Basic Of Economic Theory Is Incorrect

"...The agent of economic theory is rational, selfish, and his tastes do not change..."

Bruno Frey as quoted by Daniel Kahneman 2012

. This is an economist's approach while a psychologist would say that people are neither fully rational nor completely selfish and their tastes are not constant. People's view of the world is limited by the information that is available at the time.

. Decision-making - every significant choice we make in life comes with some uncertainty.

. Expected utility theory is the foundation of rational-agent model, ie choices are not based on dollar values but on the psychological values of outcomes (utilities). It is logic of choice based on elementary rules (axioms) of rationality including probability. It has a dual role as a logic that prescribes how decisions should be made and as a description of how choices are made by rational people. In contrast, psychologists look at humans actually making choices without assuming anything about their rationality. This involves judgement and intuitive preferences. Psychologists look for systematic violations of the axioms of rationality in choice.

. Framing = the large changes of preferences that are sometimes caused by inconsequential variations in the wording of a choice problem

. Prospect theory = facts about choices. This is linked with psychophysics, ie relate the subjective quantity in the observer's mind to the objective quantity in the material world. This includes physical quantity like energy of light, frequency of tone, amount of money, etc and subjective experience of brightness, pitch or value.

. Fechner's law = the psychological response to a change of wealth is inversely proportional to the initial amount of wealth

. Most people dislike risk and favour sure things. A decision maker with diminishing marginal utility for wealth will be risk averse.

. People become risk-seeking when all their options are bad.

Reference Point

. This involves thinking of outcomes in terms of losses and gain, not states of things like wealth. People dislike losing more than they like winning.

. Evaluation is relative to a neutral reference point (adaptation level). For financial outcomes, the usual reference point is the status quo or it can be the outcome you expect. Outcomes that are better than the reference points are gains; outcomes that are worse than reference points are losses. Gains are preferred to losses; losses have a greater impact than gains (loss aversion), ie threats (losses) have a greater impact than opportunities (gains). Furthermore, the principal of diminishing sensitivities applies to both dimensions, ie subjective difference between $900 and $1,000 is significantly smaller than the difference between $100 and $200. Thus people tend to evaluate gains and losses in relative rather than in absolute terms.

. An example of the importance of a reference point is golf, ie par put on each hole. A birdie (1 stroke under par) is a gain while a bogey (one stroke over par) is a loss. Comparing 3 situations, ie

i) putt to avoid a bogey

ii) putting for par (status quo)

iii) putt to achieve a birdie

. Failing to make a par is a loss, but missing a birdie putt is a foregone gain, not a loss. Analysing 2.5+ m putts, players were more successful when putting for a par than for a birdie. Also, there was an intense aversion to a bogey that was stronger than the potential to gain of a birdie

. Goals can be reference points; not achieving the goal can be seen as a loss, while exceeding the goal is a gain.

. Theory Induced Blindness = once you have accepted the theory and used it as a tool in your thinking, it is very difficult to notice its flaws

. Endowment effect = reluctance of people to part from assets that belong to their endowment; people are more worried about the loss of something they have had for a while than the possibility of gaining something they do not have; losses loom larger than corresponding gains. This is most noticeable when the asset under evaluation has given much pleasure. On the other hand, there is no endowment effect expected when owners view their goods as carriers of value to future exchange, like in routine commercial and financial markets.

. For people living in poverty, anything they receive is perceived as reducing losses, not necessarily as a gain. Because they are living below ones reference point, all their choices are between losses, as money spent on one good signifies a loss of another good that could have been purchased instead


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