The Economist "Economics focus" column this week highlights research examining the implications of cognitive psychology for economic analysis.
Modern mainstream, or neo-classical, economics is based on assumptions about decision making that cognitive psychology finds wanting. Neo-classical economics assumes that people make decisions to maximize a satisfaction or utility that does not depend on their income or consumption levels relative to those of the people around them. It assumes that people make decisions without regard to sunk costs or to their current endowments of goods. It assumes that they don't psychologically compartmentalize their budgets or resources, devoting the different compartments to different purposes.
Results from cognitive psychology are challenging many of these assumptions, and economics is faced with figuring out the implications. The Economist column is devoted to research on one of these issues - the endowment effect. In summary, the article finds that experience in market contexts is associated with a learning process. Persons with little experience with market transactions have a significant endowment effect, but this disappears as they acquire experience. The article is here: "To have and to hold". The following selection doesn't address the main result of the article, but it does indicate what's at stake:
"Some recent work should at least help. It explores the �endowment effect�, one of the chief tenets of prospect theory. Put simply, this means that people place an extra value on things they already own. Think of a favourite sweater, or your house: would you swap either for something of equal market value? Over the past decade, prospect theorists have found support for the endowment effect in scores of experiments. In one of the best-known, researchers at Cornell University began by giving university students either a coffee mug or a chocolate bar, each with identical market values. First the experimenters confirmed that roughly half the students preferred each good. After the goodies were handed out, they let the students trade: those who had wanted mugs but got chocolate (or vice versa) could swap. "With barely 10% of students opting to trade, the endowment effect seemed established (you would expect 50% to have swapped, given the random allocation of gifts). Even after a short time with things of little value, ownership had overwhelmed the students' prior tastes. Dozens of other tests have produced similar results, and have produced a wave of criticism of neoclassical economics. "The criticism has been taken seriously, as it should be: if the endowment effect is real, people's economic decisions are fundamentally different from what economists have assumed. The implications of this are profound. To take one example, the Coase theorem, which argues that initial allocations of wealth do not matter as long as markets allow people to trade their stakes�the rationale for government auctions of everything from radio spectrum to mobile-telephone licences�would no longer be valid. To take another, although economists have shown that you need only a few sharp traders for prices in financial (and other) markets to become efficient, the volume of trade with an endowment effect will be below what it might be without one."
I learned about this from "Pejmanesque". I think cognitive psychology will enhance and enrich neo-classical economics, but that neo-classical economics will ultimately retain much of its essential character. I've thought this since I read a book called Choosing the Right Pond by Robert Franks of Cornell (many years ago).
Franks accepted that status matters to people, an idea not built into the neo-classical assumptions. He pointed to evidence that people care less about their position vis-a-vis people they don't come in contact with, and more about their position with respect to others in the circles within which they move. He also recognized that people are different, that status matters much more for some than for others, In this, he saw, were opportunities for gains from trade.
Neo-classical theory suggests that in competitive markets, people will be paid a wage equal to the value of their marginal product. Now people differ in their marginal productivity as well as in their taste for status. Everyone could work in a firm where everyone else had the same marginal products and was paid the same wage. But how much better off things would be if people with a taste for status worked in firms with people who were indifferent to it! This would make the people who really valued status happier without a proportionate reduction in the happiness of the others. Relatively high wage people, who valued status highly, might be willing to give up some part of their wages in order to enjoy the proximity of other persons who had lower wages (and thus status). People with lower wages might be willing to work in an organization with higher wage and status persons if they were given a somewhat higher wage than they would otherwise have had as compensation for their relatively lower status.
Frank's conclusion was that the range of wages observed would not be as wide as a marginal productivity wage model would suggest. As I recall he then had some ingenious tests of the hypothesis and did not reject it.
minor editorial revisions June 11, 2007
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