Friday, May 22, 2015

Homo economicus or homo paleas?

Or at least that's how Google translate renders "straw man."

Dick Thaler is in the news, with a long review of his book in the Wall Street Journal  and a thoughtful opinion piece in the New York Times, earning plaudits from Greg Mankiw no less.

The pieces are nice reference points to think about just where psychological economics is. (That's a better adjective than "behavioral" since we are all students of behavior.)

Bottom line: People do a lot of nutty things. But when you raise the price of tomatoes, they buy fewer tomatoes, just as if utility maximizers had walked into the grocery store.

Homo paleas

Dick spends the first half of his precious space in the New York Times and much of the WSJ review complaining about homo economicus, the dispassionate rational maximizer of economic theory.

Economists discount any factors that would not influence the thinking of a rational person
Econs do not have passions; they are cold-blooded optimizers
This is a straw man, and we all know it. As the joke goes, physics studies massless elephants on frictionless sandpaper. All sciences and engineering make simplifying assumptions appropriate to the problem at hand. If you want to figure out the effect of prices on tomato demand, the absurdly simplified rational maximizer approach gives a darn good answer. If you want to figure out where to put the signs advertising a tomato sale, or what color to draw them, let me suggest some psychology.

To jump from the fact that economists often study simplified models focusing on "rational" decision making, to say that economists uniformly deny that any other principle is useful for understanding any human behavior is absurd. And where in rational maximizing does it state that rational maximizers have no feelings about what they're doing? The experience of rational maximization carries immense feeling.

And even if we are all wrong, that doesn't make Thaler right.

One could just as easily make fun of psychologists and sociologists for ignoring the rationality of much human decision-making, and price incentives in particular. Gary Becker made a splendid career out of that fact.  We could easily write parallel opeds saying all of psychlogy is wrong because they omit the fact that sometimes people do in fact add two and two to get four. But "rationalists" respect logic and their reader's intelligence too much to do that: Psychologists' omissions and simplifications likewise do not invalidate their observations about other aspects of behavior.

Stories vs. achievements

Dick tells good stories. Of 20 paragraphs in the New York Times piece, Dick spends 6 on how his students were happier by rebasing exams to 137 points. Just happier, there is no actual behavior here other than a reduction in "grumbling." Then 5 more paragraphs of stories, like why do non-economist spouses want presents on anniversaries.

Only on paragraph 16 do we get a real observation about real behavior: Employers have found that people tend to take the default retirement plan, so if that default plan includes more saving, people are likely to save more. And that this incentive works better than some complex tax deduction that even economics professors often can't figure out. One might complain that it shouldn't take a PhD in psychology to figure this out, but peace, it's a good observation.

Paragraph 19 has a second real-world observation: The Obama administration chose to send taxpayers a $100 per month extra rather than a lump sum $1200, in an effort to nudge the taxpayers to spend it rather than pay down debt.  This one is also concrete, but he doesn't give us any evidence that it actually worked as claimed.  More deeply, is psychological economics about changing taxpayers' behavior or about selling programs to government officials?

Most of the Wall Street Journal review passes along Thaler's of complaining about how people resisted his early ideas. Really, now, complaining about being ignored and mistreated is a bit unseemly for a Distinguished Service professor with a multiple-group low-teaching appointment at the very University of Chicago he derides, partner in an  asset management company running $3 billion dollars, recipient of numerous awards including AEA vice president,  and so on.

Note that the inflammatory quotes:  “pure heresy” "blood boiling” "Chicago School’s libertarian beliefs" are his. "This was `treacherous, inflammatory territory,' he writes." He writes.  An objective history of behavioral finance this is not. And news flash, we ask sharp questions at Fama's seminars too.

The nudge for saving experience is good and solid. But the skeptical reader, who does not sing in the choir,  wonders: you've been at it three decades, and this is all you've got?

Decisions

Actually, no, and it's a shame Dick spent all this bandwidth on straw men, stories, and whining about his early reception. Psychological insights are quite useful for helping people to make more rational decisions.

This may surprise some blog readers, but I'm actually quite a "behavioralist," in my hobby life as a competition soaring pilot. We read a lot of sports psychology, and it makes a big difference. When pilots are low over inhospitable terrain in a glider, we are prey to all sorts of unhelpful emotions. "Darn why can't I fly anymore" is common; self-pity combined with ego defense. We train by visualizing a healthy set of emotions, a mental patter, as well as the actual series of decisions that must be made quickly. Better racing performance and better safety demonstrably result.

Psychology has a lot to say about how people make quick decisions in environments of information overload and scarce time.  Traditional economics is not really at fault for assuming "rationality" whatever that may mean. Traditional economics ignores information gathering and processing costs, because they are usually second-order.  Homo economicus got devoured by a lion while working out the dynamic program of how fast to run away.

Behavioral marketing, for example, is a cornerstone of the business school curriculum. I presume Dick's class "Managerial decision making" (syllabus sadly not available) covers a lot of how to use psychology to become more rational. Behavioral finance is excellent marketing for active investment strategies, that's for sure.

Cuteonomics?

When it gets to economics, though -- market outcomes, not individual decisions --  a common complaint is that "behavioral" approaches study small-potatoes effects. OK, some asset might have a price 10 basis points off. OK, Dick knows how to rebase exams to get a bit better teaching ratings. OK, so your non-economist spouse wants roses on Valentine's day. But really, in the big picture of growth, unemployment, inequality, climate -- you name it -- has this risen past cuteonomics? How do I use psychology to study the practical problems of everyday economics, say How much does progressive taxation hinder innovation and growth; How do I separate the risk premium from expected inflation in reading long-term bonds; How much carbon would a tax reduce, and so on?

That's an interesting debate. We could have it. We should have it. There are good points on both sides. Too bad Dick chose not to address it at all.
That is why “economic models make a lot of bad predictions”: some small and trivial, some monumental and devastating.  
says the Wall Street Journal. Too bad it does not list a single "monumental and devastating" prediction, made wrong by conventional economics, and convincingly made by psychological economics. I underline prediction: explanations after the fact ("there was a 'bubble' which you guys can't explain) which could go either way don't count.

Libertarian Paternalism

You know why the Times loves this stuff.
One article directly attacked the “core principle underlying the Chicago School’s libertarian beliefs,” namely consumer sovereignty: “the notion that people make good choices, and certainly better choices than anyone else could make for them.” By empirically demonstrating that consumers often do precisely the opposite, because rationality and self-control are bounded by human perceptual distortions, their paper undercut this principle. This was “treacherous, inflammatory territory,”
The first is flatly untrue. The case for the free market is not that each individual's choices are perfect. The case for the free market is long and sorry experience that government bureuacracies are pretty awful at making choices for people. "Empirically demonstrating" that some people do silly things does not empirically demonstrate that other people, organized into the US regulatory agencies, can make better choices for them. This is another simple failure of basic logic.

And psychological, social-psychological, sociological, anthropological, and sociological study of bureaucracies and regulatory agencies, trying to understand their manifest "irrationality," rather than just bemoan it as libertarians tend to do, ought to be a tremendously interesting inquiry. Where is behavioral public choice? (More in a previous post.)

(And accusing your colleagues of "beliefs" and viewing a paper as "treacherous" is ungracious at least. The Chicago school's prime belief, if there is one, is to let data speak, and hire quality and impact no matter what the answers. That's why that very Chicago school hired him.  Attacking motivations of those who disagree with you is not particularly scientific or "rational," though it is common behavior, especially at the Times. )

The hard nut: Government bureaucracies are staffed by the same homo psychologicus that makes bad private decisions. Except that social psychology is full of lessons ("groupthink" for example) on just how people, organized into committees, not subject to the discipline of competition, make truly awful decisions. And if you want stories of awful bureaucratic decisions, just open the pages of the Wall Street Journal, or the Cato or Hoover webpages.

Let's go back to that great success, the Obama administration's choice to send taxpayers a $100 per month extra rather than a lump sum $1200, in an effort to nudge the taxpayers to spend it rather than pay down debt.  Hmm, is getting the average consumer to go down to Walmart and buy a bunch of stuff they don't need, rather than pay down some debt, put off foreclosure or car reposession, such a great idea? Didn't the last paragraph just tell us how effective enrollment defaults are at getting people to increase savings? Along with a host of other Federal incentives like IRAs and 401(k)s? Just how infinitely rational is all this nudging?

There is a little offering here:
No matter how often they added that bureaucrats are Humans, with their own biases, their critics wouldn’t listen, even when Mr. Sunstein kept repeating that they were not pro-paternalism but rather “anti-anti-paternalism.”
This critic has been listening a lot, and not hearing or seeing any serious psychological study of the perfect rationality of government bureaucracies.

The central problem with Libertarian Paternalism as an alternative to Homo Economicus, is ubi est pater? Where is this hyper-rational Pater who will guide things for us better than the admittedly shoddy job we often do for our selves, and the somewhat less shoddy job that private institutions designed to help us make decisions can do?

The WSJ article takes up the issue
“Could we use behavioral economics to make the world a better place? And could we do so without confirming the deeply held suspicions of our biggest critics: that we were closet socialists, if not communists, who wanted to replace markets with bureaucrats?” Yes, he argues, and yes. Because people make predictable errors, we can create policies and rules that lower the error rate, whether it has to do with reducing driving accidents, getting men who use public urinals to aim better or enticing people to save for retirement—and do it in a way that makes people themselves happier with the results.
"We." Well, at least it is better than the usual passive, "people can be made better off." But just who is this "we, " and how did that "we" avoid all the chaos coming from federal bureaucracies trying to regulate behavior?
The problem, Mr. Thaler argues, is that although economists “hold a virtual monopoly” on giving policy advice, ...
Ah, the benevolent bureaucrat is just getting bad advice. This isn't socialism or communism. It is aristocratism; us the bien-pensant experts, immune from behaviorism and over emotional decision-making (a trait not terribly on display in these articles) can guide the benighted masses, if only the government would listen to us.

Always just over the hill

One would think that after 30 years, one would be looking back at a long string of solid successes. But despite 30 years of trying, both pieces keep promising a golden future, just over the next hill.
By injecting economics with “good psychology and other social sciences” and by including real people in economic theory, economists will improve predictions of human behavior,
Any day now. Well, keep trying. And I'll keep listening. I hope 30 years from now there is a string of solid successes to report, and less  straw men, antagonist-vilification, and funny classroom stories.

30 comments:

  1. John,

    Nice post. I myself found it funny to come to the end of that Thaler article in the NYT and hear him say:

    "The field of behavioral economics has been around for more than three decades, but the application of its findings to societal problems has only recently been catching on."

    If its findings were so useful, why have they taken three decades to catch on?

    As an aside, I've found that completely random behavior can actually look a bit like utility maximization (you can ignore the first part about deriving the Cobb-Douglas utility functions).

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  2. Bravo? I've criticized "libertarian" paternalism in many posts, the latest of which is here: http://politicsandprosperity.com/2015/05/11/the-perpetual-nudger/.

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  3. Excellent blogging.

    Still...as aa consumer there are many situations in which I do not know what I am doing, such as when I visit the doctor, the auto repair man or buy a house.

    Should we dlicense lawyers and doctors?

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    1. Lawyers: Absolutely. The legal systems of the present day are some of the most sophisticated rackets imaginable. Masquerading in sanctimonious scare-mongering, lawyers are the unbridled gate-keepers of the institution that enslaves and imprisons. Good luck trying to take away their accreditation.

      Doctors are of better cloth but it's questionable that government licensing bestows their clients any benefits beyond what a decent consumer watchdog agency could. In many cases government doctrines may bring perversion to your doctor's decision making.

      You should feel uncomfortable in ignorance. Check out some books on car engines, anatomy, and structural engineering. Ask around. Thirst information.

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  4. I enjoy Paul Krugman's point in The Fall and Rise of Development Economics, that by reducing the Earth to a dish-pan, scientists gain enormous insights on the real world even though the model could be called "naive" or "simplified", which is the gist of research as we know it. So I don't see, in terms of scientific research, economists' "simplified" models are necessarily problematic.

    Yet on the other hand, I guess what makes economics different is that in, like, geophysics, the Earth doesn't care if you reduce it to a dish-pan or potato or basket ball, it will continue "behaving" as it does for another billion years, until you understand it or not (of course here I don't take recent research like climate change, etc. into consideration). But economic research does have huge and instant impact on its research subject. Policies are made, products are invented, and taxed are assessed, supposedly based on economic research, which makes "simplification", valuable and actually necessary in rigorous research, much more impactful and consequential than in other fields.

    More importantly, actually practitioners in economics and finance know it all too well. Rather than being "misled" by economic theory, all too often they are fully aware of the shortcomings of its "simplification" and can't wait to take advantage of it, and then justify their decisions by the over-simplified economic theory. It's like a wall streeter push-sell what he exactly knows as a "shitty product" to a client, and justify his decision by saying that in a free market, if a transaction is made it should be a win-win, according to what he learns in Economics 101. In this sense, "simplification," although necessary and beneficial in any scientific field, clearly posts a threat to the reputation of economics. And, my guess is many economists also know it, but they don't want to acknowledge it openly, or even, they'd prefer playing innocent by saying that we are just doing scientific research and don't know it could be used in practice in such a bizarre way but at the same time feeling comfortable and satisfied to benefit from its being used or misused.

    So maybe a cautionary tale like "smoking could harm your health" put on the cover of an economics textbook would help? I'm not sure. It's all human nature, and sadly, maybe ultimately we can never do anything about it.

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  5. I enjoy Paul Krugman's point in The Fall and Rise of Development Economics, that by reducing the Earth to a dish-pan, scientists gain enormous insights on the real world even though the model could be called "naive" or "simplified", which is the gist of research as we know it. So I don't see, in terms of scientific research, economists' "simplified" models are necessarily problematic.

    Yet on the other hand, I guess what makes economics different is that in, like, geophysics, the Earth doesn't care if you reduce it to a dish-pan or potato or basket ball, it will continue "behaving" as it does for another billion years, until you understand it or not (of course here I don't take recent research like climate change, etc. into consideration). But economic research does have huge and instant impact on its research subject. Policies are made, products are invented, and taxed are assessed, supposedly based on economic research, which makes "simplification", valuable and actually necessary in rigorous research, much more impactful and consequential than in other fields.

    More importantly, actually practitioners in economics and finance know it all too well. Rather than being "misled" by economic theory, all too often they are fully aware of the shortcomings of its "simplification" and can't wait to take advantage of it, and then justify their decisions by the over-simplified economic theory. It's like a wall streeter push-sell what he exactly knows as a "shitty product" to a client, and justify his decision by saying that in a free market, if a transaction is made it should be a win-win, according to what he learns in Economics 101. In this sense, "simplification," although necessary and beneficial in any scientific field, clearly posts a threat to the reputation of economics. And, my guess is many economists also know it, but they don't want to acknowledge it openly, or even, they'd prefer playing innocent by saying that we are just doing scientific research and don't know it could be used in practice in such a bizarre way but at the same time feeling comfortable and satisfied to benefit from its being used or misused.

    So maybe a cautionary tale like "smoking could harm your health" put on the cover of an economics textbook would help? I'm not sure. It's all human nature, and sadly, maybe ultimately we can never do anything about it.

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  6. Government protection of basic property rights suffers from the same ailments as Thaler's "nudges": It's still a centralized group of people deciding which behaviors should be rewarded with government protection and which should not, on the supposed basis that certain patterns of reward make people better off. Is it rational for people to steal food? "Yes," say the stealers. "No, stealing is actually irrational because stealing kills the goose that lays the golden egg, and we need a centralized body to protect people from making such lamentable mistakes," say most economists. Thus the background assumptions of neoclassical economics can also be shown to exhibit a kind of paternalism. No one is innocent here.

    It seems to me like political battles within economics are mostly about naturalizing one's own favored interventions as somehow prior to or otherwise beyond the realm of human decision-making. But as we've seen, nobody's proposals are accurately so characterized. Maybe economics would be more interesting if its practitioners dug deeper into how their own assumptions contribute to the infertility of the intellectual landscape.

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    1. I don't think we need (or should want) any economic justification for state protection of personal property. I shudder at the thought that a government might choose to "legalise" [insert horrendous crime here] on the basis of a cost-benefit analysis. Homo economicus should't have anything to do with jurisprudence and government actions. I wish more economists understood this. Tried morality lately?

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    2. A very Sunsteinian point almost straight out of Lochner's Legacy, if I recall correctly! But as in that article the central import is just that the system of property rights cannot be assumed to be superior to alternate legal systems (e.g. one that has property rights annually redefined by a government agency). Even though you can't assume it, however, there are quite good arguments for it.

      Likewise choice architecture (nudges) is present in any system relating to human decision-making-- your point. Knowing that you still want the best system and there are good arguments that means systems with little chance for government officials having the power to regularly manipulate such choice architecture.

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  7. There is a book called Myth of Rational Voter which basically says that educated peoples with PhDs make generally better decisions than poor people with no PhD. So having those smart guys to install default option in libertarian paternalistic sense (which anyone might costlessly change) might not be that bad idea.

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  8. Good post. Nudge nudge wink wink is about the worst possible direction for economics to take.

    I write to you often about stuff I disagree with in conventional economics(Arrow Debreu). But the solution is to formalize Hayek, Coase, Marshal. Not go off further into another faddish pseudo science.

    Think I may have mentioned that there is no mention of either Hayek or comparative advantage in Mas-Collel or Kreps.

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  9. As Cochrane says, obviously Homo economicus is a valid model if you're trying to explain some questions on human behaviour, such as the effects of raising the price of tomatoes.
    The criticisms of homo economicus from non-economists are not about the models themselves (properly applied), but more from the fact that the model is applied to questions where it does not sufficiently predict behaviour, either because a combination of other (e.g. psychological or sociological) factors are more important, or are important enough to significantly make the results differ from the homo economicus predictions.
    In general this is where economic models are used to predict political or social behaviour on a wide scale, such as 'why people vote for x party'.
    Cochrane says "One could just as easily make fun of psychologists and sociologists for ignoring the rationality of much human decision-making, and price incentives in particular". But again the problem is the breadth of the application, not the models themselves.

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  10. I haven't seen anyone update his most famous paper, that on 3 year mean reversion with DeBondt in '85 and '87. I presume because it simply isn't true, in that momentum at that horizon is stronger. I remember that much of the problem was simply a bias from the low-prices in losers, where the bid-ask effect is prominent (eg, going from 1 to 1 1/2 to 1 shows a positive average monthly return via arithmetic averaging).

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  11. I wonder how things are going with the urinal accuracy project. Could we turn them into target games, with your score posted above? That would bring shame unto the bad marksmen, but it would probably lead to guys wasting time in the men's room.

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  12. Huge resistance in the profession - Herbert Simon won the Nobel prize for his work on behavioral economics in ... 1978.

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  13. I often have this very simple argument with liberals/favorites of paternalism. Why are we so focused on adding more layers of intervention when we have so many failing one's we haven't even begun to peel back. Dodd Frank/Obamacare, let alone the continued trade policies that economists have been shaking their heads over for centuries. I'd prefer we amend/unravel all of those first.

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  14. I don't think the tomatoes case is disputatious. Rather it's wrong to apply complete-markets, infinite-figuring-time is applied all over the map. Let's take bargaining theory as an example. No one is going to argue with you that if one side gets more power then the deal will shift his way. But it would be wrong to assume that this is all there is to negotiation.

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  15. John, I think your frustration here is that people tend to describe markets as completely rational and efficient or completely irrational and inefficient.

    The truth is that markets are constantly gravitating toward efficiency, but information shocks constantly keep markets from ever reaching perfect efficiency.

    With that perspective, economics needs to embrace the reality that when errors in calculation are not distributed in a sum-0 way, we're going to have somewhat persistent inefficiencies, especially with frictions. To that end, understanding psychology on a deeper level is a key to making economics more scientific. After all, most of economics takes ideas about how people think and behave, and extrapolates predictions. The better we understand psychology, the better our economics are.

    On the flip-side, the error that behaviorists make is that markets are never efficient because people have irrationality. Most market-money is managed by professionals, and is subject to arbitrage, so simple behavioral biases are not going to do much. Yes, principal agent problems may arise, but those aren't really irrational.

    In the end, behavioral economics find a bigger role in non-financial economics, such as economics of hiring-firing, saving, crime and so forth. But, when it comes to financial stuff, that can be shorted (unlike employees), it's going to be the rational side that dominates.

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  16. The line about assuming in physics is a perfect example of how we got into this mess: economists don't understand science.

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    1. I think at least one, John Cochrane, (BS Physics, MIT) probably does...

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    2. Pray do tell how economists caused the recession.

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    3. Two questions:

      1. Undergraduate physics major? How much physics is there in the study of human social organization, even the subset of that focused on the exchange of goods and services for money?
      2. Can you tell me what physics class at MIT teaches the following claim: "All sciences and engineering make simplifying assumptions appropriate to the problem at hand."?
      What is he talking about? When does that happen in physics? Elephants and sandpaper? Does he mean using Newton instead of Einstein? Einstein is simpler than Newton, unifying space and time. In biology, what are the simplifying assumptions at work in the mouse model? I know, and do not assume, that both organisms have a heart. When I study the effect of a drug on a mouse's heart, I make no simplifying assumptions in order to gain evidence for or against the use of that drug in humans. What assumptions is he talking about?

      And, Steve O, "this mess" is the fact that economics is intellectually empty, a bunch of Soduku puzzles that use words that refer to the world but revealing relationships that never bear out on examination.

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  17. "...students were happier by rebasing exams to 137 points"

    Of course - it's the reciprocal of the fine structure constant; who wouldn't want their exams based on that?! (OK, dumb physics joke.)

    Great post. If hundreds of NASA managers and engineers could fall into the trap of group think, convincing themselves that there was little risk in launching Challenger in 1986, I am not so sure that we should expect consistent hyper-rationality from a group of bureaucrats.

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  18. Problem with economics is too broad appliance of theories. The government is bad at running economy. We all agree with that. Soviet-style economy is worse than capitalism. But, government does some things better than private capital ever will: ensuring that population gets agreed basic amount of necessary goods/services. Governments broad social programs (like food stamps) generally ensure that over 90% of set money goes to those who need it, and that at least 90% of targeted population is included. No charity can get those numbers, and all the standard bloating of governmental services reduces the percentage of money from 95%+ to 90%+ going to those who need it (barring extreme levels of corruption). Government is also normally more efficient than private capital in organizing military, police, firefighters and health care (US spends twice as much per citizen as Western European states, with similar results), with goal of ensuring broad access to certain level of protection. However clumsy (or worse) Obamacare looks, prices have risen much less than in any projection with or without Obamacare, and more people than ever have access to health insurance.
    Communications industry has shown all the advantages of ending government monopoly. Everybody pays much less and has many more options than would be possible if AT&T stayed the only big player.
    On the other hand, similar attempt to deregulate electrical energy market seems to show many disadvantages of moving from public to private. Deregulation introduced energy markets, and their cost (setting up markets, increasing number of players who need to be paid,...) is assessed at 33% of price of electricity. Deregulation also increased financial risk (removed guaranteed markets) in capital-intensive industry, making it much more expensive to build new power plants.Security and reliability of electricity supply has been lowered. And there are no new, exciting programs, like in communication industry. The difference: communication industry is reasonably elastic, and capital costs for new entrants are not too great. Electrical energy is highly inelastic (no matter what it costs, we need electricity to survive), and capital costs for new entrants are very high, removing one of self-correction mechanisms of the market (if markup is too high, new entrants will force the markup down).

    Another problem with economic theories: people are generally rational in standard everyday things. If price of tomatoes (and only tomatoes) goes up, people will buy less. If price of all foods goes up, people will still have to buy food, but there would be a shift towards cheaper food. But, people are very bad at reacting to sudden shocks. People are bad at assessing risks. People are bad at long-term planning and assessing current vs. future utility. When I say people, I mean any large aggregate of people, there are lots of individuals who are good at those things.
    So, when economic theory assumes rational person for short-term decisions when economy operates steadily, it is mostly correct (certainly within confidence intervals similar to most other "accepted" assumptions). But, when that theory is extended to big shocks, it will underestimate group aversion to risk and group propensity to panic. Similarly, it will overestimate the ability of a group to adequately plan for pension in their early and mid life.
    As some poster above have said, assuming rational agent is not a problem. Assuming that agent can be only always rational or only always irrational is.

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  19. Wouldn't it help if Thaler (and Dan Ariely etc) first defined rationality? Then, we could move on and have meaningful discussion of whether people are rational or not. By the way, in practical terms, most economists seem to understand that rationality means that consumers aren't subject to money pumps. It's not at all clear that in any of Thaler's examples, people are actually irrational.

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  20. Market efficiency depends of the wisdom of crowds. The market will always have the most information, but can go astray when there are correlated biases. Thus, biases and market efficiency are completely consistent, as long as biases are uncorrelated in aggregate. We can have irrational agents and rational markets. This, to me, is one of the key findings of behavioral studies: The invisible hand still (usually) works. Cognitive psychology -- how we think -- is relevant to all fields because it set the limits of understanding. If we can design information dissemination systems that minimize the risk of correlated biases, then behavioral finance will have proven very valuable indeed (fewer bubbles or irrational exuberance/depression).

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  21. This is just a more verbose version of the econ student raising their hand (or *cough* the non-scientific sociology professor lecturing *cough*) and saying "but people aren't always rational."

    The problem is addressing this criticism takes some depth, which you have done here.

    The word rationality, like all word-concepts, is loosely defined. But rationality is in fact a set of epistemic conditions we impose, which is always model based, on optimal actions. It doesn't help that pedantic economists use it to make arguments like Christmas is 'irrational.' When what they are really trying to say is "The utility observed from Christmas does not match one of a model that I created, which has zero parameters for the emotional state and feeling associated with excitement, love, and giving." Is Christmas irrational? No. You're just creating a mis-specified model of rationality

    Same with these events. This author claims we are not rational as economists think we are, but what is rational? How does 'rational' work as a catch-all term? It doesn't. Rationality is a specific model-based mapping of actions and outcomes. When the proposed 'rational model' does not match reality, the result is undefined a priori: Is the model wrong? Or are the people not acting in accordance with their utility maximizing actions? In fact, it's often challenging to find a rigorous way to define what it means for an individual to behave irrationally. And when behaviors play a role in this, why does this ruin 'homo economus'? Where is the rule that says we can't have a behavior parameter?

    Unfortunately, I've only had one professor in undergrad and my masters who ever tried to provide the philosophy-of-science rigor required to define rationality, and even only came about when I kept bugging him in his office hours... (British professors are not as welcoming as American). The rest had to come from reading older theorists and trying to guess what they would say if they took a modern game theory course.

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  22. Markets are not efficient, but that's always the direction of the restoring force.

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  23. Good point but also a lot of ideological dribble. First, it is simply rhetoric to say individuals make better decisions than government, or that government is run by the same irrational people. There is value in finding and implementing policies that make individuals and markets do better. And clearly there are cases in which people are harmed by government policy, but there are cases in which people benefit greatly from government policy. The Fed can make mistakes, but so can Enron and AIG. And both kinds of 'mistakes' impose harm on bystanders, which warrants consideration for regulation.

    Second, libertarianism is nice in theory but it presumes we live in a meritocracy, which we do not. The US is at the bottom of developed nations in terms of economic mobility. We are a class based society, which undermines the idea of libertarianism. Pursuing libertarian policies in a class based society is simply rigging the system because it places greater value and advantage on having wealth. Economists are poor at understanding the underlying social influences that make assuming everyone is identical not only ridiculous but misleading. It matters a great deal that everyone is not equal and does not have equal opportunity.

    Third, markets are efficient based on the metric economists use--surplus. This depends on willingness to pay, but this is largely defined by ability to pay. When allocating resources is based on ability to pay within a class based system that has extreme inequality, it is only efficient in a dubious and unimportant manner.

    Fourth, classic and behavioral economics are not in competition. Classical models made extreme assumptions about behavior because it was necessary for the math to work. Simplifying assumptions that nobody actually believed these assumptions are true. Those assumptions serve us well for the most part, but we must keep in mind the limits of the models due to these assumptions. The problem is that economists began to believe they were true. It became a religion instead of simplifying assumptions that can be relaxed. Behavioral sciences have highlighted how these assumptions matter and advanced our ability to use those models--the simple models and the behavioral insights are complements, not substitutes. The latter enables better use of the former. Using the former without the latter is simply ignorant. The contributions from behavioral economics cannot be denied. Context, which theory ignores, is hugely important--more than price at times. Relative payouts matter, duh. Of course, these and other things were ignored because they are hard. To dismiss behavioral because they haven't done more is ridiculous. They have done much, and should do more, but that is better than assuming away the obvious.

    It is telling that people feel threatened by behavioral insights. One would think they would welcome the knowledge that can improve the power of models instead of trying to dismiss the obvious. But it seems to be a static ideology or religion instead of evolving knowledge to some. Markets are great servants, but they are bad masters and an even worse religion.

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