Rabin (2002) on Psychology and Economics

Matthew Rabin, “A Perspective on Psychology and Economics.” European Economic Review 46: 657 – 685, 2002.
 

• “Ceteris paribus, the more realistic our assumptions about economic actors, the better our economics [page 658].” Rabin is implicitly taking on Milton Friedman’s discussion in his 1953 essay “The Methodology of Positive Economics,” where Friedman suggests that the realism of assumptions is not a test of the value of a theory; rather, theories should be judged on their ability to predict the data or explain the evidence.

• The departures of behavior from traditional economics assumptions are both common and systematic. We are not fully rational, fully self-controlled, or fully self-interested.

• Three important behavioral regularities are loss aversion, the endowment effect, and an interest in behaving in a reciprocal fashion. Further, people seem to have preferences not over final outcomes alone, but over changes from a reference point – standard economics assigns utility only over final outcomes.

• The standard economics assumption of exponential discounting of future costs and benefits has never had any empirical justification. The “behavioral” assumption of a present bias not only is more realistic, but it also explains common behaviors such as undersaving and procrastination that are hard to square with exponential discounting. Further, the standard approach to risk aversion is like the standard approach to discounting, obviously wrong and incapable of explaining common behavior.

• The argument that markets would punish irrational behavior doesn’t mean we shouldn’t study such behavior – rather the opposite, actually. The fact that in some settings a bias dissipates is not to say that people do not have such a bias or that it cannot have meaningful implications.