A Glance into Behavioral Economics
So far in this class we have dealt primarily with the theoretical, mathematical models of economics, contingent upon rational thinking and the idea that humans make their decisions based on maximum expected util. However, human beings are not always rational creatures. Behavioral economics came about in the early 1980s as an effort to understand and improve the economy through “psychologically-realistic” models. Behavioral economist Richard Thaler received the 2017 Nobel Prize in economics as he was central to the growth of this field.
There were four factors that contributed to the rise of behavioral economics. The first and biggest was that there were numerous documented anomalies to the traditional, rational models of economic behavior. From this, economists developed a new generation of models that reflected more psychologically realistic trends. From this, researchers were able to come up with ways to influence people to make better economic decisions. And finally, due to the growing popularity of the field, they were able to attract many more young researchers who accelerated the growth of the field.
Thaler was a major contributor to all four of these factors. He lead the efforts to find ways to help people become more economically conscious, including his efforts to raise saving rates in US retirement plans. He coined the term the “endowment effect” which is the phenomena that people are more likely to hold onto an object they own rather than trade it in for its cash equivalent, but they would not spend the money to buy that same object if they did not own it. In other words, people tend to overvalue the things they own, which isn’t rational and therefore doesn’t fit into traditional economic models.
Thaler then began to venture deep into financial economics and trends in the stock market. In the 1970s, the benchmark rational model for modeling returns of assets was the CAPM. According to this model, an asset’s average return is determined by measuring the asset’s risk (beta), which is the effect of the asset’s return on the overall market. This risk was said to be the reason why stocks with low market capitalizations and a lower price-earnings ratio saw higher average returns than stocks with high market capitalizations and a higher price-earnings ratio.
Due to the rational paradigm of the time, many economists were taken aback by Thaler’s publications. Thaler’s first finance paper, “Financial Decision-Making in Markets and Firms: A Behavioral Perspective” that he co-authored with Werner F.M. De Bondt, addresses the issues with the rational paradigm. Bottom line is, most economists agree that a majority of the population do not fit the rational models. But still the paradigm continues because to most economists during the time, a psychological approach was said to conflict with “good economic theory” and that it is “merely a clever way to introduce free parameters,” or that it “distracts us from the pervasive market forces that should be our principal concern.” Essentially, they are saying that introducing psychology to the economic models would give people the freedom to define their own parameters within the market. However, Thaler and Bondt argue that the definition of “rationality” isn’t so disciplined either, and because of its poor fit with a majority of the population. Behavioral research is, in fact, more disciplined because it relies on analyses and assumptions that are more true for the general population.
One of the most pervasive traits in the human race that contributes to our overall “irrationality” is overconfidence. The way this works in the market is that many people overestimate the reliability of their knowledge about another company, and are more inclined to have immense confidence in their investments as well. This kind of confidence would lead to investing more than would be considered “rational” by traditional economic standards in a certain company and therefore less in others.
Thaler and Bondt then go on to argue to use of Bayesian Forecasting in traditional economics, which is the statistical technique of using prior knowledge of an event to predict its current outcome. While Bayes theorem seems like the rational way of determining where to invest, Thaler and Bondt bring up countless other psychological studies that prove humans make probability judgements based on what is called “representativeness heuristic”, which is essentially comparing something to their supposed stereotype. The example given in Thaler and Bondt’s paper was a study done where a group of people had to judge, based on a physical description of a man, whether he was a lawyer or an engineer. One group was told that the man described was picked from a sample where 30% were lawyers, and the other group was told that the man was picked from a sample where 70% were lawyers. If we were to solely use Bayes Theorem, then group 1 would have said the man was an engineer and group 2 would have said lawyer just based on sheer probability. However, the study showed that the two groups’ responses were insensitive to the statistics given, which shows that humans don’t classify based on rational probability, but rather by stereotyping and referencing back to what we know from our experience.
There are countless other factors that Thaler and Bondt observed that prove psychology’s place in economics. When we try and mathematically model human trends and tendencies, especially on the basis of rationality, we often find ourselves with a correlation of less than 0.5, as many sociologists experience. At least in the case of economics, thanks to Richard Thaler and other behavioral psychologists, we are now able to factor in human psychology into our models, although it does make those models that much more complicated to map out. However, we are now in the midst of a paradigm shift to an economy still based on rationality, but also taking into account human tendencies.
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WOAH. It was really interesting to learn all of this new information about behavioral economics. It was cool to learn that there is a lot more logic and strategy that comes to economics than I thought and I never knew psychology would and could play such a role in such a number based subject.
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