Behavioural Economics and the Rationality Assumption in Economics

Inspired by The Price Is Too Damn High, Canadian Edition and Frances' post on behavioural economics.

There is a temptation for non-economists to answer any question that puzzles economists by simply declaring "people are irrational!"

"Why are prices so much higher in Canada?"

"PEOPLE ARE IRRATIONAL!"

"What explains the equity premium puzzle?"

"PEOPLE ARE IRRATIONAL!" etc.

There are two reasons why the rationality assumption is popular in economic modelling:

1. It works an awful lot of the time, in that it is a good predictor of human behaviour.
2. It provides models which are falsifiable.

I will explain with the use of an example.  Suppose consumers are choosing between five options: A, B, C, D, E.  Given what we know about consumer preferences, costs, and benefits, we predict that consumers should always choose A.  However, it turns out only 80% of the time they are choosing A, and 20% of the time they are choosing B.

If we assume consumers are rational, then there must be some cost to choosing A or some benefit to choosing B that we have not accounted for.  We can find candidates for that cost/benefit and test if it makes a difference.  If we believe there's a factor X that is a hidden cost to choosing A, we can compare situations where factor X exists and where it doesn't.  If our theory is correct, we should expect to see consumers choose A when the factor is not in play, but choose B to a much greater degree when it is in play.  This provides the falsifiability we need - we can actually test our theory.  We can use a number of methods - we can run laboratory experiments or we can collect data from real-world situations where the cost is both present and not present.

Contrast this with simply saying "people are irrational!".  There's no insight, plus there is no falsifiability - it "explains" everything.

If we want to introduce non-rational behaviour, we need to be specific and we need our explanation to be falsifiable.  In our A, B, C, D, E example, there could be explanations such as:

• The number of options overwhelm consumers, and causes them to make a mistake.
• One or more of C, D, E is providing some form of framing effect that makes B appear more attractive than it actually is.

If we have a framing effect, replacing one of 'C', 'D' or 'E' with 'F' should reduce the frequency of people choosing 'B'.  If this is not occuring, then we can conclude that it is not a framing effect.  We could then try removing one of 'C', 'D', or 'E' and see what that does to the frequency of people choosing 'B'.  This provides us with the falsifiability we require.  We also have discovered not just that people are irrational, but something about the ways people make a decision.

Caveat: I happen to agree with my former Professor Jeff Smith when he states: 

Fourth, it irritates me when people equate rational behavior with an assumption of costless information processing. It seems to me that the correct way to proceed is to incorporate a cognitive budget constraint into the optimization problem. It is hardly rational to spend huge amounts of costly cognitive resources to solve some problem when a quick, cheap but slightly wrong heuristic is available Our models should reflect this and, more broadly, we should not treat clearly irrational behavior as the benchmark of rationality. This requires learning a bit of psychology and/or neuroscience in order to get the budget constraint right. 

A fair bit of what might be classified as 'irrational' behaviour is simply useful heuristics that occasionally fail.  As such, I think the border between rational behaviour and irrational behaviour is very blurry.

When building our models, the distinction between rational and irrational is irrelevant.  What matters is that are models are a good predictor of human behaviour and they are falsifiable.

Comments

[Stephen Gordon]

Yeah. My inner Bayesian econometrician also says that model evaluation exercises based on testing a fully-worked-out model against an unspecified alternative are pointless.

[Chris J]

One of the insights of BE is the default-choice becomes more popular than it should. Therefore BE predicts that given a distribution of choices the default will be taken more. This is quantitative.

Framing effects are, at least in popular BE books, considered BE. Ariely wrote up why the economist offers a print-only subscription for exactly the same cost as the "print + web" subscription.

Simply saying "people are irrational" is a cop out and not BE. Investigating quantitatively the psychological, social and cultural forces that have people behave in a way not in their immediate economic self interest is BE.

[david]

Nonapples:

To paraphrase:

So when you stand up and shout: "Aha! I've got it! We've got to solve this problem using irrationality!", it's like shouting, "Aha! I've got it! We need to build this wagon out of nonwood! Let's go down to the market and buy a ton of nonwood from the nonwood shop!" You've got to choose some specific alternative to rationality.

As Robin Hanson points out, this is indeed a common scourge of the econ.

[White Rabbit]

I think we should mention the theory of rational expectations - which is often debunked via "people are irrational!" claims.

The theory of rational expectations is clearly contrary to real-world evidence and should be thrown away, but irrationality is not the only alternative of it: more complex, stateful forms of rationality, such as the one described by you.

[White Rabbit]

Another very important argument is that an individual human's behaviour, like the behaviour of our neurons, is fundamentally stochastic.

So they might choose product B not because they were mistaken in their judgement in a repeatable way - they chose it just due to the sheer randomness that is so inherent in any complex biological living being's daily actions.

This will also happen with products that have similar qualities: the less differentiation the noisier the end result.

[Stephen Gordon]

The theory of rational expectations is clearly contrary to real-world evidence and should be thrown away

The confidence with which these sorts of assertions are made sometimes takes my breath away. It's not a *perfect* representation of behaviour, sure. But 'clearly contrary to real-world evidence'? And thrown away in favour of what, precisely?

[Oliver]

define 'rational'

[Stephen Gordon]

I'm leery of definitions that must be true always and everywhere; definitions are never 'right', they are at best useful, and always depend on context.

Generally, the way economists use the rationality assumption is if the agent's goal is X, and if A will achieve that goal, then she will choose A.

*Lots* of wiggle room there. What if A achieves X plus a small error term? What were the other choices? Etc.

[Oliver]

I was trying to say that it isn't necessarily people who behave irrationally, but economists' models that can't capture the complexity of human behaviour and their interdependencies (fallacies of composition, etc) and thus spout out an error message that reads: does not compute: irrational, whenever something hapens that wasn't previously accounted for. That doesn't necessarily mean it's irrational, though, whichever way you define the word.

[RC]

I agree with the spirit of the post. Rationality itself however still explains too much. It is not falsifiable. It must be coupled with stable preferences, for example, to get a useful (i.e. falsifiable) theory.

PS: the usual definition of "rational" is: a complete and transitive preference ordering.

[Stephen Gordon]

No-one - and especially no economist - is surprised when the difference between a model's prediction and reality is greater than machine epsilon.

[Min]

Stephen Gordon: "Generally, the way economists use the rationality assumption is if the agent's goal is X, and if A will achieve that goal, then she will choose A."

Instrumental rationality. But my impression is that economists also assume that certain goals are rational or irrational. Is that not so? Thanks. :)

[Stephen Gordon]

That doesn't sound right to me. Did you have an example in mind?

[Stephen Gordon]

It must be coupled with stable preferences, for example, to get a useful (i.e. falsifiable) theory.

Or at least, preferences that evolve in a predictable way.

[Min]

Stephen Gordon: "Did you have an example in mind?"

I guess that is to me.

OK, how about Determinant's post about colleges in the previous thread?

Determinant: "It has been the trend in Canadian universities to guarantee a room to First-years. First-Year Experience and all that. It's advertising. Once they have you enrolled and since transferring universities isn't easy, they don't care about your living arrangements. Hence the move to reserve 80% of residence beds for Frosh. Upper-years were left to seek off-campus accommodation.

"Having seen the operation of university advertising and all the first-year gimmicks in person, I can say that once they have your tuition fees, they stop caring about you so much. It really is that venal."

To which I responded: "Venal? You mean rational, right? ;)"

It is my impression that economists in general would say that the behavior that Determinant calls venal is actually rational, and that, in fact, for a college to behave differently would be irrational. That is, they would not say that for a college to behave differently would be rational, assuming different values, such as those Determinant holds. My impression is that economic rationality is value-laden, not simply instrumental.

[DavidN]

Rationality is one of those words I wish economists never decided to use (others include welfare and price ‘discrimination’) because it means different things to different people and often as not laypersons conflate the word with it’s everyday use. With respect to it’s use in BE, I think instead of ‘rational’ and ‘irrational’, it’s better to say utility functions that include cognitive biases or not. I feel it’s also important to emphasise to the extent that economists are able to be show that individuals exhibit cognitive biases doesn’t necessitate that it’s a ‘bad’ characteristics, and I feel any conclusions that implies that is a normative statement rather than a positive one.

With respect to rational choice theory, I like to think of it as simply a framework/tool that assumes people are predictable, as in it assumes people have utility functions, u(x), and behaviour is dictated by the function and it’s argument(s). We can all quibble about the shape of function, whether it’s stochastic or deterministic, includes cognitive biases or not, but at end of the day if we can’t make this assumption we have to concede that people in fact aren't predictable. So in that sense I agree with Mike that the implications of the model are naturally falsifiable, but the framework/paradigm doesn’t need to be, hence (preempting an argument) I don’t agree with any of the rebuttals often made about economic theory that assuming people are ‘rational’ is unrealistic or ‘bad’ and therefore any conclusions based on the ‘rationality’ premise is worthless or wrong. To draw an analogy (this might be a bad idea because I don’t really know anything about physics except at 101 level), given the state of technology we don’t really know if gravitational or electromagnetic fields exist, we can only verify them empirically, the fact we assume those fields just exist and are ‘invisible’ doesn’t necessitate that conclusions based on these assumptions are invalid because those implications can be and are falsifiable.

[Mandos]

"The confidence with which these sorts of assertions are made sometimes takes my breath away. It's not a *perfect* representation of behaviour, sure. But 'clearly contrary to real-world evidence'? And thrown away in favour of what, precisely?"

Nothing. It could be that there *is* no good way of making these models that has sufficient authority for predicting policy outcomes in the "real world".

[steve]

I think we need a better definition of rational. I see people make economic decisions based upon fear, superstition, tradition, inertia and laziness. These do not seem rational to me, but you can find psychological rationalizations for them. What would be economically rational?

Steve

[Mike Moffatt]

"I think we need a better definition of rational. I see people make economic decisions based upon fear, superstition, tradition, inertia and laziness."

A bear is chasing me. I experience fear. I run away. How is this not rational behaviour?

[Georgioz]

I completely agree with the post. I think this applies to all sciences - you don't have to know all the details or to be able to explain plethora of details for model to be good. If models with rational agents bring good results, then they are usable. The same is valid for physics. You observe the phenomena, you formulate a hypothesis and then test it. You don't need to know exactly if your model is perfect representation of how the phenomena works, you just need results from it. Let's take one example from quantum physics. They model quantum states of the particle by wave function and model it in a way that whenever this quantum state of the particle is observed its wave function collapses to a single quantum state. Now it is silly to ask where the particle stores its wave function, or how it senses the observer or how exactly does it computes the collapsed state. You just know that you have a model which describes a reality sufficiently enough to make valid predictions. And if it stops doing so, you then try to find another model which can be tested against evidence.

And the same is valid for BE. Do we observe hyperbolic discounting? Then lets find what the factor is and how to model it. Are people also altruistic, not only profit maximizers? Let's study the conditions under which altruism has significant impact and adjust our model so that it captures it. I think that Samuel Bowles microeconomy takes huge steps towards this approach.

[Patrick]

" A bear is chasing me. I experience fear. I run away. How is this not rational behaviour?"

Great example.

It's not rational at all. Running from a bear is most peoples first reaction, but it is pretty much the worst possible response.

http://safety.eas.ualberta.ca/node/13#Recommendations

[Mike Moffatt]

Ha! I should have thought of that. Particularly since an expression I use on a weekly basis is 'I don't have to outrun the bear, I only have to outrun you'.

[JL]

Instrumental rationality is not simply “value laden” it is socially localized. Modern, market based economic behaviour is instrumental, not because humans are always instrumental but because those are the rules of the game.

Science for instance requires individuals contributing original peer evaluated research to an academic readership. Many mechanisms within the university are used as instrumental incentives to grease the wheels, but the production itself is based on a collectively defined and institutionalised rationale that operates on normative principals relative to the specific activity at hand: the production of true knowledge. Truth being defined in criteriological terms.

[Chris Auld]

"Rationality is one of those words I wish economists never decided to use."

This. A thousand times this. If only "goal directed" were the jargon instead of "rational."

[Determinant]

Eh? I'm being quoted? Now I feel famous. Thanks Min!

[econometrician]

From the post: "Suppose consumers are choosing between five options: A, B, C, D, E. Given what we know about consumer preferences, costs, and benefits, we predict that consumers should always choose A. However, it turns out only 80% of the time they are choosing A, and 20% of the time they are choosing B."

The most glaring problem with this statement is that we don't know much (if anything) about preferences. I'm not sure if you mean that, put in the same scenario, 80% of individuals do A and 20% do B, but let me assume that you do (since experimental evidence would typically be based on a numberer of different individuals as opposed to one individual at a number of different times). Accordingly, why are 20% of subjects doing B and not A? Is not the most obvious explanation that we're confused about the preference of this 20%? Why would we even consider calling them "irrational"?

By the way, even if it was the same individual who did A 80% of the time and B 20% of the time, we can't say this individual is being "irrational". If an economist sits down and calculates that coffee is the optimal morning beverage for me, but If I drink tea 20% of the time , am I being "irrational"? More likely, the economist just doesn't understand my preferences.

[K]

A lot of the the time the cognitive resources are not "costly". They are infinite. Ie the subject doesn't get it, can't get, isn't ever going to get it. So you could say they are performing an optimization problem with an infinitely steep cost function (hard bounds) or you could say they just aren't smart enough to get it. For every one of us there's a set of problems for which this is the case. But if (like Tracy W in the previous post) they refuse on principle to accept the conclusions of experts, then there is nothing that can be done for them. Give them a billion dollars and they are still beyond help. So you want to say they have a "special cognitive cost function". I say there's a word for that.

[White Rabbit]

"The theory of rational expectations is clearly contrary to real-world evidence and should be thrown away

The confidence with which these sorts of assertions are made sometimes takes my breath away. It's not a *perfect* representation of behaviour, sure. But 'clearly contrary to real-world evidence'? And thrown away in favour of what, precisely?"

Rational expectations live or die on whether cognitive biases are statistically significant in our world.

All evidence suggests that cognitive bias is not only significant but is a main driving factor of our species and hence a main driving factor of our economies.

With a little bit of exaggeration, if there was no cognitive bias then the advertising industry would be dead, Google and Apple would go bankrupt, futures prices would be mostly flat lines between key macroeconomic data events and politicians would be out of job shortly after they vote on the wrong policy.

A world without cognitive bias would be a bit like a planet without gravity. Yeah, still a spheroid and you could talk about its chemical composition but not quite a correct planetary model in general, and it's not just slightly wrong, agreed?

[Bob Smith]

"It's not rational at all. Running from a bear is most peoples first reaction, but it is pretty much the worst possible response.

http://safety.eas.ualberta.ca/node/13#Recommendations"

It isn't a good reaction (or, at least, it isn't the best reaction, thought as Mike point's out, if you're not the slowest member of the herd, it might not be a bad reaction), but that doesn't mean it isn't rational, given most people's fairly imperfect knowledge about bears. There is no shortage of human behaviour which, while self-destructive, may well be rational given the constraints facing the humans involved (Stephen Levitt's work on the economics of prostitution and the condom/no-condom premium comes to mind). Rational decisions aren't neccesarily objectively good ones.

[Too Much Fed]

"The theory of rational expectations is clearly contrary to real-world evidence and should be thrown away

The confidence with which these sorts of assertions are made sometimes takes my breath away. It's not a *perfect* representation of behaviour, sure. But 'clearly contrary to real-world evidence'? And thrown away in favour of what, precisely?"

A model that incorporates the budgets of the major economic entities.

[Purple Library Guy]

Thing is, contrary to your claim it doesn't work that much of the time and the people who follow it never use this fact to falsify it, so its being falsifiable isn't much help.
To put it a different way, the "rational" human isn't "falsifiable", it is "falsified". If you want to be a science, once a construct is "falsified" you're supposed to stop using it. This isn't rocket science . . . well, I guess it is rocket science, the problem is that it apparently isn't economic "science".

"Rational" is in any case a rather dubious shorthand to describe the set of behaviours economists assume for human beings. For instance, these "rational" human beings are supposed to in all cases consider a prospective loss equal in significance to a prospective gain. Say I've got ten thousand dollars, and that's just enough to feed and house my family until I expect to receive another ten thousand. If you offer me a bet where we flip a coin and heads I get ten thousand and one dollars, tails I have to give you my ten thousand, if I were "rational" apparently I should take this bet. Problem is, having ten thousand and one dollars extra for luxuries is not as important as dying of starvation and exposure, so really it would be utterly irrational for me to take that bet, even considerably sweetened. The bias towards loss-aversion demonstrated in real humans is quite rational by comparison.

[Min]

Purple Library Guy: "To put it a different way, the "rational" human isn't "falsifiable", it is "falsified". If you want to be a science, once a construct is "falsified" you're supposed to stop using it."

The rationality assumption is an idealization. There are any number of situations where using idealizations is justified, even though they are not strictly true. For instance, in celestial mechanics the N-body problem is not solved. Modern ephemerides use numerical methods to predict motion within the solar system decades in advance. But if you want to calculate the positions of a planet several centuries from now your error is less if you assume that the planet and the sun are points or perfect spheres and ignore the effects of other planets.

[Too Much Fed]

Here is a decent attempt at budgeting.

Title: Finance and Macroeconomics: The Role of Household Leverage

IMO, replace leverage with debt

http://www.nber.org/reporter/2011number3/sufi.html

[K]

Purple library guy:" If you offer me a bet where we flip a coin and heads I get ten thousand and one dollars, tails I have to give you my ten thousand, if I were "rational" apparently I should take this bet."

Uh, no. This is basic economics. Concave utility functions, equivalent to risk averse behaviour are generally considered a characteristic (though not a necessary one) of most rational actors. You need to review (read for the first time?) a basic micro text book.

[DavidN]

I second K's comment.

[Nemi]

Rationality (complete and transitive preferences) in itself doesn´t let you predict anything. If you add a assumption that preferences is rather stable, and that the person behavioral rule is utility maximization – it does. Thus, your model can be falsified if people don´t act as it predicts. Any conceivable behavior is consistent with “rationality” since you can´t do two things at the same time, and even with stability you can fit pretty much anything with enough parameters (and by adding a little bit of idiosyncratic risk aversion here, a little altruism there, and norms, ethical belief and game theoretic considerations all over the place) .

However, I don´t know what behavioral economics literature that you have been reading, but as far as I can see (from the little I have read), their predictions is as falsifiable as neoclassical economics – hence the name of Ariely´s book “predictably irrational”. (except, maybe, the stuff about heuristics which sometimes seem somewhat ad hoc but of course is how people often make choices – as you also seem to think).

A neoclassical economist would say that if a person rather take 10 $ today than 11 $ tomorrow, (s)he will prefer 10 $ in a year instead of 11 $ in a year and a day. A behavioral economist might claim that this isn´t necessarily true – and that a person might have hyperbolic discounting. You certainly can test who is right.

Is a person equally likely to accept a gamble between 5 $ with certainty than 10/0 $ with x % probability if the outcome implies a gain or loss with respect to base income (MU of income should stay pretty constant for most of us over that range). Well – I think we can test for it.

PS: When I think about it, both of these examples seem to have more to do with instability of preferences than clear rationality violations. However, if you want to view it this way the changes in preferences with respect to the time dimension or baseline wealth is still predictable – and unlike what is assumed in neoclassical economics)

PS 2: Concavity of the utility function doesn’t have anything to do with rationality. Your preference ordering can be 5$>1$>10$ as long as this implies that 5$>10$. This absurdity fortunately disappears with the, at least with respect to wealth, reasonable assumption of free disposability or/and with the assumption about monotonicity.

[Jim Rootham]

In defence of Purple Library Guy some public economists do sound more or less like that. In particular the ones that say that government spending cannot stimulate the economy because private individuals, being rational and omniscient (OK, they leave out the last bit), will cut their spending in order to pay for the future tax increases the government spending will require.

[Chris Auld]

@Nemi: " You certainly can test who is right."

I realize you're just illustrating a point (which I broadly agree with), but the same issue also illustrates the counterpoint: Once we move beyond the simplest framework dynamic inconsistency becomes difficult to assess empirically, even in experimental settings:

Farmer and Geanakoplos, Hyperbolic discounting is rational.

Fernandez-Villaverde et al, Can we really observe hyperbolic discounting?

Besharov and Coffey, Reconsidering the experimental evidence for quasi-hyperbolic discounting.

Even putting aside most of the complications discussed in these and other papers, the positive predictions from models with hyperbolic discounting are all but indistinguishable from those with geometric discounting. In many contexts geometric discounting is a desirable modeling simplification.

I would quibble with "A neoclassical economist would say...." I would instead put it: "A conventional model which assumes geometric discounting would predict...." Providing evidence against geometric discounting is not necessarily a threat to a modeling approach assuming geometric discounting, much like providing evidence that there are more than two countries, two factors of production, and two goods in the world is not necessarily a threat to a 2x2x2 trade model. Contrary to the claims Dan Ariely likes to make, assuming something in a model does not mean that the modeler thinks the assumption is literally true, nor do false assumptions in models render the model useless. Quite the opposite, in fact.

[Too Much Fed]

Jim Rootham said: "In particular the ones that say that government spending cannot stimulate the economy because private individuals, being rational and omniscient (OK, they leave out the last bit), will cut their spending in order to pay for the future tax increases the government spending will require."

Back to budgeting. Would some private individuals who were unemployed, had their hours reduced, or wages per hour reduced spend the demand deposits from gov't debt now because their previous expectations for hours and/or wages per hour turned out to be incorrect and then hope someone else has their taxes raised or benefits cut?

[Stephen Gordon]

Contrary to the claims Dan Ariely likes to make, assuming something in a model does not mean that the modeler thinks the assumption is literally true, nor do false assumptions in models render the model useless. Quite the opposite, in fact.

The George Box quote: "All models are wrong, but some are useful."

This is a point many non-economists seem to miss. Telling us that a modeling assumption is not literally true is not a death-blow to a model's usefulness.

And it's not only economics. Look at all the simplifying assumptions that go into climate models. The fact that these assumptions are not literally true does not mean that we should reject the conclusions of climatologists. Does it?

[W. Peden]

That's true, Stephen Gordon. Models, like experiments, can be realistic only at the cost of losing scope i.e. a model that replicates an economy with exactitude can tell us nothing about economies in general, because we can't extend derivations from that model to other economies by uncovering causal relations within the model. Economists are no less justified in having some unrealistic assumptions than Galileo.

However, one has to be very suspicious of results that are model-specific because they only derive from the assumptions of that model, and economics models almost always have a LOT of structural assumptions because of the scarcity of definite general principles in economics. For this reason, it's very important that models are rigorously formalised, so we can tell what's doing the legwork.

Which justifies another often-criticised part of economic models!

(Yes, I've been reading Nancy Cartwright today.)

[Stephen Gordon]

Well, checking to see what assumptions buy which results, and checking what the data can tell us about which assumptions are most plausible is what economists *do*.

As Kevin Milligan says, non-economists seem to think that we spend our days proving the First Welfare Theorem to each other. Can anyone come up with a way of shaking people from this conviction?

[W. Peden]

"Can anyone come up with a way of shaking people from this conviction?"

Tell them.

That said, I think that Thomas Kuhn was onto something when he said that social scientists would always be fighting for their discipline with one hand tied around their backs, because they are ALWAYS expected to produce socially useful research, whereas pursuing natural science for its own sake is almost always acceptable. Can you imagine what economists could do with the kind of funding that CERN gets?

[Stephen Gordon]

Physicist: Our knowledge is based on two contradictory theories. Please give us many, many billions of dollars so we can play around.

Government: Sure! Is many, many billions enough?

[rsj]

"Can anyone come up with a way of shaking people from this conviction?"

How about

* Micro -- change the econ 101 curriculum so that the CE and welfare theorems aren't the culminating topic.

* Macro -- Spend as much time on OLG style models that support non-pareto optimal equilibria rather than viewing these models as an oddity.

* PR -- Actively participate in public debates whenever the welfare theorems are used to beat down proposals for government intervention in markets

But as long as economists believe that "to first order", competitive markets yield optimal allocations of resources (modulo some asterisks), the public will have this rough, first-order view of economics. And it is basically a correct view (modulo some asterisks).

The day when economists spend as much time and vigor publicly discussing the dead-weight losses of voluntary exchange as they do of taxation, the public will begin to change their view of what the discipline is about.

[Patrick]

What are you complaining about? You got all of Europe to play with!At least the physicists haven't broken their toy.

[Patrick]

Going back to the OP... Don't overlook the fact that functional markets are themselves are an incentive to more rational behavior, even if people are irrational in other ways at other times.

Put a price on that marshmallow, and make little Johnny earn his a loonie, then tell him the price halves in 10 minutes, and my guess is that his ability to resist temptation will be greatly enhanced.

[DavidN]

I knda agree with RSJ. If economists want to be treated more like scientists then they need to act less like politicians. My personal opinion is to often normative economic statements are stated like they are positive economic theory. Maybe a norm needs to develop from within to ostracise economists who pretend normative statements are positive ones.

[Jim Rootham]

Too Much Fed said:

Back to budgeting. Would some private individuals who were unemployed, had their hours reduced, or wages per hour reduced spend the demand deposits from gov't debt now because their previous expectations for hours and/or wages per hour turned out to be incorrect and then hope someone else has their taxes raised or benefits cut?

I do not understand this. Could you clarify?

[Too Much Fed]

Jim Rootham, I will try. Let's say it is 2006. Someone is making $40,000 per year in wages and decides to save 10% of it per year. The person makes either knowingly or unknowingly assumptions about future wages, future prices, and future interest rates. This person assumes that $40,000 per year or more will be earned thru wage income for at least the next 10 years. The person buys a car (auto loan), a house (mortgage), and some other items (credit card) now (notice all three are debt). That means the budget looks something like this:

$40,000 - $4,000 in savings = $36,000

$36,000/12 = $3,000 per month

Monthly expenses plus auto loan payment plus mortgage payment plus credit card payment = $3,000 per month.

Next, gas price, electricity, and/or food prices start rising (especially the first two). That starts pressuring the monthly budget.

Moving on to 2009, the person loses the job in the recession. That person struggles thru with unemployment, stops saving, and may even dip into their past savings.

In 2011, the person gets rehired at $30,000 per year ($2,500 per month). The person might spend the payroll tax cut hoping that the economy will grow enough or someone else's taxes will rise or someone else's benefits will be cut. That person is thinking my wages are down from what I expected and from the past so why should I pay more taxes or get less benefits. Why not raise taxes on someone making $250,000 per year or more. These people didn't seem to lose their jobs or wages.

Does that help?

[Min]

DavidN: "If economists want to be treated more like scientists then they need to act less like politicians."

Well put. :)

[Min]

Stephen Gordon: "Physicist: Our knowledge is based on two contradictory theories. Please give us many, many billions of dollars so we can play around.

"Government: Sure! Is many, many billions enough?"

Physicist: Our research spins off technological innovation, from Tang to the Internet. Besides, we help you blow people up.

Gov't: How much do you want?

[Too Much Fed]

"Behavioural Economics and the Rationality Assumption in Economics"

Here is a perfect example of what is wrong.

http://www.nytimes.com/2011/09/09/business/economy/fed-speech-offers-no-new-aid-for-economy.html

Titled: "Fed Chief Describes Consumers as Too Bleak"

"Then he said something new: Consumers are depressed beyond reason or expectation.

Oh, sure, there are reasons to be depressed, and the Fed chairman rattled them off: “The persistently high level of unemployment, slow gains in wages for those who remain employed, falling house prices, and debt burdens that remain high.”

However, Mr. Bernanke continued, “Even taking into account the many financial pressures that they face, households seem exceptionally cautious.”

Consumers, in other words, are behaving as if the economy is even worse than it actually is.

Economic models based on historic patterns of unemployment, wages, debt and housing prices suggest that people should be spending more money. Instead, just as corporations are sitting on their money, households are holding back, too."

Maybe bernanke should get some economic models NOT based on the post WWII period. No wonder he couldn't see the housing bubble because he sure seems not to understand the word/phrase budget and negative real earnings growth based on budgets and NOT CPI. Is it more like the lower and middle class are starting to make more accurate assumptions about nominal and real wage growth in the future? In other words, if he can't sucker the lower and middle class (the ones experiencing negative real earnings growth) into debt, then what is his plan B? Nothing?

Title again: "Fed Chief Describes Consumers as Too Bleak"

Is he actually saying I chairman of the fed am right and you consumers are acting irrationally? Start acting rationally (the way I want) and go into debt. Is it really the lower and middle class consumers who are getting more rational, and the chairman of the fed can't accept that?

[Too Much Fed]

Here is a good place for bernanke to start.

The origins of the economic crisis

http://bilbo.economicoutlook.net/blog/?p=277

I believe that what applies to Australia also applies to the USA.

Here is the Nonfarm Business Sector: Labor Share (PRS85006173) from the St. Louis FRED

http://research.stlouisfed.org/fred2/series/PRS85006173

[Nemi]

@Chris

I´m sure you can fit hyperbolic discounting into the rationality framework. That is, as I tried to state in the beginning, ALWAYS possible – given that you include more parameters. The simplest way, I guess, would be to simply state that the preferences isn’t stable/stationary with respect to changes in time/base income.

I did not mean that Behavioral economics was any “threat” to a neoclassical economist (but to neoclassical economics, which usually is defined by the assumption of rational actors). All (or at least most) of the skills you learn as a neoclassical economist can/will/should probably be used when you include cognitive problems in the utility/decision function.

So – you can call e.g. hyperbolic discounting “rational”, and incorporate them into “Neoclassical economics” - or - call them “irrational” and use Behavioural economics. Does not matter and does not affect whether the results found by people that call themselves behavioral economists is valuable or testable.

Sure the usual framework might be desirable at times – but when you see e.g. a debate over private health insurance or similar things involving probabilities and long time periods you sometimes just want to cry.

PS: Yes – of course everybody don´t agree that there is hyperbolic discounting. For me, with a rather “free” job, hyperbolic discounting however creates a lot of problems and undesirable outcomes (lets party today and work tomorrow).