Thursday, October 10, 2002

Nobel prize for Economics, 2002

When I wrote about last year's Nobel prize for economics I ended up getting a cease and desist letter from MIT Press and had to take it down. *Sigh* For those who remember, last year's prize went to information asymmetry, which showed how people would not trade if they could not be convinced that they weren't being cheated. A nice and interesting wrinkle on Chicago School micro.

This year's prize goes to Behavioral Economics. There are two schools of "behavioral economics", one which focuses on empirical research and the other which takes the classical micro model into new areas.

First, some context. The standard microeconomic approach looks at how a rational individual, who tries as best as he can to look into the future, goes about maximizing his "utility." While it's easy to make jokes about how unrational people are in real life, this approach is unparalleled in its power and generality, and by that I mean it explains a great deal of many different sorts of behavior. Quantum Mechanics aside, I struggle to come up with any other theoretical model that has had quite the material success of the microeconomic rational utility maximizer. This school of economics was invented at Chicago in the 50s.

One school of "behavioral economics" takes the standard micoeconomic rational actor and extends the utility function to include all kinds of goods that go beyond wealth. For example, racial prejudice can be thought of as a consumption good where an individual exchanges money for prejudice (by not hiring black labor even though it's cheaper and better). This school of behavioral economics was also invented at Chicago by Gary Becker (who won a Nobel Price in 1992), who has done amazing work in this area with Kevin Murphy. Through this, they've come up with powerful and insightful models of personal taste, addiction, the family, crime, etc.

The other school of "behavioral economics" does away with the rational actor and instead presents real people with real choices in a lab and sees what they do. One of the leaders in this field, Richard Thaler, is also at Chicago (along with Barberis) and focuses on "unrationality" in the financial markets. It is for this school that Kahneman and Smith won their prize this year. (Note: Kahneman was the thesis advisor of a good friend of mine at Chicago).

Of course it's hard to argue that people are perfectly rational, but you can make the utility function in the the standard microeconomic model pretty broad, including alturism, (unstable) preferences, and lots of other things and come up with good, robust predictions about the world. Whenever you deviate from this sort of thing you end up with someone losing all their money unless they become "rational" again, so the model is pretty self correcting. I don't think the experimental behavioral economics gained much traction until it found irrationalities in the stock market (which, when publicized, were arbitraged away and no longer exist).

The main criticism of the experimental school of BE is that, well, people perform strangely in labs. When Thaler points to some small, market irregularity and calls it the tip of the iceberg, Gene Fama (Chicago, invented modern Finance) says "No, that's the whole iceberg!"

So I'm pretty torn about this year's prize. I guess I'm skeptical of how useful lab experiments are in generating useful data, but people are wacky and market anomalies remain (for example, there is too much volatility in the stock market, and there are financial booms and busts). Useful stuff may come out of experimental BE in the future, but I'm still trying to wrap my head around the standard microeconomic model.


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