When are economics models of human behaviour reasonable?

Colin Camerer and Ernst Fehr have a great review paper in When Does ‘Economic Man’ Dominate Social Behavior? (Science 6 January 2006: 47-52), of how social context interacts within individual difference. The article begins by laying out the ‘rational actor’ assumption that has underpins most economic theory, along with the recent challenges to this view. Populations seem to farily consistently contain self-regarding and cooperative individuals individuals. Self-regarding individuals approximate ‘Economic Man’, while cooperative actors reward cooperation and are willing to bear a cost for punishing unfair behaviour.

The rationality assumption consists of two components: first, individuals are assumed to form, on average, correct beliefs about events in their environment and about other people’s behavior; second, given their beliefs, individuals choose those actions that best satisfy their preferences. If individuals exhibit, however, systematically biased beliefs about external events or other people’s behavior or if they systematically deviate from the action that best satisfies their preferences, we speak of bounded rationality. Preferences are considered to be self-regarding if an individual does not care per se for the outcomes and behaviors of other individuals. Self-regarding preferences may, therefore, be considered to be amoral preferences because a self-regarding person neither likes nor dislikes others’ outcomes or behaviors as long as they do not affect his or her economic well-being. In contrast, people with other-regarding preferences value per se the outcomes or behaviors of other persons either positively or negatively. A large body of evidence accumulated over the last three decades shows that many people violate the rationality and preference assumptions that are routinely made in economics. Among other things, people frequently do not form rational beliefs, objectively irrelevant contextual details affect their behavior in systematic ways, they prefer to be treated fairly and resist unfair outcomes, and they do not always choose what seems to be in their best interest.

The interesting part of this review is how the behaviour of ‘cooperative’ and ‘economic’ actors changes based upon the context in which they interact and their perceptions about the composition of population an individual is interacting with. The presence of cooperators can causes ‘economic’ actors to behave cooperatatively, and the presence of ‘economic’ actors can cause cooperative actors to behave in a more self-regarding fashion.

To show how the interactions between strong reciprocators and self-regarding individuals shape bargaining behavior, we consider the ultimatum game, in which a buyer offers a price p to a seller, who can sell an indivisible good. For simplicity, assume that the buyer values the good at 100 and the seller values it at 0. The buyer can make exactly one offer to the seller, which the latter can accept or reject. Trade takes place only if the seller accepts the offer. If the seller is self-regarding, she accepts even a price of 1 because 1 is better than nothing. Thus, a self-regarding buyer will offer p=1 so that the seller earns almost nothing from the trade. Strong reciprocators reject such unfair offers, however, preferring no trade to trading at an unfair price. In fact, a large share of experimental subjects reject low offers in this game, across a wide variety of different cultures, even when facing high monetary stakes. This fact induces many self-regarding buyers to make relatively fair offers that strong reciprocators will accept. Often the average offers are around p=40, and between 50% and 70% of the buyers propose offers between p=40 and p=50. The behavior of both buyers and sellers changes dramatically, however, if we introduce just a little bit of competition on the seller’s side. Assume, for example, that instead of one there are two sellers who both want to sell their good. Again the buyer can make only one offer which, if accepted by one of the sellers, leads to trade. If both sellers reject, no trade takes place; if both sellers accept, one seller is randomly chosen to sell the good at the offered price. Almost all buyers make much lower offers in this situation, and almost all sellers accept much lower offers. In fact, if one introduces five competing sellers into this game, prices and rejection rates converge to very low levels such that the trading seller earns only slightly more than 10% of the available gains from trade.

Camerer and Fehr argue that the concepts of “strategic substitutability” and “strategic complementarity” are useful for understanding how individual heterogeneity effects aggregate behaviour.

Strategies are complements if agents have an incentive to match the strategies of other players. Strategies are substitutes if agents have an incentive to do the opposite of what the other players are doing. For example, if a firm can earn more profit by matching the prices chosen by other firms, then prices are strategic complements. If firms can earn more profit by choosing a low price when other firms choose high prices (and vice versa), then prices are strategic substitutes.

Under certain conditions, models based on self-regarding preferences and homogeneous rationality predict aggregate behavior rather well, even though many people exhibit rationality limits and other-regarding preferences. However, under strategic complementarity, even a small proportion of other-regarding or boundedly rational players may suffice to generate collective outcomes that deviate sharply from models of Economic Man.

These deviations occur because strategic complementary establishes a connection between the actors and establishes an incentive for ‘economic actors’ to act cooperatively, because it becomes more ‘economic’ to act cooperatively. This can even occur in markets, because of the difficulty of predicting when a market will correct its prices. Camerer and Fehr quote Kenyes as saying “markets can stay irrational longer than you can stay liquid.” They conclude:

The new models of heterogeneous social preferences and bounded rationality explain these puzzling results in a unifying way because they explicitly take heterogeneity and incentive interactions between different types of individuals into account. Therefore, they can explain when Economic Man dominates aggregate outcomes and when he fails to do so.

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