Implications

Economic theory informs:

• anti-trust law

• contracts law

• Federal Reserve policy

• business decisions

• financial markets (traders, arbitrageurs)

Traditional Theory

• Utility

• Expected Utility

• Maximization

• Calculate how to do this

• Rationality

• An approximation, a metaphor, or an ideology?

Cost-Benefit Analysis

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Some Departures fromHomo Economicus

• Reciprocity

• Calculational Capacity

• Heuristics

• Absolute Value vs Relative Value

• Probability

Some Departures fromHomo Economicus

• Reciprocity

• Calculational Capacity

• Heuristics

• Absolute Value vs Relative Value

• Probability

Probability

• Reasonable guess: if people who know exactly what’s coming maximize utility, maybe people who can guess what’s coming maximize expected utility.

• People have a very good inborn heuristic for averaging. They can do it in a blink.

• Plus the mathematics of probability are already worked out (Boltzmann, Kolmogorov), so economists can hypothesize about behavior without having to invent new mathematical tools.

Expected Utility

• Say an agent is choosing what to do in the face of uncertainty.

• Option X might result in one thing, or it might do something else.

• Same for Options Y and Z.

• Example: Messrs. X, Y, and Z are guys you could date.

• Of course there are a variety of possible outcomes associated with each of these choices, but let’s just reduce it to: {break up after 1 month, break up after 1 year, break up after 10 years, die together}

Probability

• That turned out to be insufficient to describe people’s behavior.

• (After all, people do play the lottery and buy insurance, which on average is a losing proposition.)

• The next guess was that people care about variance as well as mean.

• (Chalkboard: pictures of distributions.)

Risk Attitudes

Since this person’s utility is proportional to wealth, they weigh the fiftieth dollar the same as the millionth dollar.

For this person, having only a few dollars will be extremely painful: they can’t risk it!

Risk Attitudes

Uncertainty Aversion

• Say there are two classes you are considering enrolling in. You want to know how good the teacher is, so you go to a website that rates teachers.

1. One of the teachers, you cannot find any information about.

2. The other teacher, the reviews are half positive, half negative.

• Most people would prefer the second teacher because they have more information, hence less uncertainty.

• However, both situations would be represented probabilistically as uniformly random, i.e. completely random.

• That means risk aversion does not suffice to describe preferences.

Ellsberg ParadoxSuppose you have an urn containing 30 red balls and 60 other balls that are either blue or black. You don't know how many black or blue balls there are, just that the total number of black balls plus the total number of blue balls equals 60. You are now given a choice between two gambles:

Gamble A You receive $100 if you draw a red ballGamble B You receive $100 if you draw a black ball

Also you are given the choice between these two gambles (different draw, same urn):Gamble C You receive $100 if you draw a red or blue ballGamble D You receive $100 if you draw a black or blue ball

According to expected utility theory, you should prefer Gamble A to Gamble B if, and only if, you believe that drawing a red ball is more likely than drawing a black ball. Similarly you should prefer Gamble C to Gamble D if, and only if, you believe that drawing a red or yellow ball is more likely than drawing a black or blue ball. If drawing a red ball is more likely than drawing a black ball, then drawing a red or blue ball is also more likely than drawing a black or blue ball.

A⋎B

C⋏D

Allais Paradox

1A⋎1B 2A⋏2BBoth gambles give the same outcome 89% of the time, so in expected utility, these equal outcomes should not affect the desirability of the gamble. If the 89% ‘common consequence’ is disregarded, both gambles offer the same choice; a 10% chance of getting $5 million and 1% chance of getting nothing as against an 11% chance of getting $1 million.

Some Departures fromHomo Economicus

• Reciprocity

• Calculational Capacity

• Heuristics

• Absolute Value vs Relative Value

• Probability

Absolute Wealth• A friend of mine works twelve hours a week at a $6/hour job.

= $3600/year

• That’s not a lot, right?

source: globalrichlist.com

• A half gallon of milk cost the average worker 10 minutes of labor in 1970, 8.7 minutes in 1980, and only 7 minutes in the latest year for which data are available.

• A gallon of gasoline cost 11 minutes in 1950 but is now less than half that. But these are nothing compared to some price drops.

• A scratchy-sounding three-minute phone coast-to-coast phone call cost an incredible 90 hours of work back in 1910. Today, it's less than two minutes of work time.

• A hundred kilowatt hours of electricity in 1900 cost a shocking 107 hours of worker time in 1900, a bit over an hour by 1960, and less than 45 minutes today.

• "A typical American at the turn of the century spent $76 out of every $100 on food, clothing, and shelter. By the 1990s, this portion had fallen to $37 of every $100.”

from

Myths of Rich & Poor: Why We're Better Off than We Thinkby W. Michael Cox and Richard Alm, New York: Basic Books, 248 pages, $25.00

from

Myths of Rich & Poor: Why We're Better Off than We Thinkby W. Michael Cox and Richard Alm, New York: Basic Books, 248 pages, $25.00

Economist’s point: See, we’re doing better.

Psychologist’s point: So why don’t we appreciate it?

• Comparison to peers (rank) (mate choice)

• Hedonic treadmill

• Don’t accurately predict what will make them happy, so they spend on things that don’t actually make them better off.

• Happiness ∝ log(income)

So why do people making $90,000 a year still feel poor? (“I’m just an accountant.”)

Prospect Theory

• Reference point, not absolute• Gains are valued, less than losses are hated• Small probabilities overweighted; large probabilities underweighted

Implications

• GDP growth less important than stability, jobs

• Low, steady inflation rather than stable prices

• Precautionary principle

• “Downside risk” rather than standard deviation in investments

• “Libertarian paternalism” (Thaler’s)

• Better theoretical basis for government regulation

• Buy more “experience goods,” fewer durables

Efficient Markets?WSJ.com - As Two Economists Debate Markets, The Tide Shifts

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Mr. Thaler Takes On Mr. Fama

By JON E. HILSENRATHStaff Reporter of THE WALL STREET JOURNAL

October 18, 2004 ; Page A I

For forty years, economist Eugene Fama argued that financial markets were highly efficient i n

reflecting the underlying value of stocks . His long-time intellectual nemesis, Richard Thaler, a

member of the "behaviorist" school of economic thought, contended that markets can veer off

course when individuals make stupid decisions .

In May, 116 eminent economists and business executives gathered at the University of Chicago

Graduate School of Business for a conference in Mr . Fama's honor . There, Mr. Fama surprised

some in the audience . A paper he presented, co-authored with a colleague, made the case tha t

poorly informed investors could theoretically lead the market astray. Stock prices, the paper said ,

could become "somewhat irrational . "

Coming from the 65-year-old Mr . Fama, the intellectual father of the theory

known as the "efficient-market hypothesis," it struck some as an unexpecte d

concession. For years, efficient market theories were dominant, but her e

was a suggestion that the behaviorists' ideas had become mainstream .

"I guess we're all behaviorists now," Mr . Thaler, 59, recalls saying after he

heard Mr. Fama's presentation .

Roger Ibbotson, a Yale University professor and founder of Ibbotso n

Associates Inc ., an investment advisory firm, says his reaction was that Mr .

Fama had "changed his thinking on the subject" and adds : "There is a shift

that is taking place . People are recognizing that markets are less efficient

than we thought." Mr . Fama says he has been consistent.

The shift in this long-running argument has big implications for real-life problems, ranging from

Eugene Farna

http://online .wsj .com/article print/0,,SB109804865418747444,00 .html

10/19/2004

Current Events

• Credit crunch – illiquid markets

• Loss-averse traders

• Uncertainty-averse traders