relying as little as possible on the domain of psychology”
• Behaviorism in psychology (c 1920)
• Study stimulus-response relations, eschew unobservable “mentalist” variables

• Friedman-Savage (1954) example

• Pool player acts “as if” s/he knows geometry and mechanics
• …but that “as if” assumption may predict badly when conditions change (e.g., warped table, lighter balls, fatigue)

• Claim:

• “As if” optimization comes from somewhere (evolution, learning, education, imitation…)
• But that process in the model

Housing

• Housing

• Marriage/divorce

• Children

• Education & career choices

• Violence (crime, war)

• Health

Why not?

• Why not?

• Many are political decisions (median voter theorem)
• Evolution did not face these challenges
• Learning from experience is difficult
• Advice markets may or may not work well
• Imitation of successful people may or may not work well

Computation

• Computation

• Chess, consumer choice

• Willpower

• Hyperbolic discounting

• Greed

• Ultimatum games

Works in simplest situations

• Works in simplest situations

• Two goods
• animals with many trials of training
• (Chen et al JPE 06)
• Neural firing in LIP, OFC for juice reward
• Evolutionarily-sculpted specialized rules (but they are brittle)

Standard theory

• Standard theory

• Max u(x1,x2,…xn)
• s.t. Σi pixi <y (income)

• Central prediction:

• Buy less when prices go up (law of demand)

What about more complicated situations?

• What about more complicated situations?

• n>3 goods (Pareto “integrability” problem)
• over time (no interest rate)
• Max Σtut (x1t,x2t,…xnt)
• s.t. Σi pitxit <yt + bt for all t, Σt bt =0
• intertemporal substitution, habit formation
• Forecasting future preferences (houses, fertility, marriage, careers…)
• Borrowing, investment, discounting, self-control
• with risk and uncertainty (subj. prob.πs)
• Max Σsπs u(x1,x2,…xn|s)
• s.t. Σi pixi <y

Choose: A $20 today $22 in 1 wk

• Choose: A $20 today $22 in 1 wk

• B $20 in 8 wks $22 in 9 wks

A sensible formula

• A sensible formula

• Exponential weight δt on future time t
• The only formula which is “dynamically consistent”

• Violated by A-now, B-later

• u($20)>δu($22)

• δ8u($20)<δ9u($22)  u($20)<δu($22)

Transactions costs

• Transactions costs

• Hard to control perfectly, probably not the full explanation

• Uncertainty about the future

• Needs special structure

• Judgments of similarity of $ and time

• Hyperbolic discounting d(t)=1/(1+kt)

• Quasi-hyperbolic discounting

• Weights 1, βδ, βδ2, βδ3…
• Claim: Studies with statistical power never support exponential over hyperbolic

• Evidence: Animal choice, humans, calibration to US savings, experiments with juice & Army buyout, fMRI…

• Hyperbolic also creates demand for deadlines & external commitment devices

How much do people care about fortunes of others?

• How much do people care about fortunes of others?

• Some (e.g. families, military)
• Not so much (e.g. animals, firms, “purchased friends”)
• Economic view: “when self-interest and ethical values with wide verbal allegiance are in conflict, much of the time, most if the time in fact, self-interest theory…will win.” (George Stigler)

• How to measure?

• Simple decisions involving money for self and others (e.g. ultimatum games)
• Use these to build up a theory of “social preferences” to explain charity, strikes, wage compression, bequests…

Not everyone is the same

• Not everyone is the same

• Differences create division of labor, specialization
• Interactions are interesting: Is the effect of limitedly-rational agents multiplied or erased? (Fehr Camerer Sci 07)

• Individual differences

• Gender, lifecycle, IQ, patience
• Example: Aging and credit (Laibson et al 07)

[W]e are concerned only with certain relations between objective facts and subjective facts, principally the tastes of men. Moreover, we will simplify the problem still more by assuming that the subjective fact conforms perfectly to the objective fact. This can be done because we will consider only repeated actions to be a basis for claiming that there is a logical connection uniting such actions.

• [W]e are concerned only with certain relations between objective facts and subjective facts, principally the tastes of men. Moreover, we will simplify the problem still more by assuming that the subjective fact conforms perfectly to the objective fact. This can be done because we will consider only repeated actions to be a basis for claiming that there is a logical connection uniting such actions.

• A man who buys a certain food for the first time may buy more of it than is necessary to satisfy his tastes, price taken into account. But in a second purchase he will correct his error, in part at least, and thus, little by little, will end up by procuring exactly what he needs. We will examine this action at the time when he has reached this state.

Herbert Simon

• Herbert Simon

• 1954 JASA/OR/Econometrica/PoliSci
• “bounded”, “procedural” rationality (a/k/a Aumann “rule rationality)
• Inspired by cognitive revolution in psych, AI

• Thaler 1980 “Toward a theory of consumer choice” (JEBO, first article, first issue)

• Met Kahneman, Tversky in 1970’s

• KT, Slovic, Fischhoff, Lichtenstein

• Used deviations from Bayesian judgment, EU to understand psychological principles
• Analogy to visual illusions in study of perception

Second wave empirics & psychology

• Second wave empirics & psychology

• Camerer, Loewenstein, Shafir, Shefrin (c. 1985+), Shiller (1981)

• Third wave formalists

• Rabin (1993 AER), Laibson (1997 QJE)
• Koszegi, O’Donoghue
• Empirics: Malmendier, Della Vigna, D. Silverman et al, +++

• Nobel prize (Kahneman-Smith 02)

• Thaler: “Did you ever think we would be here?” CFC: ______

• Converts

• Benabou-Tirole (03?), Fudenberg-Levine (06), Benhabib-Bisin (05), many more…

• 2005+ Fundamentalist backlash

• Shaked “pamphlet” on social prefs, Rubinstein, Gul and Pesendorfer (05) (echo of Pareto-Friedman argument), Levine (“Is behavioral economics doomed?”)
• Relatively easy to publish ‘ refutations’ of behavioral economics findings (Plott-Zeiler AER, Manaiadis AEJ, AER, Sprenger AER…)

Finance (Shiller-Thaler, Shleifer, Barberis, Odean)

• Finance (Shiller-Thaler, Shleifer, Barberis, Odean)

• Rationality limits influence pricing, corporate

• Game theory (Crawford, Camerer…)

• Formal models of cognitive hierarchy, learning

• Labor (Fehr…)

• Reciprocity/crowding out overturns many conclusions

• Law (Sunstein)

• Influence of framing, norms, tackle paternalism

• Public finance (Slemrod et al )

• What is welfare?

• Poverty (Shafir, Mullainathan)

‘New’ psychology & sociology

• ‘New’ psychology & sociology

• Attention, motivated cognition, self-image, social networks + peer effects

• Formal theory

• Deriving bounds on rationality from familiar primitives (beliefs, preferences, rational attention)
• Dual-process models (planner-doer, controlled-auto…)
• My view: Theories that fit the most data and make sharp, bold predictions are preferred

• Field data

• Friedman’s desideratum– what new effects are predicted & explained?

Behavioral economics is now well-established

• Behavioral economics is now well-established

• Should cease to be a distinct subfield around 2015

• Grounds economics in psychology and biology

• Imperfect rationality is as natural as

• Imperfect competition
• Imperfect information

• Interesting questions about market equilibrium

• Controversies are healthy (normal science)

• E.g. reference points are fragile

• Frontiers:

• Field data, careful theory, “new” psychology…

“The conclusion of so-called behavioral economics is that people don’t behave in a rational way, that they don’t respond as expected to economic incentives. Empirical economics shows that people do respond very precisely to economic incentives.” (Robert Aumann interview 9/04 http://www.ma.huji.ac.il/~hart/papers/md-aumann.pdf?. )

• “The conclusion of so-called behavioral economics is that people don’t behave in a rational way, that they don’t respond as expected to economic incentives. Empirical economics shows that people do respond very precisely to economic incentives.” (Robert Aumann interview 9/04 http://www.ma.huji.ac.il/~hart/papers/md-aumann.pdf?. )

• Not quite: People respond imprecisely (perhaps slowly) to incentives. And they respond to variables which are not incentives (not prices, income, or information)

“The thesis that behavioral economics attacks is that people behave rationally in a conscious way—that they consciously calculate and make an optimal decision based, in each case, on rational calculations. [Ed. : False] Perhaps behavioral economists are right that that is not so. Because their experiments or polls show that people, when faced with certain kinds of decisions, do not make the rational decision. However, nobody ever claimed that; they are attacking a straw man, a dead horse. What is claimed is that economic agents behave in a way that could be described as derived from rationality considerations; not that they actually are derived that way, that they actually go through a process of optimization each time they make a decision.” (Aumann interview)

• “The thesis that behavioral economics attacks is that people behave rationally in a conscious way—that they consciously calculate and make an optimal decision based, in each case, on rational calculations. [Ed. : False] Perhaps behavioral economists are right that that is not so. Because their experiments or polls show that people, when faced with certain kinds of decisions, do not make the rational decision. However, nobody ever claimed that; they are attacking a straw man, a dead horse. What is claimed is that economic agents behave in a way that could be described as derived from rationality considerations; not that they actually are derived that way, that they actually go through a process of optimization each time they make a decision.” (Aumann interview)

• Not so: We are questioning predictions of the “as if” view and attempting to construct models which make better predictions. Read Friedman carefully...