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July 20, 2014

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Posted: 20 Jul 2014 12:06 AM PDT

'Is Choosing to Believe in Economic Models a Rational Expected-Utility Decision Theory Thing?'

Posted: 19 Jul 2014 10:01 AM PDT

Brad DeLong:

Is Choosing to Believe in Economic Models a Rational Expected-Utility Decision Theory Thing?: I have always understood expected-utility decision theory to be normative, not positive: it is how people ought to behave if they want to achieve their goals in risky environments, not how people do behave. One of the chief purposes of teaching expected-utility decision theory is in fact to make people aware that they really should be risk neutral over small gambles where they do know the probabilities--that they will be happier and achieve more of their goals in the long run if they in fact do so. ...[continue]...

Here's the bottom line:

(6) Given that people aren't rational Bayesian expected utility-theory decision makers, what do economists think that they are doing modeling markets as if they are populated by agents who are? Here there are, I think, three answers:

  • Most economists are clueless, and have not thought about these issues at all.

  • Some economists think that we have developed cognitive institutions and routines in organizations that make organizations expected-utility-theory decision makers even though the individuals in utility theory are not. (Yeah, right: I find this very amusing too.)

  • Some economists admit that the failure of individuals to follow expected-utility decision theory and our inability to build institutions that properly compensate for our cognitive biases (cough, actively-managed mutual funds, anyone?) are one of the major sources of market failure in the world today--for one thing, they blow the efficient market hypothesis in finance sky-high.

The fact that so few economists are in the third camp--and that any economists are in the second camp--makes me agree 100% with Andrew Gelman's strictures on economics as akin to Ptolemaic astronomy, in which the fundamentals of the model are "not [first-order] approximations to something real, they're just fictions..."

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