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Andrew Caplin

Ph.D. Yale University Professor of Economics; Microeconomic Theory, Macroeconomic Theory, The Housing Market

http://www.econ.nyu.edu/user/caplina/

PSYCHOLOGY AND ECONOMICS: THEORY

Economic analysis is based in large part on the assumption of deliberative goal pursuit. The choices we make are seen as rational, in light of our goals and our perceived constraints. This assumption has proven extraordinarily fruitful in classical economics, yet is seen by many as meeting its demise in the field of behavioral economics. Behavioral economics aims to introduce certain aspects of psychological realism to decision making. In general, this realism is seen as contradicting the assumption of rational goal pursuit.

In research with John Leahy, I have questioned whether the dividing line between economics and psychology should be framed in terms of rational versus irrational. We believe that psychological forces such as fear of the future, suspense, and disappointment, can rationally be factored into many decisions. To accommodate this insight, all that is needed is a recognition that prizes can have a psychological as much as a physical nature. We developed a simple theory to capture this idea. The attached links are both to the article as published, and to the prior working paper, which contains additional illustrations, including an application to gambling.

Psychological Expected Utility Theory and Anticipatory Feelings, with John Leahy, Quarterly Journal of Economics, 2001, 55-80. Earlier unpublished version

Why would such an obvious idea require elaboration and defense? Because it contradicts a fundamental axiom of the profession: the principle of revealed preference. According to this principle, the only legitimate basis for a theory of choice is direct observation of choices. Mental states are presumed to be unobservable and therefore unsuitable building blocks for the theory of choice. While ordinary folk may discuss fear and anxiety, the principle of revealed preference says that social scientists must limit ourselves to analyzing behavioral consequences. In standard economics, actions speak louder than emotions. In order to widen support for our view that it is time to take a closer look at mental states, it is necessary first to analyze the limitations of the revealed preference view of the world. The following paper makes a start on just this program: The Supply of Information by a Concerned Expert

The paper shows that there are crucial policy questions that can be answered only if one uses a utility function that goes beyond revealed preference. These are questions involving the supply of information by a well-informed policy maker. The essential idea is this. If dislike of information is the result of an individual's love of surprise (as when that individual is watching a game played by a favorite team without knowing the result ahead of time), it is never a good idea to reveal the actual outcome, even if you happen to know it, and the outcome accords with their preferences. On the other hand, if their dislike of information results from a fear of getting bad news about, say, their health status, then it may be profoundly beneficial to pass on good news as soon as possible. Apparently, the motive for information avoidance is critical in this decision, not merely the fact of such avoidance. We wrote a second paper that makes an important point about the limitations of the principle of revealed preference. The classical approach involves using choices as a proxy for welfare, and therefore deriving from our models strong policy statements. It turns out that the argument for this approach is far weaker in dynamic than in static settings. The reason is simple: it is not feasible to change past choices, even were such changes to be currently desirable. One can disagree with one's prior choices, yet find no market in which to express this disagreement. Recognition of this problem has a devastating impact on the standard arguments of dynamic welfare theory. The Social Discount Rate (with John Leahy), NBER Working Paper 7983, 2000.

Armed with these insights, John and I have become increasingly comfortable that choice theorists will ultimately move in our direction. Just as game theorists discuss strategies in a manner based on intuitive realism rather than actual observation, so one day will choice theorists. The following papers move this agenda forward. All three papers focus on one of the profound advantages of our fully rational approach to psychology over partly rational behavioral models. Our approach allows one to conduct policy analysis in areas that have classically been considered too "fuzzy" for such analyses to be worthwhile. In essence, we are able to propose new policies in settings in which factors such as anxiety and fear play a role. We believe that these ideas may be applied fruitfully in the fields of health care, and in the arena of savings, investment, and portfolio choice. Hints (and more) in this direction can be found in the following three papers: Aids Policy and Psychology: A Mechanism Design Approach, with Kfir Eliaz, forthcoming Rand Journal of Economics Behavioral Policy (with John Leahy), in Essays in Economics and Psychology (I. Brocas and J. Carrillo eds.), Oxford University Press, 2003 Fear as a Policy Instrument, in Time and Decision (George Loewenstein, Daniel Read, and Roy Baumeister eds.), Russell Sage, 2003.

One big question concerning this line of research concerns evidentiary issues. If one is going to go beyond choice, where is the additional information to come from? It is with this question in mind that John and I have pursued survey research, in combination with John Ameriks of the TIAA-CREF Institute, who had his own earlier struggles against the tyranny of revealed preference. According to many economists, the reason that some individuals save far more than others with similar economic and demographic characteristics is to be found in the fact that they have different "discount factors". When John enquired as to the meaning of this elusive concept, he found it to be circularly related to whatever it was that made one person save more than another. Our line of joint research is detailed on the survey research portion of this Web site.