Behavioral vs Neoclassical Economics

In my paper entitled “Empirical Evidence Against Neoclassical Utility Theory: A Survey of the Literature,” I have argued that neoclassical utility theory acts as a blindfold, which prevents economists from understanding simple realities of human behavior. The paper provides many examples of this phenomenon, which I will illustrate briefly with one simple example in this post.

Consider the two player Ultimatum Game. The Proposer (P) has ten dollars in single dollar bills. He makes an offer of $m to the Responder (R), which allows him to keep $(10-m). The responder can either Accept or Reject. If Responder Accepts than P get $10-m, and R get $m as proposed; it is convenient to denote this outcome as (P:10-m,R:m). If Responder Rejects, then both get $0: (P:0,R:0)

Here are four predictions made by Game Theory, based on utility maximization behavior.

  1. Responder will be indifferent between the two choices Accept and Reject if he is offered $0.
  2. Responder will Accept an offer of $1, resulting in outcome (P:9, R:1). R prefers 1 to 0.
  3. Proposer believes that Responder is a Utility Maximizer; that is, he will behave in accordance with propositions 1 & 2 above.
  4. Proposer will therefore offer $1, as it maximizes his share at $9. If he offers $0, the outcome is uncertain because both responses A and R are possible maximizing responses, which is why an offer of $1 is the unique utility maximizing offer.

All four of these propositions are false. Furthermore, every layman will easily be able to see that all four of these propositions are false. However, economists have great difficulty in seeing that they are false and in understanding why this is so. This is because economic theory teaches economists to “think like economists” which means modelling humans as being homo economicus: cold, selfish and callous (Vulcans, for short). This makes economists unable to understand real human behavior. As everyone (except economists) knows, the responder will reject the offer of $0; he will not be indifferent between accept and reject. Empirical studies conforming to our intuition about human behavior show that in situation 2, the vast majority of responders will reject the offer of a 10% share, preferring to get $0 rather than accepting injustice or an unfair offer.

While no one else is surprised by this [rejection of small offers], economists are startled to learn about this routine finding of the ultimatum game. Empirical findings of research on ultimatum game along these lines were routinely rejected by economics journals on the grounds that small stakes and unfamiliarity led people to irrational behavior in an artificial environment. As Colin Camerer , Behavioral Game Theory 60-62 (2003) puts it: “If I had a dollar for every time an economist claimed that raising the stakes would drive ultimatum behavior toward self-interest, I’d have a private jet on standby all day.” Despite this ideological conviction of economists, experiments at high stakes, equivalent to one months salary, replicated this phenomenon of refusal of unfair offers. Widespread robust replication in different environments designed to answer the standard objections to experiments ultimately led to a reluctant acceptance by economists, and publications of these results in reputable journals. However, despite the flat rejection of utility theory by human behavior, this theory continues to be taught as a tautological” truth in mainstream economic textbooks.

ultimatum

The fact that proposition 3 is false is somewhat deeper than the fact that 1 and 2 are false. Whereas 1 and 2 represent false assumptions by economists about human behavior, 3 represents a stronger false assumption about human beliefs about human behavior.  Even if the proposer is Vulcan, he might have enough intelligence to realize that others on this planet are not like him. In which case, he would not rely on propositions 1 and 2. Even a Vulcan may be able to realize, without necessarily understanding why, that normal human beings might resent being offered such a pittance, and might refuse a low offer for emotional reasons. However, not only does game theory teach economists to think that everyone is a Vulcan, it also misleads them into believing that everyone is a stupid Vulcan – they cannot figure out that they are on planet Earth, and therefore other people will not behave like them. It is only a stupid Vulcan who will offer $1 under the mistaken belief that the responder accept this offer because $1 is better than the $0 he will receive by rejecting. We cannot quantify the level of stupidity displayed by economists who calculate outcomes of games under the assumption the every on this planet is a stupid Vulcan, are surprised when their predictions fail to match reality, and stubbornly refuse to revise theories in face of obvious conflicts with Reality. Keynes rejection of classical theories led him to the same perception of economists: The classical economists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight, as the only remedy for the unfortunate collisions which are occurring. 

And that is why the findings of behavioral economics conflicts with economic theory, and are not welcomed by economists. When economists talk about “sound” microfoundations, these are the micro-foundations upon which they wish to build a macroeconomics. In his written testimony for the Congress on “Building a Science of Economics for the Real World” Robert Solow wonders about which planet the macro policies based on DSGE models are designed for.   My one hour video-lecture on Behavioral Economics Versus Neoclassical Economics expands on this brief sketch.

ShortLink for this post: bit.do/azultima. My author page on LinkedIn. Other works: Index . My personal website: asadzaman.net. For related articles, see Unlearning Economics

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6 comments
  1. Perhaps a few insights from Anthropology might help clarify. Homo Sapiens groups have been distinguishable from other primate groups by the egalitarianism. Humans evolved to enforce egalitarianism by multiple means. Up to and including killing violators. As part of this process humans also evolved in physical appearance (eyes, hands) to make cooperation and communication easier and more direct. Also, humans evolved a “communal” brain. Its brain and thus its mental functions are predicated upon sharing and cooperation. The error that economists make, in terms of evolution is one shared by many others. That error is to consider a kind of genetic intelligence as the hallmark of Homo Sapiens. The “thinking ape” is used sometimes to sum up this view. But this is in error. The hallmark of Homo Sapiens is mental and physical teamwork. Human societies are “team-based.” And from an evolutionary perspective cannot be otherwise. In human society information, assistance, and welfare are freely shared. But such societies can be disrupted. First, size alone sometimes provides a disruption. After all, it’s not difficult to share in society of 1000 but difficult or impossible in a society of 300,000,000. Second, violators (those who refuse to share or help, for example) are always present (that’s part of evolution too). These must be controlled and punished. This has been poorly done for hundreds of years now. Third, as with violators there are also always exemplars of cooperation and sharing. Unfortunately, for society obstacles for these exemplars have been increasing for the last 700 years. Today they are at a high point. Evolution is about surviving in one’s environment. If the current trends continue human tendencies for cooperation and mutual understanding and caring will provide less and less evolutionary advantage. And the species will change, first in mental directions and later perhaps even in physical appearance. For example, human eyes are unique among primates. Humans use them to share information and signal their emotional commitments. All the players at the World Poker Championship wear sunglasses. These change their eyes to look like those of other primates – dark and unable to share information or commitment. Human society seems to heading in the direction of “Chimp society.” Competitive, brutal, and extremely unequal. I’ll share at another time what I believe might be done to stop such changes.

    • Excellent points, yours and Asad’s. Together, they mean that we co-operate when and only when we believe — together and as individuals — that the outcomes of our cooperation/play are ‘fair’. Since ‘fairness’ is a highly desired outcome of our cooperation, and since fairness is also fuzzy over the range ‘least’ to ‘most’ … as is the cultural acceptability of various outcomes … we cannot use (always) independent abstract, monetized ‘utility’ functions to mathematically encapsulate human behaviors.

      This is very different from my stress upon our looking at the objective consequences of ‘consumption’ — as realized values-in-use — as a better grounding for what poses as ‘rational’ behavior in current economics, for these objective consequences are about what we are providing for ourselves, and ‘why’ we are doing so.

      “Fairness” moves us outside the unique subjectively maximizing individual consumer, revealing that, among our interpersonal concerns is a ‘fair’ distribution of outcomes, not as a normative concept per se, but as a realized glue that binds us together.

      • Larry, you read too much detail into evolution. Evolution is about surviving. Those traits that lead to survival are passed along to the next generation. Those that don’t are not. This process is not precise so some traits that promote survival are lost and some that do not are retained. Plus, survival is always an average effect process. Which means some traits that harm survival chances will be passed along, but on average the species will have improved survivability. The general direction for Homo Sapiens is in the directions I identify, however. Humans adapt culturally as well, which sometimes leads to physical and genetic changes, sometimes not. Cultural adaptability is also an average effects process for the species. Overall, both genetic/physical evolution and cultural adaptation apply to the species, not particular members.

        Since humans invented mathematics it’s impossible that these processes of evolution and adaptation could be subsumed within mathematics. Rather, the reverse is the case.

        Objectivity is a word used to summarize the processes by which humans make multiple observations with multiple approaches/perspectives to describe something in the world, including humans. With each new observation or change in perspective the “objective” may change. Similarly, if humans stop observing or never change perspectives, the objective becomes fixed. This is what economists have done.

        You are correct that humans have because of their evolution a unique but changeable (by further evolution) perception of their “right” relationship with other humans, and with other humans and the world around them. Fairness is as good as any for this.

      • Read a interesting Guardian article (Zoe Williams:Totalitarianism in the Age of Trump, where she summarized and extensively quoted Professor Griselda Pollock on the insights of Hannah Arendt.

        Taken to its logical end, the economic overtaking the political results not in the extermination camp but in the concentration camp; the difference is crucial, Pollock explains. The concentration camp exists not to extinguish life but to extinguish the human. “You are removed from moral action, you become a number and, finally, you are reduced physiologically to a bundle of reactions, as the body struggles to survive extreme emaciation.” If politics is only a set of economic decisions, then the person is no more than the work they do and the infinite preciousness of every person’s potential cascades into a brutal homogeneity, one person indivisible from the next.

        Neoclassical economic theory, large and small, imposed that brutal homogeneity. It did so by having divested itself of the moral/ethical elements within humanity; and this it accomplished so by divorcing personal morality from interpersonal ethics —as if there is no interrelationship between morality and ethics, thereby reducing the ‘greatest good for the greatest number’ into merely a summation of individuated ‘exchange welfare gains’ bearing no relation to social welfare, except as a substitution for whatever social welfare actually means in our interdependent and interpersonal human existence as social beings.

        Pardon me, Ken/Assad, for not having been more clear in my prior posting.

  2. dewald van rensburg said:

    I recall first encountering this species of crit of ‘orthodox’ economics in Joan Robinson’s Economic Philosophy (1962)
    The phrase “impregnable circularity” stuck with me.
    page 48:
    “Utility is a metaphysical concept of impregnable circularity;
    utility is the quality in commodities that makes individuals want
    to buy them, and the fact that individuals want to buy commodities
    shows that they have utility.”

  3. I and many others use the term psychopathic to refer to Homo Economicus. Such traits provide little evolutionary advantage for the species but they do for members of the species that hold such traits. It is technically possible to evolve a psychopathic species, but unlikely. Such traits put members of the species at constant war with one another. The species ends up killing itself. No need to wait for natural disasters or disease outbreaks. A blogger friend summed it up thus,
    1. We’re all psychopathic in our decision-making (cold, rational, unconcerned for others);
    2. Utopia exists when we’re all equally clever psychopaths; and
    3. If you’re not a psychopath, or if you’re less clever than the other psychopaths, then that’s your own fault, and that’s
    why you’re poor.
    Clearly this set of arrangements is cultural adaptation, not physical evolution. There’s little chance it will lead to physical evolution since the stronger psychopaths kill/dominate the weaker ones till only the strongest psychopath is left. That’s not species survival. But it’s a damned fine summary of Herbert Spencer and Ayn Rand.

    Larry, I don’t concern myself much with the unique humanity or preciousness of each individual. I’m more concerned with species survival. But still members of the species are not homogeneous. This would contradict evolution, since variation is essential in testing physical and mental traits for survival value.

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