Lecture 2 BE in Relation to other Sciences & Economics

Introduction - Economics
- Economic phenomena relate to
  - any aspect of human behavior
  - involving allocation of scarce resources
- e.g. Each and every decision in life can be driven by some concept in economics
- Assumptions are required
  - Some are explicitly stated, others hidden
  - to diagnose issue, verify the logical consistency between assumptions and predictions
What is Behavioral Economics?
- Embed, not replace equilibrium models
- Here, only to solve anomalies
Standard Models and Economics
- Called mainstream economics
- Standard theory is highly incomplete
- We should be careful in assuming that a standard model is complete (Because it may not be, like classical mechanics was thrashed by quantum mechanics)
- In econ: Neoclassical Model (NM) was the standard model
  - By 1970s, it was understood that it is incomplete
  - More behavioral concepts have been adopted and the standard model has been revised
- We should benchmark BE against a static Neoclassical model rather than against a dynamic Standard model that keeps changing now and then.
Economics to BE
- Heart of of many debates in BE, methodological considerations
Economic Rationality
- Standard model in Neoclassical tradition, claims to be both descriptive (description: I study 2 minutes) and normative (norms: I should study for 2 hours)
- A model cannot be simultaneously normative and descriptive
Positive & Normative (book)
- Positive Statements
  - Relate to descriptions involving factual information
  - can be judged for correctness based on empirical observations
  - Normative statements relate to value judgements, is subjective
- Non-normative Statements
  - We can contextualize: "Firm A ought to pay its workers a higher wage if it wants to maximize profit"
  - This can be evaluated empirically. But one can also question the social value of profit (seperate issue)
- Normative Statements
  - Behavior as it should be
  - (descriptive)
  - Prefer calling it prescriptive rather than descriptive
- Prescriptive vs Descriptive Statements
  - "In firm A's situation, a higher wage will maximize profit"
  - More precise prescription: Determine the specific level of wage that would maximize profit.
- Prescriptive Statements
Positive & Normative
- A statement can either be positive (stating facts) or normative (telling how things should be/ought be). Positive statements are easy to identify, one may say. However, we should understand the logical implication of the statements and then judge whether the implication fits into one of the categories
  - Positive
  - Normative(value Judgement)
  - Normative (prescriptive)
- \(S_{1}:\) It is not fair that Firm A pays its workers such low wage
  - A fact
  - Positive statement
  - Can be empirically determined
- \(S_{2}:\) Firm A should pay its workers a higher wage.
  - Its something that the firm "should" or "ought to" do
  - It is a value judgement
  - Cannot be empirically determined
- \(S_{3}:\) Firm A should pay its workers a higher wage if it wants to maximized profits
  - It's still something that the firm "should" do. However...
  - It is something that can be empirically determined. This is because its contextual. IF the firm wants to maximize profits. Meaning, if the firm pays a higher wage, we can check whether profits are maximized or not
  - So, let's call these statements prescriptive
  - Prescriptive statements suggest how people should behave to reach certain goals.
- \(S_{4}:\) In Firm A's situation, a higher wage will maximize profits
  - It is descriptive, but in a logical sense it is prescriptive. Because you are giving a suggestion, and essentially meaning the same thing as \(S_{3}\).
  - So, this is also prescriptive
  - A more precise prescription would be to also mention the specific level of wage that would maximize profits
Value Judgements
- We are not interest in whether a value judgement is justified or not, rather we want to figure out why people make certain value judgements.
- Purely rational models fail to explain actual behavior in complex economic models.
Rationality vs Irrationality
- Actual-response strategies deviate from the best-response path
Economic Rationality
- Vernon Smith etc judge rationality by systemic outcomes, and so rationality = market efficiency
- Kahneman, Tversky etc use standard model as benchmark
  - there are irrationality
  - But systematic errors and biases do not necessarily constitute irrational behavior #doubt
Rationality in Psychology
- Pursuit of Enlightened self-interest
- enlightened is perfect knowledge (unreal)
- "long-run self-interest" makes more sense
- Bounded rationality: self-interest is satisfied rather than optimized HOOMAN
- Is "Pursuing" = maximizing?
  - use heuristics, under time-constraints and incomplete information
- Suboptimal outcomes: Misjudgements of self-interest. If faculty members are surveyed, 90% of them consider themselves to be above-average. But then the average is violated, only 50% of them should have said that they are above average. This comes from overconfidence or optimism
- Self-interest is measured in terms of utility (subjective)
- BE distinguishes between "self-regarding" and "other-regarding" both of which can be combined in the utility function
Behavioral Perspective on Economic Rationality
- "Arational": neither rational nor irrational
- Irrationality with intention
- So does rationality pertain only to actions or also attitude and believe?
- Belief formation may be beyond conscious control
Nature of the Neoclassical Model (NM)
- "Pursuing enlightened self-interest" has a lot of ambiguities
  - enlightened is quite a problematic term
- Economists avoid this by using a more precise and formal model of rational behavior in the NM
  - doesn't assume enlightenment but puts a lot of assumptions that restricts an individual's behavior