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a blog from young economists at Nova SBE

Is there room for irrationality in models?

The basics of Microeconomics, as it is teached today in an introductory level, have not changed for a while. These principals are solid since the late 19th Century, with the “Marginal Revolution”. There is a common consensus regarding this, the Neoclassical Model for Microeconomics. It is based in 3 main principles: Rational preferences and expectations, maximizing agents (utility and profits) and full information.

Although all of these assumptions have been challenged to some extent, I feel that we still rely on perfectly rational agents a lot more than we should.
Irrationality of agents has been widely studied, more deeply since the 60s, with great contributions from cognitive psychology and with the rise of Behavior Economics.
The whole point of models is a trade-off between simplifying and being able to extract meaningful conclusions. So we don’t want a very, very simple model, since it will we too detached from the reality, but we don’t want a too complex model as well, as it will be too specific, and we won’t be able to draw conclusions with policy implications. So does it make sense for us to try to include some degree of irrationality in agents?

Agents are found to deviate from “rational preferences” in many different ways. Some of these ways are more obvious and some efforts have been made to include some of these concepts in models.

One of them is the idea of time-inconsistent preferences, or present bias which the biggest implication is the violation of the permanent income hypothesis. Although it is easy to understand why I would prefer a euro today than a euro tomorrow (positive interest/inflation), it is not very clear why I would prefer a cake today than a cake tomorrow. More, if have 2 cakes today, I probably prefer to eat a little more than 1 today, and a little less tomorrow. This is very well document by Walter Mischel in his experiment with kids. He offered 1 marshmallow to them, and said he would give them a second marshmallow if they waited roughly 15 minutes. Only about a third of the kids could wait that longer. There are many examples in our life of this (delaying study, delaying going to the gym, saving too little money to pay our debts), and has been represented as a “game” between the present and the future self (Daniel Kahneman’s idea of Two Selves). The idea is that when we take actions, we don’t take future’s interests into account accurately, so we value more consumption today then consumption 5 years from now. But when I get to this 5 year time, I will be worse-off than I could, due to this bias.

This has been taken into account in some models, including a impatience factor, or hyperbolic discounting (For example, a Utility function such as U= C1+C2/(1+µ); where µ is a measure of how impatient I am. Of course this is very hard to measure, but with some revealed preferences techniques we can have a fair proxy.

Other efforts have been made to integrate some sense of fairness in social preferences. Agents, as we present them, are self-interested maximizing pieces of the market, but it is undeniable that most of them have some tendency towards social fairness. This idea has been integrated in some models (Rabin Model), with some influences of psychology and game theory.

So can we relax the perfectly rational agent assumption? I think with the raise of behavioral and experimental economics, this is already being done, step-by-step. And its policy implications are huge. We know for a fact, right now, that it is very different to say to a patient that he has 30% of probability to live or to say that he has 70% of dying (called framing), although these are statistical synonyms. We know that giving monthly food stamps to people will cause them to decrease consumption over the month, due to present bias. We know that, even regarding econometricians and statisticians, giving some irrelevant numbers, will cause them to judge towards this value (anchoring effect). We know for a fact that many people cannot help but be influenced by sunk costs. People still play in the lottery, although economists call this the “Tax on stupidity”. The truth is that the Homo Economicus does not exist, and if we want to have significant and efficient policy results, we have to embrace a big interdisciplinarity between Microeconomics, Psychology and Behavioral Economics.

Sérgio Rocheteau #620

Author: studentnovasbe

Master student in Nova Sbe

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