More on Behavioral Economics

Again, a reposted post from the old blog.  This one refers to the fractal nature of human thinking (another reposted post).

In Democracy in America, Alexis de Tocqueville discusses "self-interest, rightly understood," praising the American people for recognizing that it is in their self-interest to help their neighbors, for example. I recently ran across that phrase again in a brand new book from Prof. Ryan Patrick Hanley of Marquette University, entitled Adam Smith and the Character of Virtue. The book is clearly targeted for the academic as it is very dense and heavily footnoted. Thus, even though it only weighs in at a little over 200 pages, the book demands careful reading.

One of the theories that I have been pursuing since I first read the chapter of The Wealth of Nations in which the "invisible hand" aphorism appears is that Smith, too, was discussing self-interest, rightly understood and not selfishness. Prof. Hanley's book identifies more evidence that supports the theory.

Unfortunately, neoclassical economics assumes selfishness, not self-interest rightly understood. This assumption is embedded in the notion that economic value is the sole measure of utility. Indeed, Milton Friedman and others resurrected the invisible hand aphorism in the mid-20th century as rhetorical support that there is no society, only a collection of individuals each pursuing his own self interest. Apparently, the invisible hand aphorism had been ignored by economists until libertarians and their ideological brethren (e.g., objectivists) recognized its value in supporting their views and started putting it to use.

Because behavioral economics starts with the assumption that neoclassical economics is largely correct and seeks only to explain anomalies between what neoclassical theory predicts and what actually occurs, behavioral economists are predisposed to treat reality as the aberration and tend to use perjorative terms to describe real human behavior (e.g., irrational, herd behavior, etc.). Politically, this makes sense: to the extent that behavioral economists are trying to create meaningful and lasting change in the models that neoclassical economics uses to understand human behavior, they must do so incrementally for fear of being marginalized. Your voice cannot be heard if the herd banishes you. Unfortunately, the politics of the situation frame the conclusions of behavioral economists in a way that obscures much of the value of the research and prevents deeper insights.

Describing the tendency of large groups of people to act the same way at the same time as an "economic anomaly" and perjoratively label it "herd behavior," as behavioral economists do, is a tragedy. The problem lies not with reality but with the assumptions underlying the model.

It was actually "herd behavior" that inspired me to start developing the concept that human decision-making is "fractal" in nature. The bottom line is that human beings have a hard-wired decision-making system, the dopamine system, that is involved in every decision they make. Built on top of that hardware is a software system, cognition, that interpets events based on how the hardware system sorted them (e.g., enjoying events flagged as meeting expectations, worrying about events flagged as possibly not meeting expectations, and ignoring those events not flagged). Each of these human systems is part of a human network, i.e. society. Because of specialization, different people know different things, and no one person can be expected to learn everything. So, people watch what other people do to understand what they should do, particularly in making decisions in areas that they don't understand. Viewed in this way, "herd behavior" is really more a form of delegation than it is an example of herding.

The reason that "herd behavior" can lead to violent business cycles is the dopamine system itself. Again, all human decisions are filtered through the dopamine system and the cognitive function. Some decisions, however, are derived from one's perception of others' decisions. One example is the impact of falling or rising prices in the decision to buy or sell a particular stock. It takes time to develop such perceptions, which is why it takes time for people to "jump on the bandwagon." Because of the dopamine system and confirmation bias in the cognitive function, it also takes time to determine that such perceptions are wrong. The more abstract the problem is to a person, the longer it takes that person to make up or change his mind. (This is what I was trying to get at with the concept of a bias error function.) When reality falls far short of expectations, the dopamine system kicks into overdrive and sends signals of fear and dread that can lead to panic. To the extent that one person's decision is based on his perception of another person's decision, and the perception suddenly changes, those signals of fear and dread propagate by virtue of the observer's dopamine system.