The Case for Mindless Economics† docx

The Case for Mindless Economics † Faruk Gul and Wolfgang Pesendorfer Princeton Univ ersity November 2005 Abstract Neuroeconomics proposes radical changes in the methods of economics. This essay dis- cusses the proposed chang es in methodology, together with the the neuroeconomic critique of standard economics. We do not assess the cont ributions or promise of neuroeconomic research. Rather, we offer a response to the neuroeconomic critique of standard economics. † This research was supported by grants from the National Science Foundation. We thank Drew Fuden berg and Philipp Sadowski for helpful comments and suggestions. 1. Introduction Neuroeconomics proposes radical changes in the methods of economics. This essay dis- cusses the proposed chang es in methodology, together with the the neuroeconomic critique of standard economics. Our definition of neuroeconomics includes research that makes no specific reference to neuroscience and is traditionally referred to as psychology and eco- nomics.Weidentifyneuroeconomicsasresearch that implicitly or explicitly makes either of the following two claims: Assertion I: Psychological and physiological evidence (such as descriptions of hedonic states and brain processes) are directly relevant to economic theories. In particular, they can be used to support or reject economic models or even economic methodology. Assertion II: What makes individuals happy ( ‘true utility’) differs from what they choose. Economic welfare analysis should use true utility rather than the utilities go verning choice (‘choice utility’). Neuroeconomics goes beyond the common practice of economists to use psycholo gical insights as inspiration for economic modeling or to take into account experimental evidence that challenges behavioral assumptions of economic models. Neuroeconomics appeals di- rectlytotheneuroscienceevidencetorejectstandardeconomicmodelsortoquestion economic constructs. Camerer, Loewenstein and Prelec (2005) (henceforth CLP (2005)) express the neuroeconomics critique as follows: “First, we show that neuroscience findings raise questions about the usefulness of some of the most common constructs that economists commonly use, such as risk aversion, time preference, and altruism.” (p. 31-32) In section 5 of this essay, we argue that Assertion I of the neuroeconomic critique mis- understands economic methodology and underestimates the flexibility of standard models. Economics and psychology address different questions, utilize differen t abstractions, and address differen t types of empirical evidence. Neuroscience evidence cannot refute eco- nomicmodelsbecausethelattermakenoassumptions and draw no conclusions about the physiology of the brain. Co nversely, brain science cannot revolutionize economics because 1 the latter has no vehicle for addressing the concerns of eco nomics. We also argue that the methods of standard economics are much more flexible than it is assumed in the neuroe- conomics critique and illustrate this w ith e xamples of h ow standard economics d eals with inconsistent preferences, mistakes, and biases. Neuroeconomistsimportthequestionsandabstractions of psychology and re-interpret economic models as if their purpose were to address those questions. The standard eco- nomic model of c hoice is treated as a model of the brain and found to be inadequate. Either economics is treated as amateur brain sc ience and rejected as such or brain evidence is treated as economic evidence to reject economic models. Kahneman (1994) asserts that s ubjectivestatesandhedonicutilityare“legitimate topics of study”. This m ay be true, but such states and utilities are not useful f or calibrating and testing standard economic models. Discussions of hedonic experiences play no role in standard econ omic analysis because economics makes n o predictions about them and has no data to test suc h prediction. Economists also lack the means for integrating measurement of hedonic utility with standard economic data. Therefore, they have found it useful to confine themselves to the analysis of the latter. The neuroeconomics program for change in economics ign ores t he fact that economists, even when dealing with questions related to t hose studied in psychology, have different objectives and address different empirical evidence. These fundamental differences are obscured by the tendency of neuroeconomists to describe both disciplines in very broad terms. “Because psycholog y systematically explores human judgement, behavior, well-being it can tea ch us important facts about how humans differ from the w ay traditionally described by economics,” (Rabin (1998)). Note the presumption that across disciplines there is a single set of constructs (or facts) for describing ho w humans are. Rabin omits that economics and psychology study different kinds of behavior a nd, more importantly, focus o n different variables that influence behav- ior. Realistic assumptions and useful abstractions when relating visceral cues to behavior may be less realistic or useful when relating behavior to market variables. Consider the following two s ta tements: 2 “Much aversion to risks is driven by immediate fear respo nses, which are largely trace- able to a small area of the brain called the amygdala;”(Camerer, Loewenstein and Prelec (2004), p. 567 (henceforth CLP (2004)). “A decision-maker is (globally) risk averse, [ ] if and only if his von Neumann- Morgenstern utility is concave at the relevant (all) wealth levels.” Ingersoll (1987). Which of these statemen ts is (m ore) true? Which provides a better understanding of risk aversion? Most researchers recognize the various terms in the second statement as abstractions belonging to the specialized vocabulary of economics. Though less apparen t, the language of the first statement is equally specialized in its use of discipline-specific abstractions. T he terms ‘ immediate fear’ and ‘traceable’ are abstractions of psychology and neuroscience. Moreover, the term ‘risk aversion’ represents adifferent abstraction in the two statements above. For Ingersoll, risk aversion is an attitude towards monetary gambles. For C LP (2004), risk aversion seems to be a much broader term that is readily applied to decisions involving plane travel. It makes little sense to insist that the economic notion of risk aversion is false while the psychological notion is true. We discuss Assertion (II) of the neuroeconomic critique in section 6. We argue that the assertion misunderstands the role of welfare analysis in economics. Standard economics identifies welfare w ith choice, i.e., a change (in consumption) is defined to be w elfare improving if and only if, given the opportunity, the individual w ould choose to make that change. The neuroeconomic critique of standard welfare analysis mistakes the economic definition of welfare for a theory of happiness and proceeds to find evidence against that theory. The standard definition of welfare is appropriate because standard economics has no therapeutic ambition; it does not try to improve the decision-maker but tries to evaluate how economic institutions mediate (perhaps psychologically unhealthy) behavior of agents. Standard w elfare economics functions as a part of positive economics. It provides a benchmark for the performance of economic institutions at aggregating individual prefer- ences. Economists use welfare analysis to explain the persistence of som e (efficient) insti- tutions or to identify problems and anomalies in models of other (inefficient) institutions. For example, observing that an existing institution leads to Pareto efficien t outcomes may increase the researcher’s confidence in his model, while noting that the institution leads 3 to Pareto inefficiency may lead researchers to seek explanations for the persistence of that institution. Within this conception of welfare economics, what is relevant are the agents’ interests (or preferences) as perceived by the agents themselves. An i nstitution’s effective- ness at maximizing the true happiness of its participants cannot justify the persistence of that institution if the criterion for true happiness conflicts with the participants’ revealed preferences. After all, only the latter plays a role in behavior. Neuroeconomists expect recent developments in psychology and brain science to yield answers to age-old philosophical questions such as “what is happiness?”; “should we be willing to take actions contrary to a person’s wishes if we happen to know that such actions will make them happier?” andinsistonanewnotionofwelfarebasedontheseanswers. Perhaps a therapist or a medical professional is guided b y his answers to the two ques- tions above; he ma y fashion his advice to advance the perceived objectives of the patient or to increase the patient’s true happiness, as defined by the therapist himself. 1 Neu- roeconomic welfare analysis assumes a relationship between the economi st and economic agents similar to the therapist-patien t relationship. Normative economics is therefore iden- tified with effective therapy. The economist/therapist can influence individuals’ happiness by dispensing compelling advice or by influencing the decisions of pow erful (and perhaps paternalistic) intermediaries. For example, Kahneman (1994) suggests that there is “ a case in favour of some paternalistic interventions, when it is plausible that the state knows more about an individual’s future tastes than the individual knows presently.” Hence, the goal of welfare economics and perhaps the goal of all economics is to affect changes that result in greater happiness to all. In this endeavor neuroeconomists plan to enlist the support of the state — a stand-in for a benign therapist — who may, on occasion, conceal facts and m ake decisions on behalf of the individual’s future selv es. Neuroeconomists seek a welfare criterion that is appropriate f or an economist who is part social scientist and part advocate/therapist; someone who not only analyzes economic 1 This description might over-state the therapist discretion. Either a professional code or market forces ma y limit the extent to w hich he can pursue the patient’s true h appiness. Hence, the two philosophical questions above may or may not have s ome relevance to the therapist. O ur contention is that they have none for economists. 4 phenomena but also plays a role in shaping them. Neuroeconomists assert that the stan- dard economic w elfare criterion is not adequate for this task. Our response to this criticism is simple: the standard welfare criterion is not intended to facilitate advocacy for therapeu- tic interventions. T he standard approach assumes a separation between the economist’s roleassocialscientistandtherolethatsomeeconomistsmayplayasadvisorsoradvocates. This separation is valuable because it enables economists to analyze and compare different institutions without having to agree on the answers to difficult philosophical questions. Besides the t wo assertions stated above, neuroeconomists pose an additional chal- lenge to standard economics: they argue that economics should take advantage of recent improvements in neuroscience, in particular, improvements in measurements. They claim that these improvements may facilitate the unification of economics and brain science: “This ‘rational choice’ approach has been enormously successful. But now advances in genetics and brain imaging (and other techniques) have made it possible to observe detailed processes in the brain better than ever before. Brain scanning (ongoing at the new Broad Imaging Center at Caltech) shows which parts of the brain are active when people make economic decisions. This means that we will eventually be able to replace the simple mathematical ideas that have been used in economics with more neurally-detailed descriptions.” Camerer ( 2005). We discuss the unification argument in section 7. Our main point is that the separation of economics and brain science is a consequence of specialization around different questions and differen t data; it has little to do with technological limitations in measuring brain activity. T herefore, there is no reason to expect improvements in such technologies to lead to a unification. In this essay, we do not assess the contributions or promise of neuroeconomic research. Instead, we offer a response to the neuroeconom ic critique of s tandard economics. Our conclusion is that the neuroeconomic critique fails to refute an y particular (standard) economic model and offers no challenge to standard economic methodology. Inthenextsection,wedefine the standard approac h (or standard economics) and the neuroeconomics approach. In section 3, we discuss how the different goals of psychology and of economics necessitate different abstra ctions. As an example, we contrast the eco- nomic concepts of “complements” and “externalities” with the psychological concept of a 5 “cue.” In s ection 4, we present an example o f each approach to illustrate our classifica- tion and highlight the differences in the concerns and abstractions of standard economics and neuroeconomics. In sections 5, 6, and 7 we discuss the three main arguments of the neuroeconomics critique. Section 8 c ontains our closing remarks. 2. The Two Approaches: Definitions and Objectives 2.1 Standard Economics The standard approach to behavioral economics extends standard ch oice theoretic methods to analyze variables that are often ignored. Some of these extensions are modest and entail little more than specifying a richer set of preferences over the same economic consequences. Others necessitate novel descriptions of the relevant economic outcomes. Yet, in most cases, the subsequent analysis is very similar to what can be found in a standard graduate textbook. In the standard approach, the term utility m aximization and choice are synonymous. A utility function is alwa y s an ordinal index that describes how the individual ranks various outcomes and how he behaves (chooses) given his constraints (available options). The relevant data are revealed preference data; that is, consumption choices given the individual’s constraints. These data are used to calibrate the model (i.e., to identify the particular parameters) and the resulting calibrated models are used to predict future choices and perhaps equilibrium variables suc h as prices. Hence, standard (positive) theory identifies choice parameters from past behavior a nd relates these parameters to future behavior and equilibrium variables. Standard economics focuses on revealed preference because economic data come in thisform. Economicdatacan—atbest—revealwhattheagentwants(orhaschosen) in a particular situation. Such data do not enable the economist to distinguish between what the agent intended to choose an d what h e ended up choosing; what he chose and what he ought to ha ve chosen. The standard approach provides n o methods for utilizing non-choice data to calibrate preference parameters. The individual’s coefficient of risk aversion, for example, cannot be iden ti fied through a physiological examination; it can only be revealed through choice behavior. If an economist proposes a new theory based on 6 non-choice evidence then either the new theory leads to nov el behavioral predictions, in which case it can be tested with revea led preference evidence, or it does not, in which case the modification is vacuous. In stand ard economics, the testable implications of a theory are its con tent; once they are identified, the non-choice evidence that motivated a novel theory becomes irreleva nt. As its welfare criterion, standard economic s uses the individuals’ choice behavior, that is, revealed preferences. Alternative x is deemed to be better than alternative y if and only if, given the opportunity, the individual would choose x over y. 2 Hence, welfare is defined to be synonymous with choice behavior. In standard economics, an individual’s decisions may improve when a constraint is relaxed. For example, an agent may make better decisions if he is given better information, more resources, or more time to make his decision. However, standard economics has no therapeutic ambition, i.e., it does not try to evaluate or impro ve the individual’s objectives. Economics c annot distinguish between choices that maximize happiness, choices that reflect a s ense of duty, or choices that are the response to som e impulse. Moreover, standard economics takes no position on the question o f which of those objectives the agent s hould pursue. The purpose of economics is to analyze i nstitutions, such as trading mechanisms and organization structures, and to ask how those institutions mediate the interests of dif- ferenteconomicagents. Thisanalysisisuseful irrespectiv e of the causes o f individuals’ preferences. Standard economics ignores the therapeutic potential of economic policies and leaves it to therapists, medical professionals, and financial advisors to help i ndividuals refine their goals. 2.2 Neuroeconomics “‘This new approach, which I consider a revolution, should provide a theory of how people decide in economic and strategic situations,’ said Dr. Aldo Rustichini, an 2 The welfa re statement is made relativ e to the constraints the agent faces. For example, the agent ma y be imperfectly informed of the consequences of his actions. In that case, the c hoice of x is welfare maximizing given the agent’s information. If the agent had better information, he might choose y and hence y is the welfare maximizing c h oice for a better informed agent. See our discussion of mistakes in Section 5.1. 7 economics professor at the University of Minnesota. ‘So far, the decision process has been for economists a black box.’” 3 Later, in the same article, the auth or explains that “In a study published in the current issue of the journal Science, Dr. Cohen and his colleagues,includingDr.AlanG.SanfeyofPrinceton,tookimagesofpeople’sbrains as they played the ultimatum game, a test of fairness be tween two people. In the ultimatum game, the first player is given, say, £10 in cash. He must then decide how muchtogivetoasecondplayer. Itcouldbe£5,thefairestoffer, or a lesser amount depending on what he thinks he can get away with. If Player 2 accepts the offer, the money is shared accordingly. But if he rejects it, both players go away empty-handed. It is a one-shot game, a nd the players never meet again. Most people in the shoes of Player 2 refuse to take amounts under £2 or £3, Dr. Cohen said. They would rather punish the first player than feel cheated. ‘But this makes no economic sense,’ he said. ‘You’re better off with something than nothing.’” As the quotes above illustrate, neuroeconomics emphasizes the physiological and psycho- logical processes underlying decision-making. Theobjectiveistorelatethedecision-making process to physiological processes i n the brai n or to descriptions of emotional experiences. From its predecessor, psychology and economics, 4 neuroeconomics inherits the idea of modeling the decision-maker as a collection of biases and heuristics susceptible to system- atic errors (effects) and inconsistencies (reversals). Hedonic utilities (true utilities) are primitives, defined independently of behavior, while behavior is determined by biases and heuristics. The focus is on showing how factors that have no effect on these true utilities—or at least affect these utilities in a man ner that is ignored by standard economics—influence behavior. Neuroeconomics is therapeutic in its amb itions: it tr ies to improve an individual’s objectives. The central questions of neuroeconomists are: How do individuals make their c hoices? How effective are they at making the choices that increase their own w ellbeing? By con trast, economists analyze how the choices of different individuals interact within a particular institutionalsetting,giventheirdiffering objectives. 3 “Brain Experts Now Follow the Money,” by Sandra Blak eslee, New York Times, June 17, 2003. 4 This line of inquiry is often referred to as behavioral economics. We have avoided using this term, in order to distinguish it from standard economics models that deal with similar behavioral issues. 8 3. Different Objectives Demand Different Abstractions Neuroeconomistsarguethatthetimeisripeforthemethodologyofeconomicsto be brought in line with the methods and ideas of psych ology and neuroscience. The neuroeconomic critique begins with the implicit or explicit assumption that economics, psychology and possibly other social sciences all address the same set of questi ons and differ only with respect to the answers they provide: “More ambitiously, students are often bewildered that the models of human nature of- fered in different social sciences are so di fferent, and often contradictory. Economists emphasize rationality; psychologists emphasize cognitive limits and sensitivity of choi- ces to contexts; anthropologists emphasize acculturation; and sociologists emphasize norms and social constraint. An identical question on a final exam in each of the fields about trust, for example, would have different “correct” answers in each of the fields. It is possible that a biological basis for behavior in neuroscience, perhaps com- bined with all-purpose tools like learning models or game theory, could provide some unification across the social sciences (cf. Gintis, 2003).” CLP (2004) p. 572-3. Contrary to the view expressed in the q uoted paragraph, economics and psychology do not offer competing, all-purpose models of human nature. Nor do they offer all-purpose tools. Rather, each discipline uses specialized abstractions that have proven useful for that discipline. Not only is the word trust much less lik ely to come up in an economics exam than in a psychology exam, but when it does appear in an economics exam, it means something different and is associated with a different question, not just a different answer. Far from being an all-purpose tool, game theory is a formalism for stripping away all strategically irrelevant details of the context, details that Gin tis describes as central for psychologists. Similarly, a learning model in economics is different than a learning model in psychology. For an economist, a theory of learning might be a process of Bay esian inference in a multi-armed bandit model. This theory of learning is useful for addressing economic phenomena such as patent races but may be inappropriate for cognitive psychologists. Once the goals of economics and psychology are stated in a manner that mak es it seem as if the two disciplines address the sam e questions and deal with the sa me empirical 9 [...]... alerts the American tourist to ‘look right’ alters the decision even though such a sign does not change the set of alternatives The standard model can incorporate this effect by assuming that the sign changes the set of feasible strategies for the tourist and thereby alters the decision With the help of the sign, the tourist may be able to implement the strategy “always look right then go” while without the. .. axioms is to summarize the empirical content of the theory independently of the specific application The generality of the representation theorem, the usefulness of the key parameters, the ease with which the parameters can be measured and, most importantly, the empirical success of the model at dealing with economic evidence determine the extent to which the theory succeeds Kreps-Porteus’s model has been... just like forks and knives Forks do not generate a craving for knives and therefore psychologists would not consider the fork/knife complementarity to be the same phenomenon as the hamburger/fries complementarity For economists the physiological distinction between the two examples is unimportant What matters is that demand for those goods responds in a similar way to price changes Another form of complementarities... models because the latter make no assumptions or draw no conclusions about physiology of the brain Conversely, brain science cannot revolutionize economics because it has no vehicle for addressing the concerns of the latter Economics and psychology differ in the question they ask Therefore, abstractions that are useful for one discipline will typically be not very useful for the other The concepts of... of an externality that causes a shift in the demand for a good For psychologists, the craving for drugs by seeing drug-dealers in the neighborhood is similar to the craving for cigarettes caused by drinking coffee On the other hand, they would consider it absurd to describe the car buying example and drug addiction example as being the same phenomenon because the underlying psychological mechanisms are... situation, as in the situation of the pure profit maximizing employer, there is no role for the TS principles The TS argument amounts to telling employers that when they face incomplete information they should adopt a different objective Standard economics would predict that employers will take the best action given their own objectives and given what they know about the preferences of the employees In... preference for early resolution of uncertainty is anxiety But there could be many other reasons for a preference for early resolution of uncertainty Suppose, for example, the agent owns a lottery ticket that will either yield a large reward (with small probability) or nothing Prior to the lottery drawing, the agent must decide which car to purchase The outcome of the lottery will typically affect the optimal... asymmetrically informed Hence, standard economics deals with ‘mistakes’ by employing the tool of information economics Consider the following thought experiment A prize ($100) is placed either in a red or in a blue box and the agent knows that there is a 60% chance that the money is in the red box Confronted with a choice between the two boxes, the agent chooses the red box An observer who has seen that the money... z∈Z ! u(z)p(z) ν(p) The formula above applies the standard expected utility formula twice The term in brackets is the expected utility formula for lotteries that resolve at date 2 whereas the outer term is the expected utility formula for lotteries that resolve at date 1 The Kreps-Porteus formalism yields a precise definition of a new phenomenon: preference for early (or late) resolution of uncertainty... would force people to make their choices explicit.” Finally, the libertarian paternalist might select the approach that minimizes the number of opt-outs.” TS offer no arguments for why their principles are likely to lead to greater happiness In fact, they offer no defense of these principles They simply say that the libertarian paternalist might choose to use them 33 The fact that the TS principles are not . standard economic data. Therefore, they have found it useful to confine themselves to the analysis of the latter. The neuroeconomics program for change in economics. ≥ X D 2 W Ã X z∈Z u(z)p(z) ! ν(p) The formula above applies the standa rd expected utility formula twice. The term in brackets is the expected utility formula for lotteries