Wanted: equilibrium mass psychology theory
2009-03-24 · Original WordPress address
Results from psychology or experimental economics don't (as in DO NOT) translate directly into equilibrium behavior. This is because one person's psychological bias may cancel out another person's bias. Or even if people have anomalies that systematically bias behavior, the presence of a few non-biased actors may reverse the bias of the rest.
Psychologists usually report the systematic sorts of biases, so there's not very many examples of the first kind of equilibrium outcome in that literature. That said, examples of human impreciseness are apparent. As individuals, for example, we're imprecise estimators of value. For every potential widget buyer that overestimates the value to him of a widget, there's a potential widget buyer that underestimates its value to her. The price will be set somewhere in between and would be equal to the price set if the buyers didn't make mistakes ((needs cite... I'm sure I've seen results like this somewhere)).
On the other hand, psychologists and experimental economists love to report systematic biases, so-called anomalies. The examples of these are numerous. Just today, The Economist cited evidence of the money illusion ((BTW, guys, the relevant parts of economics, i.e. macro, know all about money illusion and don't deny its existence. I'm not sure why this one finding "refutes" anything.)) and here they are talking about regret. It turns out people feel buyers remorse soon after buying, but after a while they start to think they should have consumed more.
In the case of money illusion, we know --- in, like, an empirical sense --- that money is neutral in the long run; doubling money will double prices. In other words, there's some mechanism at play that corrects for this psychological bias. In the case of the finding about regret, its not clear at all if this would have systematic effects. Does the long term effect swamp out the short term effect? Does either effect have real affects on consumption decisions?
One way to assume these anomalies have macro effects is to assume all agents have perfectly coordinated states of mind (e.g. every last investor becomes chicken little). This isn't exactly a bleedingly obvious assumption, so my theory of equilibrium mass psychology sucks. Can you do better?
We can't just assume individual instances of "irrationality" aggregate up into systematic irrationality. Given our general ignorance of these individual psychological effects, their aggregate properties and the mechanisms underlying this aggregation, a theory like rational expectations that assumes anomalies wash out seems prudent to me.
Now excuse me, I need to go read Vernon Smith.