• Does Behavioral Economics Matter?

    Sendhil Mullainathan and Richard Thaler (M & T) address some interesting questions in their paper Behavioral Economics (September 2000). In doing so they justify the import and relevance of the concepts of bounded rationality, bounded willpower, bounded self-interest. Their application is finance and savings.

    1. Don’t market incentives lead to rational choices? While it is true that incentives matter, in that they influence behavior, they are not decisive. The market may reward choice A over B so there is an incentive to choose A, but they do not force the choice of A.

    2. Aren’t irrational choices arbitraged away? No arbitrage opportunities exist for all sets of choices. M & T use the example of the fictitious economist Sam who goes into the field of behavioral economics even though he could earn more money in finance. Remuneratively speaking he made an irrational choice. But there is no arbitrage opportunity for him or anyone else, not for this choice or his choice of how much to save for retirement, wife, car, and so forth.

    3. Didn’t evolution select for rationality? Not at all. Evolutionary arguments can explain irrational behavior as well. It may, in fact, have been an advantage to be or appear overconfident. Appearing so would have provided an incentive for one’s foes to back down. Is the “irrational exuberance” of the modern age a vestige of evolutionary selection? It is at least plausible.

    4. Don’t we learn from our irrational choices and correct them? Opportunity cost can prevent the switching from a sub-optimal choice to an optimal one. Even if one is not stuck in a non-optimal equilibrium, learning can take longer than the time scales of a changing environment allow. That is, by the time you’d have learned the optimal way to decide something the world has changed: there are new choices, you have a different income, different needs, and so forth. Finally, sometimes we only get to decide once. There are few, if any, chances to learn from our retirement saving decisions and the cost of experimentation is high.

    Next, M & T focus on three unrealistic assumptions of standard economics: unbounded rationality, unbounded willpower, and unbounded selfishness.

    5. What’s the problem with unbounded rationality? Well, it is just wrong. People don’t have unlimited brainpower. Assuming they do is bad economics, “the equivalent of presuming the existence of a free lunch.” There are loads of empirical studies that demonstrate various ways in which people are not rational; they solve problems with heuristics that lead to sub-optimal results.

    6. Do people choose the optimum (rational) option even when they identify it? No, not always, due to lack of self-control. It is common for humans to overeat, over drink, over spend, under exercise, under save, under work, and so on. People procrastinate. In short, people have bounded willpower.

    7. Finally, people are not as selfish as rational actors would be.

    What are the implications for finance and savings?

    8. First, M & T dispense with the efficient markets hypothesis (EMH) by describing some well-known ways in which it has clearly been violated.

    9. If the EMH doesn’t hold, and moreover if markets sometimes over- and sometimes under-react, there doesn’t seem to be a unifying framework to explain market behavior. What next? M & T only make a few passing remarks about emerging research on this question. It isn’t clear they’ve made any real contribution in their paper so I’m not sure why they even raise the issue.

    10. Turning to savings, M & T describe how bounded willpower explain lack of sufficient saving for retirement. The phenomenon of mental accounts explain the relative increase in savings that occurred when personal IRAs became available. When funds were mentally designated for retirement and placed in an IRA they were less likely to be used for other purposes.

    Well, that was a rather weak conclusion to a paper with a very interesting start. No doubt behavioral economics can and has made important contributions to personal finance. They’re not to be found in this paper. I believe behavioral economics matters more than M & T let on. If you read their paper, do so for points 1-7 above. Those are well made.

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    • Austin,

      I have not read this paper, but what is your definition of rationality here? I do not see how any of these examples suggest irrationality. (Rather, you generally seem to imply that we might have incorrectly specified our optimization problem.) Addressing your points in turn:

      1. That the market rewards A over B does not imply that it is always rational to choose A over B given uncertainty, the cost of acquiring information, and benefits of A over B that are not captured in the market.

      2. The example you give is not an irrational choice. It merely suggests that the economist cares about things other than monetary remuneration. She agent could still be acting rationally in the sense that she is maximizing her utility. (Analytically, this means that we risk maximizing the wrong maximand.)

      3. If people get a benefit from acting overconfident, then how is that irrational? Again, this suggests that we are not setting up our maximization problem correctly.

      4. Imperfect information and switching costs can easily be modeled and do not imply irrationality.

      5. So, there are costs of acquiring information and costs of engaging in rigorous problem-solving that make heuristics the more optimal approach in the long-run.

      6. This seems more closely aligned with what I would consider “irrational.” A lack of willpower suggests that the person is maximizing over the short-run and is not fully internalizing the long-run costs. However, there is evidence that people consider the long-run costs more than a completely myopic model would predict (see Beck and Murphy’s work on rational addiction).

      7. How is it irrational to be unselfish? That another person’s utility is a factor in my own utility is not irrational.

      Finally, with regards to the EMH, that markets sometimes over- and sometimes under-react, but neither consistently over- nor under-react, can be viewed as evidence that the EMH is doing rather well.

      • @STaylor – I’m just summarizing the paper. These are not my ideas. I think there is room for debate about many of the points you raise. Without trying to pin down what the authors mean by “rationality” I think it is clear that most standard economic models assume a type of rationality (or use another word if you like) that leaves out the effects the authors raise. Behavioral economics brings them back in. To your points:

        1. If the market says A > B but really it is not, what does that say about the market? Or, this is just observed heterogeneity in (complete) valuations of A vs. B.

        2. Yes. And those are elements typically left out of standard models (back to “what is rationality?”)

        3. Something could have been rational and evolved to be prominent in our ways of being but is no longer so. That’s the point.

        4. Yes. Again, these are considered enhancements to standard models and certainly within the purview of behavioral econ, though not exclusively so.

        5. Heuristics need not mean “wrong.”

        6. OK.

        7. Vs. standard models. Factoring other’s utility into one’s own is quite a departure, isn’t it? Smacks of extra-welfarist.

        I think assuming EMH is right leads to better personal investing behavior so I tend to act as if it is true even though in a strict sense it can’t be everywhere and always so.

        Bottom line, we agree.

    • Thanks, Austin. I think we can agree to agree:)

      I read “irrational” to mean that an agent is not maximizing utility, not that he cares about “goods” not priced on the market or that information is costly to obtain. Your point about behavioral economics bringing these effects back into the framework is perhaps what I want to highlight. That is, the appropriate response to these findings is to return to the framework, add new parameters into the model, etc. (which is what I would hope a good graduate course on price theory would teach students to do). I worry that a casual reader might think that these effects are reasons to abandon the approach entirely.