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30 April 2007Ec 101: Topics in Behavioral EconomicsProf. Colin Camerer office Baxter [email protected] Mon 7-10 pm Baxter 25TA’s: Meghana Bhatt ([email protected]), David Young ([email protected])http://www.hss.caltech.edu/~camerer/Ec101.htm“All economics rests on some sort of implicit psychology. The only question is whether the implicit psychology is good or bad. We think it is simply unwise, and inefficient, to do economics without paying some attention to good psychology”Colin Camerer and George Loewenstein [2002, Advances in Behavioral Economics intro]The interface of psychology and economics has a long history. In 19th century social science the two were indistinguishable. Economics books now considered classics (Adam Smith,Marshall, Fisher, Edgeworth) were filled with psychological insight and did not insist agents were always rational (in the sense of foresightful utility-maximization) or self-interested. Early in this century, however, the two disciplines took different methodological paths. While both economics and psychology were inspired by empirical and theoretical methods in physical and natural sciences, they took different routes. Psychologists began to use experimentsto chart the details of how people think and behave, but did not seek to express theories in parsimonious mathematical terms. Economists turned to highly simplified models of individual agents as building blocks for theories of markets (general equilibrium) and strategic behavior (game theory). (One view is that psychology emulated biology, accumulating carefully-documented facts that were organized under broad themes, while economics aspired to be like a physics of social life (or as Edgeworth named his book, “Mathematical psychics”).)This course will describe a modern attempt to draw the disciplines back together, called "behavioral economics", which incorporates psychological regularities into economics while being formal, and predictive. The idea is to retain much of the basic style of neoclassical economic reasoning and modelling, but generalize conventional models to allow patterns of behavior that appear to be common but are paradoxical for conventional models based on strong assumptions of rationality and equilibrium. Loosely speaking, behavioral economics means refusing to keep a straight face when implausible assumptions are made purely for the sake of tractability (without a conscientious, empirically-based search for better assumptions that might turn out to be tractable with a little more thought). Specifically, we assume people are limited in their self-interest, willpower, and calculating ability (including foresight, and knowledge of their own preferences).Note that relaxing the assumption of perfect (unlimited) rationality simply follows in the footsteps of earlier developments in economic theory, relaxing perfect competition to allow imperfect competition (spawning a huge, useful literature in industrial organization etc.), and later relaxing perfect information to allow imperfect information (cf. the Akerlof-Spence-Stiglitz 2001 Nobel prize). Since these generalizations are now widely-accepted, why not do the same for the constraint on perfect rationality? 1Some papers start with an obvious assumption about limited rationality and see what follows. For example, if people are tempted by nearby rewards (exhibiting "present bias" etc) what does that imply for savings-consumption decisions? If attention is limited, what follows? Ifvery low probabilities are overweighted, what follows? In most cases, behavioral economics modelling is motivated by an applied problem or phenomenon, like: Why do stock prices sometimes underreact to information and sometimes overreact? Why do people in "ultimatum games" reject substantial offers, and how can their apparent expressions of social preference be included in economic theorizing? Why do people succumb to immediate temptations which they later regret? How does equilibration occur through processes of individual learning, evolutionary selection, or imitation? Because the modelling is meant to substitute more realistic assumptions for less realistic ones, modelling often proceeds from the top (or middle) down, rather than trying to start at the most basic foundational assumptions about knowledge and inference and work up. As a result, the idea is not always to create the most general possible theory (i.e. to show what broad behavior follows from the weakest, most general assumptions), although such exercises are certainly useful. Instead, the assumptions that are chosen are deliberately restricted to fit data better than more general ones. Obviously, the two approaches should be complementary-- sometimes more foundational work provides startling insight (e.g., the no-trade theorems) and tools to do middlebrow theory with; and hopefully observations encapsulated in middlebrow theory sometimes inspire serious theorists to think about foundational issues (e.g., it would be interesting to know what basic assumption about knowledge is consistent with widespread optimism about relative skill). The first day I will provide an overview of methodological and substantive differences in economics and psychology, and give a sample of ideas from a couple of areas. The topics to be covered after that fall into several categories. Each will be covered [tentatively] in one week, with some time at the end for revisiting rich topics and adding applications or topics which are popularly acclaimed. Notice that while the categories are mostly organized on the basis of phenomena, the range of applications is very wide (e.g., consumer choice, finance, microfoundations of macro-- savings/consumption models, game theory, labor). As you read the papers you should focus on the following:1. What first motivated the papers (earlier research, a policy question, a puzzling empirical fact…). 2. How do their assumptions relate to psychological regularities (or if it is not a theory paper, what regularities it reports or uses)? Give enough detail on the formalism and the intuition it captures or generates to be able to judge its surprise value and generality, but don't lose sight of the broader question. 3. Do you believe their explanation and results? If not, why not? 4. Think about what future research (particularly empirical tests) the paper inspires. As you learn you should be constantly thinking about various themes that will come up


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