Lecture 2 - Why has econ not always included behavioural

Econ periods over time

20th century (modern / orthodox) econ focus

Attempt to rid econ theory of “unobservable” concepts, that were seen as “unscientific”

economic theory on formal model of rational choice by individuals

View that choices are observable, but psychological experiences not

• psychological realism or realistic underlying assumptions not necessary

Quotes of orthodox econ on psychology

Pure political economy has therefore a great interest in relying as little as possible on the domain of psychology.” (Vilfredo Pareto, 1897.)

“ if we wish to place economic science upon a solid basis, we must make it completely independent of psychological assumptions.” (Evgeny Slutsky, 1915)

Utility & econ

Enters during 19th/20th century neoclassical marginal revolution

In psychology utility was a psychological experience BUT in econ it became more mathematical (differentiable - Marginal Utility & optimisation)

• Idea of diminishing marginal utility also included

Late 19th/20th century economists began to doubt possibility of measuring pleasure or being able to compare it between people - unobservable

• econ moved away from psychology in early/mid 20th

• Utility became a representation of complete and consistent preferences

Quotes of econ on utility

Edgeworth (1881): “Let it be granted to the science of pleasure what is granted to the science of energy: to imagine a perfect instrument (utility) continually registering the height of pleasure experienced by an individual”

Jevons (1871): “Pleasure and pain are undoubtedly the ultimate objects of the Calculus of Economics. To satisfy our wants to the utmost with the least effort ….. in other words, to maximise pleasure is the problem of Economics.”

Complete preferences

For any outcomes a and b, either a > b or b > a (or both – i.e. indifference)

Transitive preferences

If a > b and b > c, then a > c

Ordinal Representation Theorem:

If the preference relation > is complete and transitive, then there exists a (real-valued) utility function u(),

• defined on outcomes such that, for any two outcomes a and b

u(a) ≥ u(b) if, and only if, a > b

Maximisation of u() represents satisfaction of preferences given by relation >

• whatever they are, provided complete + transitive

agent maximises utility theory

They choose from among the available actions the one that best satisfies her preferences over outcomes

preferences satisfy conditions required for the theorem

• complete + transitive preferences

The Pareto Improvement criterion

Outcome x is a Pareto-improvement on outcome y if at least one person strictly prefers x to y and no-one strictly prefers y to x

Compares outcomes using preferences, without needing to measure of intensity of preference or pleasure

Friedman & psychology

instrumentalist methodology (1953)

• argued that economics does not need realistic assumptions at all, if its models predict successfully the variables they are intended to predict

• Theory judged only by how well it achieves its purpose of prediction

Modern econ & psychology

Late 20th/21st econ put psychology back into econ

Stimulated by:

• need for explanation not just prediction

• empirical failings of orthodox theory (experimental methods)

• Realisation that greater psychological realism still allows tractable, formal models that can be more general ( keep orthodox theory as special case).

Characteristics of (most) BE

Methodological individualism

• Still tries to ground economic theory in theories of individual behaviour;

Theoretical generalisation

• Often tries to keep standard “rational” theory as special case

• Allows departure from ‘rationality’ when suggested by psychology & evidence

PEEMs - Rabin (2013)

Portable Extensions of Existing Models

Used to extend existing model of utility maximisation

• Retaining standard theory as special case (when a parameter = 0)

• Allowing cases with more realistic psychology too, via a measureable departure from orthodox model

PEEM example - present bias