Do people and groups maximize expected utility? A survey of alternative theories, for the non-economist.

1. Implications
Economic theory informs:
• anti-trust law
• contracts law
• Federal Reserve policy
• business decisions
• financial markets (traders, arbitrageurs)

2. Traditional Theory
• Utility
• Expected Utility
• Maximization
• Calculate how to do this
• Rationality
• An approximation, a metaphor, or an
ideology?

3. Cost-Benefit Analysis
max E dt · ut (ct ) , given It
At
t

4. Some Departures from
Homo Economicus
• Reciprocity
• Calculational Capacity
• Heuristics
• Absolute Value vs Relative Value
• Probability

5. Some Departures from
Homo Economicus
• Reciprocity
• Calculational Capacity
• Heuristics
• Absolute Value vs Relative Value
• Probability

6. Probability
• Reasonable guess: if people who know exactly what’s
coming maximize utility, maybe people who can guess
what’s coming maximize expected utility.
• People have a very good inborn heuristic for
averaging. They can do it in a blink.
• Plus the mathematics of probability are already worked out
(Boltzmann, Kolmogorov), so economists can hypothesize about
behavior without having to invent new mathematical tools.

7. Expected Utility
• Say an agent is choosing what to do in the face of
uncertainty.
• Option X might result in one thing, or it might do
something else.
• Same for Options Y and Z.
• Example: Messrs. X,Y, and Z are guys you could date.
• Of course there are a variety of possible outcomes associated with
each of these choices, but let’s just reduce it to: {break up after 1
month, break up after 1 year, break up after 10 years, die together}

8. Probability
• That turned out to be insufficient to describe
people’s behavior.
• (After all, people do play the lottery and buy
insurance, which on average is a losing proposition.)
• The next guess was that people care about variance
as well as mean.
• (Chalkboard: pictures of distributions.)

9. Risk Attitudes
Since this person’s utility is
proportional to wealth, they
weigh the fiftieth dollar the
same as the millionth dollar.
For this person, having only a
few dollars will be extremely
painful: they can’t risk it!

10. Risk Attitudes

11. Uncertainty Aversion
• Say there are two classes you are considering enrolling in. You
want to know how good the teacher is, so you go to a website
that rates teachers.
1. One of the teachers, you cannot find any information about.
2. The other teacher, the reviews are half positive, half negative.
• Most people would prefer the second teacher because they
have more information, hence less uncertainty.
• However, both situations would be represented probabilistically
as uniformly random, i.e. completely random.
• That means risk aversion does not suffice to describe
preferences.

12. Ellsberg Paradox
Suppose you have an urn containing 30 red balls and 60 other balls that are either blue or black.
You don't know how many black or blue balls there are, just that the total number of black balls plus
the total number of blue balls equals 60. You are now given a choice between two gambles:
Gamble A You receive $100 if you draw a red ball
Gamble B You receive $100 if you draw a black ball
A B
Also you are given the choice between these two gambles (different draw, same urn):
Gamble C You receive $100 if you draw a red or blue ball
Gamble D You receive $100 if you draw a black or blue ball C D
According to expected utility theory, you should prefer Gamble A to Gamble B if, and only if, you
believe that drawing a red ball is more likely than drawing a black ball. Similarly you should prefer
Gamble C to Gamble D if, and only if, you believe that drawing a red or yellow ball is more likely
If drawing a red ball is more likely than
than drawing a black or blue ball.
drawing a black ball, then drawing a red or blue ball is also
more likely than drawing a black or blue ball.

13. Allais Paradox
1A 1B 2A 2B
Both gambles give the same outcome 89% of the time, so in expected utility,
these equal outcomes should not affect the desirability of the gamble. If the 89%
‘common consequence’ is disregarded, both gambles offer the same choice; a 10%
chance of getting $5 million and 1% chance of getting nothing as against an 11%
chance of getting $1 million.

14. Some Departures from
Homo Economicus
• Reciprocity
• Calculational Capacity
• Heuristics
• Absolute Value vs Relative Value
• Probability

15. Absolute Wealth
• A friend of mine works twelve hours a week at a $6/hour job.
= $3600/year
• That’s not a lot, right?
source: globalrichlist.com

16. from
Myths of Rich & Poor: Why We're Better Off than We Think
by W. Michael Cox and Richard Alm, New York: Basic Books, 248 pages, $25.00
• A half gallon of milk cost the average worker 10 minutes of labor in 1970, 8.7 minutes in 1980,
and only 7 minutes in the latest year for which data are available.
• A gallon of gasoline cost 11 minutes in 1950 but is now less than half that. But these are nothing
compared to some price drops.
• A scratchy-sounding three-minute phone coast-to-coast phone call cost an incredible 90 hours of
work back in 1910. Today, it's less than two minutes of work time.
• A hundred kilowatt hours of electricity in 1900 cost a shocking 107 hours of worker time in 1900, a
bit over an hour by 1960, and less than 45 minutes today.
• quot;A typical American at the turn of the century spent $76 out of every $100 on food, clothing, and
shelter. By the 1990s, this portion had fallen to $37 of every $100.”

17. from
Myths of Rich & Poor: Why We're Better Off than We Think
by W. Michael Cox and Richard Alm, New York: Basic Books, 248 pages, $25.00
Economist’s point: See, we’re doing better.
Psychologist’s point: So why don’t we appreciate it?

18. So why do people making $90,000 a year
still feel poor? (“I’m just an accountant.”)
• Comparison to peers (rank) (mate choice)
• Hedonic treadmill
• Don’t accurately predict what will make
them happy, so they spend on things that
don’t actually make them better off.
• Happiness log(income)

19. Prospect Theory
• Reference point, not absolute
• Gains are valued, less than losses are hated
• Small probabilities overweighted;
large probabilities underweighted

20. Implications
• GDP growth less important than stability, jobs
• Low, steady inflation rather than stable prices
• Precautionary principle
• “Downside risk” rather than standard deviation in
investments
• “Libertarian paternalism” (Thaler’s)
• Better theoretical basis for government regulation
• Buy more “experience goods,” fewer durables

21. Efficient Markets?
WSJ.com - As Two Economists Debate Markets, The Tide Shifts Page 1 of 5
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Mr. Thaler Takes On Mr . Fama
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL
October 18, 2004 ; Page A I
For forty years, economist Eugene Fama argued that financial markets were highly efficient i n
reflecting the underlying value of stocks . His long-time intellectual nemesis, Richard Thaler, a
member of the quot;behavioristquot; school of economic thought, contended that markets can veer off
course when individuals make stupid decisions .
In May, 116 eminent economists and business executives gathered at the University of Chicago
Graduate School of Business for a conference in Mr . Fama's honor . There, Mr. Fama surprised
some in the audience . A paper he presented, co-authored with a colleague, made the case tha t
poorly informed investors could theoretically lead the market astray. Stock prices, the paper said ,
could become quot;somewhat irrational . quot;
Coming from the 65-year-old Mr . Fama, the intellectual father of the theory
known as the quot;efficient-market hypothesis,quot; it struck some as an unexpecte d
concession. For years, efficient market theories were dominant, but her e
was a suggestion that the behaviorists' ideas had become mainstream .
e

22. Current Events
• Credit crunch – illiquid markets
• Loss-averse traders
• Uncertainty-averse traders