Bradley A. Hansen on Richard Thaler, Behavioral Economics and Anomalies

The blogging gods are alive and well, and their “In A Weird Coincidence” department is in fine fettle.

So, in a weird coincidence, Bradley Hansen posted on his blog about the same topic as my blogpost from yesterday. And even better, his take on the issue is different from mine, which means I get to write one more post about the topic (yay!).

Here’s his opening paragraph:

I was listening to a recent episode of Hidden Brain the other day about anomalies, specifically things that are supposedly anomalies in economic theory. The guest was Richard Thaler, who is famous as a behavioral economist and Nobel Prize winner. The discussion reminded me of some of the problems that I have with some work that is described as behavioral economics. One of the stories he told was about Richard Rosett, a professor of his when he was in graduate school at the University of Rochester. Rosett collected wine. He wouldn’t spend more than $20 or $30 on a bottle, but sometimes a bottle he had purchased would increase in price to as much as $200. There was a wine shop in Rochester that would have purchased these valuable bottles from him, yet he would serve them rather than sell them, despite the fact that he would not spend $200 on a bottle. Thaler regards this as an anomaly that contradicts economic theory. The claim is that economic theory says that cost is the value of the foregone opportunity. It doesn’t matter whether you paid $200 for the bottle you are serving or gave up the opportunity to sell the bottle for $200. Either way the cost is $200. That’s all well and good, but it is ignoring the value of the story, which is odd because Thaler claims stories are his thing.

As always, please read the whole post. I will quote parts that are relevant to this post throughout, but his blogpost is worth reading in its entirety.

“What are you optimizing for?” is a question I love asking on this blog, and Hansen asks this question and answers it – in the case of economists. Economists, he says, assume that people are trying to maximize their utility, and not their wealth.

I’ve added that emphasis towards the end, but I assure you that neither Hansen, nor Thaler, would object in the slightest. In fact, anybody who has taught introductory economics would likely nod approvingly upon seeing the emphasis, because this is a surprisingly widespread misapprehension – that economics is about wealth maximization.

No. No, it is not. Economics is the study of how to get the most out of life, and wealth is the means that allows us to get to our ends. What gives us utility is, for example, the eating of a plate of pani puri. And our wealth is what allows us to buy that plate of pani puri. If we choose to maximize the amount of wealth we possess by giving up on eating the pani puri, we would be missing the point.

Now, Thaler is of the opinion that Rosett was wrong to not sell the $200 bottle to the wine shop. And Hansen is of the opinion that Thaler is wrong. I’m about to tell you my opinion in the next paragraph, so hang on.

So, my opinion. My opinion is that what Hansen is really saying is that Thaler is attacking a strawman.

How so? Let’s go through this step by step:

  1. We have with us a bottle of wine that was purchased for $20. This has risen in value since our purchase, and can now be sold in the market for $200. Or we could drink it. What should we do?
  2. An economist, Richard Thaler says, should sell it. Because buy for 20, sell for 200. Duh.
  3. Hansen, on the other hand, says no, an economist shouldn’t necessarily sell it. Why not?
  4. Because what a cool story to tell your guests while you serve them the wine! “I got this bottle for only $20, and the going rate for it is now $200. Drink up, people, and cheers!”
  5. So the $180 dollars that you could have earned by selling the bottle of wine – is it worth more than the pleasure that you get from telling the story? From being thought of as a connoisseur of wine? From being seen as a Really Cool Guy? If yes, then sell. If not, well, don’t.
  6. Effectively, Hansen is saying that the utility function ought to include the pleasure of being able to tell the story about the wine.
  7. And, if you ask me, also ought to include the pleasure one gets from drinking the wine.
  8. Taking all of this into account, Hansen says, you would be irrational to sell the wine.

Does Richard Thaler not know this? Of course he does.

He (Richard Thaler) is saying that conventional economics has forgotten this stuff. Hansen is saying that they have not.

So who is right?

Well, the other thing that I like to say on my blog is that the truth lies somewhere in the middle. And in this case, I would say that both are kind of correct. But (sorry, Professor Hansen!) I do think that Richard Thaler has a bit more going for his side of the debate.

And the reason I say that is because as a teacher, I am firmly of the opinion that we teachers send far too many students out into the real world with the impression that economics is only about prices, income and expenditure, and not about “charity and love for children, spouses, relatives or anyone else“.

That is from pp 98 (Chapter 7, Utility Maximization) of Hal Varian’s graduate level textbook (Microeconomics Analysis). In English, it is saying that the problem of preference maximization is solved by maximizing utility through the consumption of x, while making sure that the money you spend on buying x (the price, p, multiplied by the number of units purchased of x) is lesser than your income, m. It is saying a bit more than that too, but this is EconForEverybody, and so I’m going to keep things simple.

Well, as simple as is possible, granted.

And it gets worse! On the second page of his chapter, this is what Hal Varian has to say about utility functions:

“A utility function is often a very convenient way to describe preferences, but it should not be given any psychological interpretation.”

Yes, I’ve added the emphasis, it is not there in the original. And in this case, one’s approval about the emphasis being added is likely to be a function of whether you think Thaler is right or wrong.

We can debate (and I would love to!) what Hal Varian meant when he wrote that, and whether there remains room to add in the pleasure of telling the story about the wine bottle, given his definition of the utility function.

But this is my charge: the impression that a student is going to be left with, if said student chooses to tackle this book, is that there’s no room for any story telling pleasure in the framing of the utility function. In fact, I happily admit to having just that impression when I did battle with this book back in 2006.

Again, sure my impression may have been (partially or wholly) incorrect. And sure there may be different ways to interpret that statement from that textbook.

But when Hansen says that “part of the problem with the wine story comes from not appreciating the many ways in which people can get satisfaction (utility)”… well, I’d argue that the diagnosis is spot on.

And the underlying cause? The textbooks we use to teach microeconomics don’t teach how to think about utility deeply enough. And we teachers (myself included) don’t emphasize this point often enough.

Hansen ends his blog by saying the following:

I’m not saying there is no value in behavioral economics, but far too much attention is given to these little stories that supposedly contradict economic theory when in fact they do no such thing.

Me, I’d say that far too little attention is given to those little mathematical versions of utility functions that supposedly help students understand economic theory, when in fact they do no such thing.

What say?

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