More on Prospect Theory

These days I’m working hard on my thesis (as always!). Plans are that the experimental design should be ready within some weeks… Hopefully, by october I will be conducting the experiments, we’ll see!!


I tried a couple of times before in this blog to explain what my thesis is about. In particular, a summary of a theoretical model of the effects of overconfidence in banking competition (‘a behavioral model of the credit boom’) and an introduction to Prospect Theory (‘Prospect Theory’), the descriptive model by D. Kahneman and A. Tversky of how people behave when facing risk.


Daniel Kahneman

Source: Google Images


Overconfidence and prospect theory are two cornerstones of Behavioral Economics, a growing field of research with sound empirical basis supporting the idea that market participants are boundedly rational, make systematic errors and, consequently, markets (particularly, financial markets) are often not efficient. Daniel Kahneman was granted the Nobel prize in 2002 for these ideas (as well as Vernon Smith, for providing experimental evidence in the laboratory of market inefficiencies). However, when I look at myself at the University, talk with colleagues and, above all, when I listen to what economic institutions in Spain (namely BdE, CNMV and so on) have to say about these topics, I still see behavioralists like me as queer as a clockwork orange…


No worries. I only need to have a look abroad these days to see what Academics think about Behavioral Economics. The blogosphere is hot these days with an article by Noah Smith about ‘The death of theory’: Smith notices theoretical papers in Economics as a percent of the total have been declining since the 1980s, and the focus is now on empirical tests and experiments. Why did this happen? According to Smith…


…my guess is that the meteor that hit the economics dinosaurs, and set the field’s evolution off in a new direction, was named Daniel Kahneman. Starting in 1973, Kahneman released a torrent of papers showing that human behavior didn’t look anything like the way that homo economicus was supposed to act. Other behavioral meteors followed. Richard Thaler, Vernon Smith, Colin Camerer… it was a giant comet of Behavioral Economics that broke up somewhere in orbit and fell to Earth in many parts.


Paul Krugman followed then on this debate (‘What killed theory?’) agreeing theory is becoming less important in macroeconomics. However, though he agrees with Behavioral Economics, he doesn’t think “Kahneman shook things up all that much; anyone sensible had long known that the axioms of rational choice didn’t hold in the real world, and those who didn’t care weren’t going to be persuaded by one man’s work.” That’s confirmation bias!!


A couple of articles more in relevant websites that I saw these days are The Economist ‘Future prospects’, which summarizes some of the contributions of Prospect Theory to Economics according to a new paper by Nicholas Barberis, another pope in the field; and Bloomberg ‘Why Homo Economicus might actually be an idiot’, which provides recent experimental evidence that greed and self-interest that rules capitalism often underperform when compared to the ‘homo socialis’ that cares about their counterparts.


But if there is one article that makes me see how Behavioral Economics is becoming mainstream also in politics is THIS ONE: the Obama Administration is financing several projects in a dozen federal departments based on Thaler’s ideas on Libertarian Paternalism in order to design efficient public policies: “Insights from the social and behavioral sciences can be used to help design public policies that work better, cost less, and help people to achieve their goals.”


I bet you these ideas will be essential for Social Democracy parties in US and Europe within years to come.

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