Economics and Cognitive Science

Economics is concerned with the equilibria reached by large systems, such as markets and whole economies. The units that contribute to these collective outcomes are the individual participants in the economy. Consequently, assumptions about individual behavior play an important role in economic theorizing, which has relied predominantly on a priori considerations and on normative assumptions about individuals and institutions.

In economics, it is assumed that every option has a subjective "utility" for the individual, a well-established position in his or her preference ordering (von Neumann and Morgenstern 1947; see RATIONAL DECISION MAKING). Because preferences are clear and stable they are expected to be invariant across normatively equivalent assessment methods (procedure invariance), and across logically equivalent ways of describing the options (description invariance). In addition, people are assumed to be good Bayesians (see BAYESIAN LEARNING and BAYESIAN NETWORKS), who hold coherent (and dynamically consistent) preferences through time. Economics also makes a number of secondary assumptions: economic agents are optimal learners, whose selfish focus is on tangible assets (e.g., consumer goods rather than goodwill), who ignore sunk costs, and who do not let good opportunities go unexploited.

Coinciding with the advent of cognitive science, Simon (1957) brought into focus the severe strain that the hypothesis of rationality put on the computing abilities of economic agents, and proposed instead to consider agents whose rationality was bounded (see BOUNDED RATIONALITY). Over the last three decades, psychologists, decision theorists, and, more recently, experimental and behavioral economists have explored people's economic decisions in some detail. These studies have emphasized the role of information processing in people's decisions. The evidence suggests that people often rely on intuitive heuristics that lead to non-Bayesian judgment (see JUDGMENT HEURISTICS), and that probabilities have nonlinear impact on decision (Kahneman and TVERSKY 1979; Wu and Gonzalez 1996). Preferences, moreover, appear to be formed, not merely revealed, in the elicitation process, and their formation depends on the framing of the problem, the method of elicitation, and the valuations and attitudes that these trigger.

Contrary to the assumption of utility maximization, evidence suggests that the psychological carriers of value are gains and losses, rather than final wealth (see DECISION MAKING). Because of diminishing sensitivity to greater amounts, people exhibit risk aversion for gains and risk seeking for losses (except for very low probabilities, where these can reverse). Prospects can often be framed either as gains or as losses relative to some reference point, which can trigger opposing risk attitudes and can lead to discrepant preferences with respect to the same final outcomes (Tversky and Kahneman 1986). People are also loss averse: the loss of utility associated with giving up a good is greater than the utility associated with obtaining it (Tversky and Kahneman 1991). Loss aversion yields "endowment effects," wherein the mere possession of a good can lead to higher valuation of it than if it were not in one's possession (Kahneman, Knetsch, and Thaler 1990), and also creates a general reluctance to trade or to depart from the status quo, because the disadvantages of departing from it loom larger than the advantages of the alternatives (Knetsch 1989; Samuelson and Zeckhauser 1988). In further violation of standard value maximization, decisional conflict can lead to a greater tendency to search for alternatives when better options are available but the decision is hard than when relatively inferior options are present and the decision is easy (Tversky and Shafir 1992).

When a multiattribute option is evaluated, in consumer choice for example, each attribute must be weighted in accord with its contribution to the option's attractiveness. The standard economic assumption is that such evaluation of options is stable and does not depend, for example, on the method of evaluation. Behavioral research, in contrast, has shown that the weight of an attribute is enhanced by its compatibility with a required response. Compatibility effects are well known in domains such as perception and motor performance. In line with compatibility, a gamble's potential payoff is weighted more heavily in a pricing task (where both the price and the payoff are expressed in the same monetary units) than in choice. Consistent with this is the preference reversal phenomenon (Slovic and Lichtenstein 1983), wherein subjects choose a lottery that offers a greater chance to win over another that offers a higher payoff, but then price the latter higher than the former. This pattern has been observed in numerous experiments, including one involving professional gamblers in a Las Vegas casino (Lichtenstein and Slovic 1973), and another offering the equivalent of a month's salary to respondents in the People's Republic of China (Kachelmeier and Shehata 1992).

People's representation of money also systematically departs from what is commonly assumed in economics. According to the fungibility assumption, which plays a central role in theories of consumption and savings such as the life-cycle or the permanent income hypotheses, "money has no labels"; all components of a person's wealth can be collapsed into a single sum. Contrary to this assumption, people appear to compartmentalize wealth and spending into distinct budget categories, such as savings, rent, and entertainment, and into separate mental accounts, such as current income, assets, and future income (Thaler 1985, 1992). These mental accounting schemes lead to differential marginal propensities to consume (MPC) from one's current income (where MPC is high), current assets (where MPC is intermediate), and future income (where MPC is low). Consumption functions thus end up being overly dependent on current income, and people find themselves willing to save and borrow (at a higher interest rate) at the same time (Ausubel 1991). In addition, people often fail to ignore sunk costs (Arkes and Blumer 1985), fail to consider opportunity costs (Camerer et al. 1997), and show money illusion, wherein the nominal worth of money interferes with a representation of its real worth (Shafir, Diamond, and Tversky 1997).

Economic agents are presumed to have a good sense of their tastes and to be consistent through time. People, however, often prove weak at predicting their future tastes or at learning from past experience (Kahneman 1994), and their intertemporal choices exhibit high discount rates for future as opposed to present outcomes, yielding dynamically inconsistent preferences (Loewenstein and Thaler 1992). In further contrast with standard economic assumptions, people show concern for fairness and cooperation, even when dealing with unknown others in limited encounters, where long-term strategy and reputation are irrelevant (see, e.g., Dawes and Thaler 1988; Kahneman, Knetsch and Thaler 1986; Rabin 1993).

The foregoing partial list of empirical observations and psychological principles does not approach a unified theory comparable to that proposed by economics. The empirical evidence suggests that Homo sapiens is significantly more difficult to model than Homo economicus. Some have argued that the descriptive adequacy of the economic assumptions is unimportant as long as the theory is able to predict observed behaviors. Friedman (1953), for example, has proposed the analogy of an expert billiards player who, without knowing the relevant rules of physics or geometry, is able to play as if he did. Nonetheless, as the preceding list suggests, the tension between economics and the cognitive sciences appears to reside in the actual predictions, not only in the assumptions. Others have argued that individual errors are less important when one is ultimately interested in explaining aggregate behavior. The observed discrepancies, however, are systematic and predictable, and if the majority errs in the same direction there is no reason to expect that the discrepancies should disappear in the aggregate (Akerlof and Yellen 1985). Cognitive scientists and experimental and behavioral economists are trying better to understand and model systematic departures from standard economic theory. The aim is to bring to economics a theory populated with psychologically more realistic agents.

See also

Additional links

-- Eldar Shafir


Akerlof, G. A., and J. Yellen. (1985). Can small deviations from rationality make significant differences to economic equilibria? American Economic Review 75(4):708-720.

Arkes, H. R., and C. Blumer. (1985). The psychology of sunk cost. Organizational Behavior and Human Performance 35:129-140.

Ausubel, L. M. (1991). The failure of competition in the credit card market. American Economic Review 81:50-81.

Camerer, C., L. Babcock, G. Loewenstein, and R. Thaler. (1997). A target income theory of labor supply: Evidence from cab drivers. Quarterly Journal of Economics 112(2).

Dawes, R. M., and R. H. Thaler. (1988). Cooperation. Journal of Economic Perspectives 2:187-197.

Friedman, M. (1953). The methodology of positive economics. In Essays in Positive Economics. Chicago: University of Chicago Press.

Kachelmeier, S. J., and M. Shehata. (1992). Examining risk preferences under high monetary incentives: Experimental evidence from the People's Republic of China. American Economic Review 82:1120-1141.

Kahneman, D. (1994). New challenges to the rationality assumption. Journal of Institutional and Theoretical Economics 150(1):18-36.

Kahneman, D., J. L. Knetsch, and R. H. Thaler. (1986). Fairness as a constraint on profit seeking: Entitlements in the market. American Economic Review 76(4):728-741.

Kahneman, D., J. L. Knetsch, and R. H. Thaler. (1990). Experimental tests of the endowment effect and the Coase theorem. Journal of Political Economy 98(6):1325-1348.

Kahneman, D., and A. Tversky. (1979). Prospect theory: An analysis of decision under risk. Econometrica 47:263-291.

Knetsch, J. L. (1989). The endowment effect and evidence of nonreversible indifference curves. American Economic Review 79:1277-1284.

Lichtenstein, S., and P. Slovic. (1973). Response-induced reversals of preference in gambling: An extended replication in Las Vegas. Journal of Experimental Psychology 101:16-20.

Loewenstein, G., and R. H. Thaler. (1992). Intertemporal choice. In R. H. Thaler, Ed., The Winner's Curse: Paradoxes and Anomalies of Economic Life. New York: Free Press.

Rabin, M. (1993). Incorporating fairness into game theory and economics. American Economic Review 83:1281-1302.

Samuelson, W., and R. Zeckhauser. (1988). Status quo bias in decision making. Journal of Risk and Uncertainty 1:7-59.

Shafir, E., P. Diamond, and A. Tversky. (1997). Money illusion. The Quarterly Journal of Economics 112(2):341-374.

Simon, H. A. (1957). Models of Man. New York: Wiley.

Slovic, P., and S. Lichtenstein. (1983). Preference reversals: A broader perspective. American Economic Review 73:596-605.

Thaler, R. H. (1985). Mental accounting and consumer choice. Marketing Science 4:199-214.

Tversky, A., and D. Kahneman. (1986). Rational choice and the framing of decisions. Journal of Business 59(4,2): 251-278.

Tversky, A., and D. Kahneman. (1991). Loss aversion in riskless choice: A reference dependent model. Quarterly Journal of Economics (November): 1039-1061.

Tversky, A., and E. Shafir. (1992). Choice under conflict: The dynamics of deferred decision. Psychological Science 3(6):358-361.

von Neumann, J., and O. Morgenstern. (1947). Theory of Games and Economic Behavior. 2nd ed. Princeton, NJ: Princeton University Press.

Wu, G., and R. Gonzalez. (1996). Curvature of the probability weighting function. Management Science 42(12):1676-1690.

Further Readings

Benartzi, S., and R. Thaler. (1995). Myopic loss aversion and the equity premium puzzle. Quarterly Journal of Economics 110(1):73-92.

Camerer, C. F. (1995). Individual decision making. In J. H. Kagel and A. E. Roth, Eds., Handbook of Experimental Economics. Princeton, NJ: Princeton University Press.

Heath, C., and A. Tversky. (1990). Preference and belief: Ambiguity and competence in choice under uncertainty. Journal of Risk and Uncertainty 4(1):5-28.

Johnson, E. J., J. Hershey, J. Meszaros, and H. Kunreuther. (1993). Framing, probability distortions, and insurance decisions. Journal of Risk and Uncertainty 7:35-51.

Kagel, J. H., and A. E. Roth, Eds. (1995). Handbook of Experimental Economics. Princeton, NJ: Princeton University Press.

Loewenstein, G., and J. Elster, Eds. (1992). Choice over Time. New York: Russell Sage Foundation.

March, J. G. (1978). Bounded rationality, ambiguity and the engineering of choice. Bell Journal of Economics 9:587-610.

Plott, C. R. (1987). Psychology and economics. In J. Eatwell, M. Milgate, and P. Newman, Eds., The New Palgrave: A Dictionary of Economics. New York: Norton.

Rabin, M. (1998). Psychology and economics. Journal of Economic Literature.

Simon, H. A. (1978). Rationality as process and as product of thought. Journal of the American Economic Association 68:1-16.

Thaler, R. H. (1991). Quasi Rational Economics. New York: Russell Sage Foundation.

Thaler, R. H. (1992). The Winner's Curse: Paradoxes and Anomalies of Economic Life. New York: Free Press.

Tversky, A., and D. Kahneman. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty 5:297-323.

Tversky, A., S. Sattath, and P. Slovic. (1988). Contingent weighting in judgment and choice. Psychological Review 95(3):371-384.

Tversky, A., P. Slovic, and D. Kahneman. (1990). The causes of preference reversal. American Economic Review 80:204-217.

Tversky, A., and P. Wakker. (1995). Risk attitudes and decision weights. Econometrica 63(6):1255-1280.