Comments (10)

1. It would seem to me that there is also the factor that someone stuck in second place when the first place reaches $20 would be better off getting $20 for $21 than nothing for $19.

   posted by anomdebus on 4-27-2010 at 4:30 pm

2. @anomdebus — I agree. The thing I can’t work out is when exactly that logic starts to kick in. Should it start being an issue as you get close to $20, or should it start at $1 since technically you’re at risk there too?

   posted by Chris Higgins on 4-27-2010 at 4:34 pm

3. I think this is a very interesting field but when youre talking about behavioral economics there are better examples you could use because this example could yield results above 20 using rational expectations. Where you would have something is if controlled experimental results differed from rational expectations.

   posted by Matt M on 4-27-2010 at 6:33 pm

4. So, Cyndi Lauper was right. Money does change everything.

   posted by Joe Maz on 4-27-2010 at 9:52 pm

5. I only caught the last 20 minutes but it was a terrific show. As Americans we’re taught early on that capitalism is the end-all-be-all of economic systems. So it is very interesting to see how human nature creates loop holes and market imperfections.

   posted by Phil on 4-28-2010 at 9:45 am

6. This was a fantastic episode and an absolutely spot-on indictment of the idiocy that is the Chicago School of Economics. These economists really need to get over their physics envy and listen to the REAL work being done by behavioral psychologists and neuroscience.
   -rufus

   posted by rufusmcbufus on 4-30-2010 at 11:08 am

7. The problem with behavioral economists is that they don’t understand the math or models at all. If you want to critique something you had better understand it.

   This experiment shows absolutely nothing. Using only high school algebra I can write up a simple model in which everybody behaves rationally, cares only about money (i.e. no emotion at all), and the same exact behavior happens as they observe in this experiment.

   Without math you can’t clearly see the problem or make any attempt at understanding what’s really going on. You can’t even tell if it should kick in at $1 or later. Well it should kick in later. The worst case scenario when deciding to bid when you aren’t currently the second best bidder is that you bid, lose, and end up paying what you just bid. From that we can say with certainty that you should bid if you think the probability of somebody else bidding is higher than your bid/value of the item. So for example you should bid that first $1 if you think your chance of winning is greater than 5% (as opposed to 95% for a first bid of $19). But that’s assuming that either you win or you have the worst case scenario – which of course you don’t; so in reality you should bid $1 if you think there’s any chance at all that you could win with that bid. It’s also immediately obvious that there should be a cutoff beyond which nobody makes a bid when they aren’t the second highest bidder (the max cutoff is $20), so you can immediately see that it should turn into a 2 person bidding war – as we see in the experiment. Now assume you’re one of the two people caught in that battle. You still have the same worst case scenario as before. If you’re risk neutral then the actual value of the bid shouldn’t affect whether you bid or not at all – the only thing that should matter is how likely you think the other person is to bid and if you assume either you win or the worst case happens then you should stop bidding when the probability of the other person bidding is greater than 10%; again after taking into account that more than just the worst case can happen you should bid at higher percentages, e.g. if you think there’s a 30% chance of winning. So essentially it’s a battle of signaling how committed you are to keep bidding while at the same time trying to figure out how likely the other guy is to keep bidding. If you’re risk averse then the actual value of your bid matters too, which makes the bidding end sooner. So models predict exactly what we see 1) people should bid, 2) it should turn into a 2 person bidding war 3) depending on the beliefs of how likely other people are to bid the bidding can easily surpass $20, 4) the bidding will eventually stop, 5) there’s important insights to be gained from actually writing down a consistent mathematical model of what you think is going on.

   Basically it would have taken these behavioral economists all of 5 minutes to realize this stuff if that had any idea at all what they were talking about. That’s why there’s so much disdain among mainstream economists for them; essentially they’re getting paid to prove that our models are right while saying that they proved them wrong. Similar models can be applied to bubbles (which economists never doubted), hyperbolic discounting (why the people wanted $100 today but $102 in a year and a day), and even why people would want to sell the cup for more than they were willing to pay for it. Also why do people have the idea that emotions are incompatible with current economic models, because they aren’t – in fact emotions (most often some concept of happiness, but also of things like regret or envy) have been a very important part of economic theory since even back in the 1800′s and are included in some way or another in the vast majority of current economic models.

   Finally, Cochrane and Fama are bad representatives of mainstream economists. They are actually decent researchers – especially Fama, but they’re crazy too – especially Cochrane. Instead they should have interviewed somebody like the Lucas, who is not only a good researcher but also sane. Also mainstream economics does not say that markets work perfectly or that there should be no regulation. The people that say that are primarily business people and political scientists, not good academic economists (although a few crazies persist).

   posted by rational economist on 5-2-2010 at 6:38 am

8. “Also mainstream economics does not say that markets work perfectly or that there should be no regulation. The people that say that are primarily business people and political scientists, not good academic economists (although a few crazies persist).”

   The problem was that regulators believed too little in efficient markets. Efficient markets says that you can’t get persistently high returns without taking on more and more risk. Had the regulators understood this, then it would have been obvious much earlier that it was excessive risk that was driving some of these high returns. Take Madoff for example. The efficient market hypothesis, for example, would say that producing mid-teen returns year in and year out with hardly any volatility is impossible. And they would have been right!

   And yes, there is fear, greed and stupid people in the marketplace. No one, even Fama, is saying otherwise. But what, as an investor, can you do about it? Fama, and I would argue, that it is still too difficult to gain any advantage.

   The insane people in finance are those that insist that active management can somehow produce higher returns than the market…when all active managers are doing is buying and selling securities back and forth between each other. So when you add them all together, they are the market. Minus their costs.

   posted by tms on 5-3-2010 at 9:44 am

9. Herbert Simon wrote more than 60 years ago about the limits of human cognition. Unlike some that criticize economics ‘without understanding the math” Simon was so brilliant that was even able to write computer program algorithms on how a bounded rational mind works. Of course, mainstream economists never paid any attention and Simon was studied in Business schools and not in Econ departments.

   And I am an economist by education but I was never convinced about the comprehensive rational assumption as I was simultaneously exposed to Simon’s arguments.

   Unlike economics that treats the mind as a black box in which they see only outputs, guess the inputs and ignores the process within, neuroscience has enormous potential to provide a more comprehensive theory of human decision making than economics alone. Neuroscience can unlock how the mind works by looking at it and controlling the inputs fed to it. Still, traditional models will have a role in those environments that meet its strict assumptions.

   posted by renegade economist on 7-6-2010 at 1:58 pm

10. What Rational Economist says is true if we can assume that all players in the market are going to act in a completely rational manner. As with all classic or mainstream econmists, everything starts with an assumption, the most common of which is “all things being equal”.

    One thing that can be said about human behaviour is that it isn’t always rational. What if someone bidding in the auction is “crazy”? What if someone is perfectly sane just wants to mess with the outcome (civil disobedience)? How does one mathematically model an irrational act that may be influenced to an unpredictable degree by any number of oborant deviant motivation?

    By his own admission Rational Economist acknowledges that people (e.g., Cochrane & Fama) do act irrationally and that irrational behaviour may or may not be intentional.

    posted by Trevor on 10-6-2011 at 10:55 pm

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