Home > Old Paradigm Economics > Preferences that make economic models explode

Preferences that make economic models explode

from Lars Syll

Commenting on experiments — showing time-preferences-switching framing effects — performed by experimental economist David Eil, Noah Smith writes:

Now, here’s the thing…it gets worse … I’ve heard whispers that a number of researchers have done experiments in which choices can be re-framed in order to obtain the dreaded negative time preferences, where people actually care more about the future than the present! Negative time preferences would cause most of our economic models to explode, and if these preferences can be created with simple re-framing, then it bodes ill for the entire project of trying to model individuals’ choices over time.

valuefunction

This matters a lot for finance research. One of the big questions facing finance researchers is why asset prices bounce around so much. The two most common answers are A) time-varying risk premia, and B) behavioral “sentiment”. But Eil’s result, and other results like it, could be bad news for both efficient-market theory and behavioral finance. Because if aggregate preferences themselves are unstable due to a host of different framing effects, then time-varying risk premia can’t be modeled in any intelligible way, nor can behavioral sentiment be measured. In other words, the behavior of asset prices may truly be inexplicable (since we can’t observe all the multitude of things that might cause framing effects).

It’s a scary thought to contemplate, but to dismiss the results of experiments like Eil’s would be a mistake! It may turn out that the whole way modern economics models human behavior is good only in some situations, and not in others.

Bad news indeed. But hardly new.

In neoclassical theory preferences are standardly expressed in the form of a utility function. But although the expected utility theory has been known for a long time to be both theoretically and descriptively inadequate, neoclassical economists all over the world gladly continue to use it, as though its deficiencies were unknown or unheard of.

What most of them try to do in face of the obvious theoretical and behavioural inadequacies of the expected utility theory, is to marginally mend it. But that cannot be the right attitude when facing scientific anomalies. When models are plainly wrong, you’d better replace them! As Matthew Rabin and Richard Thaler have it in Risk Aversion:

It is time for economists to recognize that expected utility is an ex-hypothesis, so that we can concentrate our energies on the important task of developing better descriptive models of choice under uncertainty.

In his modern classic Risk Aversion and Expected-Utility Theory: A Calibration Theorem Matthew Rabin  writes:

Using expected-utility theory, economists model risk aversion as arising solely because the utility function over wealth is concave. This diminishing-marginal-utility-of-wealth theory of risk aversion is psychologically intuitive, and surely helps explain some of our aversion to large-scale risk: We dislike vast uncertainty in lifetime wealth because a dollar that helps us avoid poverty is more valuable than a dollar that helps us become very rich.

Yet this theory also implies that people are approximately risk neutral when stakes are small … While most economists understand this formal limit result, fewer appreciate that the approximate risk-neutrality prediction holds not just for negligible stakes, but for quite sizable and economically important stakes. Economists often invoke expected-utility theory to explain substantial (observed or posited) risk aversion over stakes where the theory actually predicts virtual risk neutrality.While not broadly appreciated, the inability of expected-utility theory to provide a plausible account of risk aversion over modest stakes has become oral tradition among some subsets of researchers, and has been illustrated in writing in a variety of different contexts using standard utility functions …

Expected-utility theory is manifestly not close to the right explanation of risk attitudes over modest stakes. Moreover, when the specific structure of expected-utility theory is used to analyze situations involving modest stakes — such as in research that assumes that large-stake and modest-stake risk attitudes derive from the same utility-for-wealth function — it can be very misleading.

In a similar vein, Daniel Kahneman writes — in Thinking, Fast and Slow — that expected utility theory is seriously flawed since it doesn’t take into consideration the basic fact that people’s choices are influenced by changes in their wealth. Where standard microeconomic theory assumes that preferences are stable over time, Kahneman and other behavioural economists have forcefully again and again shown that preferences aren’t fixed, but vary with different reference points. How can a theory that doesn’t allow for people having different reference points from which they consider their options have an almost axiomatic status within economic theory?

The mystery is how a conception of the utility of outcomes that is vulnerable to such obvious counterexamples survived for so long. I can explain it only by a weakness of the scholarly mind … I call it theory-induced blindness: once you have accepted a theory and used it as a tool in your thinking it is extraordinarily difficult to notice its flaws … You give the theory the benefit of the doubt, trusting the community of experts who have accepted it … But they did not pursue the idea to the point of saying, “This theory is seriously wrong because it ignores the fact that utility depends on the history of one’s wealth, not only present wealth.”

The works of people like Rabin, Thaler and Kahneman, show that expected utility theory is indeed transmogrifying truth. It’s an “ex-hypthesis”  – or as Monty Python has it:

ex-Parrot

This parrot is no more! He has ceased to be! ‘E’s expired and gone to meet ‘is maker! ‘E’s a stiff! Bereft of life, ‘e rests in peace! If you hadn’t nailed ‘im to the perch ‘e’d be pushing up the daisies! ‘Is metabolic processes are now ‘istory! ‘E’s off the twig! ‘E’s kicked the bucket, ‘e’s shuffled off ‘is mortal coil, run down the curtain and joined the bleedin’ choir invisible!! THIS IS AN EX-PARROT!!

  1. Marko
    February 4, 2014 at 1:51 pm

    “THIS IS AN EX-PARROT!!”

    Haha. I love it. That should become the standard put-down used by all respectable economist-bashers.

    ( “ex-hypthesis” – this one also has promise , was it a typo ? Economists love to brag about the newest hip thesis , which soon becomes an over-hyped thesis. )

  2. BFWR
    February 4, 2014 at 3:54 pm

    Money is basically accounting, and most basically cost accounting. Until you stabilize/balance money there will be negative/unstable economic effects. You can create a monetary state of equilibrium….at a relatively flexible kind of lifestyle you care to be expressed in the particular nation you’re sovereignly creating it in. It’s entirely a matter of perspective. The nation’s present wealth and productive capabilities is a good baseline upon which to ADD to the individual’s guaranteed ability to purchase. Then all you have to do is periodically and mathematically equate individual purchasing power and prices…macro-economically. Considering that money is actually and best a tool rather than a commodity, and our ability to produce is abundant thanks to our technological capabilities, monetary abundance is more reflective of present reality and an engineer’s perspective on creating and mathematically maintaining a relative abundance of it is hence more realistic and conducive of individual freedom….than an enforced scarcity of same out of either the dominance of some elite and/or a mistaken ideology of austerity/refusal to confront technological/productive capability. Which concept is more relevant to individual freedom and reflective of actual productive capability….abundance or scarcity?

  3. February 4, 2014 at 4:43 pm

    The chickens are coming home to roost! It’s time to ditch the notion of unobservable utility. May I suggest two working papers that deal with this matter: 1) “Walrasian Solutions Without Utility Function”, EERI Research Paper Series, EERI-RP-2008-17. Econ. & Econometrics Research Inst. EERI, Brussels; 2) Explaining the Logic of Pure Preference in a Neurodynamic Structure” MPRA Paper 5283, Univ. Library of Munich, Germany.

  4. February 4, 2014 at 10:54 pm

    Hat dies auf Employment Relations rebloggt und kommentierte:
    Thanks to Lars Syll for this great post.

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