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Tuesday, November 24, 2009

PSYCHOLOGICAL FINDINGS ABOUT OUR BEHAVIOR VS. RATIONAL CHOICE ASSUMPTIONS IN MAINSTREAM ECONOMICS

Today's Buggy Topic Is Found . . .

as usual at Economist View, where as thread was started with the laudable boss-wizard of that web site, Professor Mark Thoma, by linking to a non-scholarly piece by Professor Robert Shiller, an economist at Yale --- and one of the pioneers of behavioral economics, especially in financial matters.  

Behavioral economics is aimed at challenging the theoretical postulate of rational-choice behavior that extends back over a century to neo-classical work in what we would now call microeconomics: all economic agents--- whether financial investors, business owners, the managers of financial institutions, consumers, and workers --- all follow rational behavior in seeking their self-interest in the economic realm.  The assumption allows for a big simplification that enables economists to work methodologically on the assumption that all economic actors are therefore self-interested maximizers (or optimizers).  With that assumption, all sorts of formal mathematical modeling is then made possible --- including, since 1945, game theory (or strategic interaction between two or more economic agents --- or even two or more nation-states treated as unitary agents). 

Strategic Action Meaning What Exactly?

Simply this: what one economic agent can achieve--- say, a new start-up company breaking into a fairly new industry dominated by a few giants (say again, Google, created by three Stanford students in 1995 or so, no longer just a search engine company, but the biggest challenge to Microsoft) --- will depend on what Microsoft and Intel seek to achieve.  In principle, their interactions --- given rational-maximizing assumptions of self-interest (measured in perhaps profits or market share or both) --- can be set out in at least "ordinal" or "rank-order" fashion. 

Rank-order refers, as an example, to 4000 IQ test-takers, being ranked comparatively in relation to others.  IQ tests are always normed for 100 with a standard deviation around the mean of 15 points (16 in some tests.  But you can't say that an IQ  of 170 --- way in the genius range --- is twice as intelligent as 85.  There is no zero, no way to say that 4th in rank is twice as high as 2nd in rank, and hence no way that this is strict  numerical or "interval" or "cardinal data."

Without the assumption of maximizing rational actors --- seen, say, as individual businesses in a perfectly competitive market (where there are large numbers of firms, no one firm can influence the general price of the products in that industry, and there is "free entry" and "free exit"  --- the latter referring to bankrupty) or in an oligopolistic market (a few giant firms that track one another's pricing and product innovations and quality to which game theory is applicable) --- mathematical economics of any sort (called econometrics) would be possible

Enter Psychological and Social Psychology That Cast Lots of Doubt on This Rational-Choice Postulate

The criticisms of that postulate are numerous and emerge from experimental laboratory work of how individuals and small groups behave in a controlled situation. 

 Since the early 1960s, their impressive work --- which doesn't mean it has its limitations (all spelled out in Prof Bug's post at Economist View --- has made inroads into economics, generating among other things behavioral economics that uses psychological work and does a lot of digging into economic behavioral data to come up with alternative theoretical postulates and modeling.  Robert Shiller, as we noted earlier, is one of them ---- and for that matter, though none of the habitual posters at Economist View seemed to remember it --- so was John Maynard Keynes, the great pioneer economist of macroeconomics.  Using essentially his intuitive folk knowledge of economic actors, not least financial and business investors, Keynes said in 1936 amid the Great Depression that what drives economic behavior is "Animal Spirits".  

In the boom phase of the business cycle, the spirits of investors and consumers become "irrationally exuberant" to use the phrase coined in the late 1990s stock market boom by Alan Greenspan.  In the Great Depression (recessionary phase), said Keynes, they become the opposite: extra-pessimistic depressed spirits. 

Small Wonder,

. . . as prof bug alone noted in that long thread at Economist View, that  Prof Shiller and his co-author George Akerlof (a Nobel-Prize winning eonomist at Berkeley) published a popularizing book last year entitled "Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism."