Lecture II Comparing the hypotheses of discovered preferences and preferences construction

Wrap up of the previous lecture Three main reasons for the assumptions of exogenous preferences: 1) division of labor between economists and sociologists; 2) axiomatic RCT; 3) after a close analysis (meta)preferences are stable. Raising of the interdisciplinary exchange between economics and cognitive sciences: are preferences endogenous? Need of a behavioral foundation of economic theory: Discovered preferences hypothesis (DPH) and preferences construction hypothesis (PCH).

RCT axiomatic core (preferences) Asymmetry axiom: > is an ordering relation: (x > y)  ¬ (y > x) Axiom of transitivity: (x > y & y > z)  (x > z) These two axioms are sufficient for a simple preference ordering on the chosen acts. Continuity axiom: (x > y > z)  [px + (1 – p)z > y > qx + (1 – q)z ] for any p and q strictly in between 0 and 1 Independence axiom: for any p such that 0 y)  [px + (1 – p)z] > [py + (1 – p)z]

RCT axiomatic core (beliefs) Given a simple lottery L k = (p k 1,…, p k n ), K = 1,…, K and a probability α k ≥ 0 Ʃ k α k = 1 Compound lottery: (L 1,…, L k ; α 1,…, α k ) Risky alternative giving L k with probability α k for K = 1,…,K Reduced lottery (multiplying the probability of each lottery - α k – by the probability p n k of the outcome n in lottery L k and adding over K) p n = α 1 p n 1 +…, α k p n k

Illustration

Representation theorem If an ordering relation (>) satisfies all the axioms, then it exists a real valued utility function U(.) For all X and Y, X > Y  EU(X) > EU(Y) The expected utility EU is given by the sum of the utilities multiplied by the probabilities of the outcomes of a lottery: EU = Ʃ pi U(xi)

Basic claim of EUT An individual whose preferences satisfy all the axioms of rationality behaves as if (s)he were maximizing his or her own expected utility function. This assertion is devoid of any causal assumptions. It is a systematic description of behavior and not a causal explanation of behavior.

Empirical content of the theory Basic assumption: the theory describes the behavior of individuals who know which action best satisfy their preferences. The theory abstract away from learning process. RCT has empirical content by virtue of operational criteria for identifying circumstances in which the learning process can be expected to be almost at an end (Bruni & Sugden 2007).

Problem of anomalous preferences Use of empirical methods coming from psychology to test the predictive power of the theory (Kahneman and Tversky 1979). Evidence of non convergent behavior (endowment effect, framing, preferences reversal). Is the theory to be revised or can anomalous behavior be accounted for within the same theoretical framework?

Behavioral foundation Causal assumptions on agents’ behavior. Substantive assumptions on preferences structure. Substantive assumptions on learning process.

Discovered preferences hypothesis Individuals are endowed with a well-defined structure of preferences hardwired by natural selection (Plott 1996). Individuals discover their “true” preferences through interactive learning (Binmore 1999). Discovered preferences are rational, that is, axioms of rationality describe an existing preferences structure.

Learning process Learning causally affects temporary preferences. Thus in the short run preferences are endogenous to choices: anomalous preferences are a systematic short run phenomenon. There is no causal link between learning and hardwired preferences. Thus in the long run preferences are exogenous to choices. Economic theory performs well only in repeated interactions that are simple enough and incentive compatible (Binmore 1999).

DPH as a conservative behavioral foundation of RCT DPH provides a behavioral foundation which is coherent with standard comparative statics: individuals preferences are held constant such that they result to be consistent across equilibria (Bruni & Sugden 2007). It avoids any reformulation of the theoretical axiomatic core. It not required to open the black box of preferences formation.

Evidence supporting DPH Consider the WTA/WTP gap in evaluating an unpleasant substance in an experimental setting (Coursey et al. 1987). Value elicitation through a second price auction. To elicit WTA the subject with the lowest bid wins the auction and gets paid with the second lowest bid. To elicit WTP, the subject with the highest bid is selected but he pays the second highest bid. Each subject submits a form expressing his WTP and WTA. The mean values of WTP and WTA converge across auctions after repetitions. Participants evaluate the consequences of their choices after a series of iterative trials. Participants learn that truthful preferences revelation is a weakly dominant strategy. The erosion of WTP/WTA gap is interpreted as a support for DPH (Braga and Starmer 2005). Does confirmation of theory predictions (WTP = WTA) imply a support for DPH?

Methodological issues on DPH Unreasonable restriction of economic domain to repeated interactions. i.e. Consider the economic relevance of one shot choices about education or career. The hypothesis does not provide a theoretical explanation of how discovered preferences satisfy consistency axioms. The hypothesis does not provide an objective measure of rationality: do we maximize a hedonic quantity of utility?

Epistemological issues on DPH Economics does not need any intellectual integration with cognitive sciences. Anomalous preferences are eroded by market forces and economics does not need psychological explanations for long run phenomena. Cognitive sciences can provide some explanation of anomalous dynamics only in the short-run. However anomalous behaviors fall out of the economic domain.

Preferences construction hypothesis Agents are not endowed with a well defined preferences structure. Agents stabilize their behavior by a process of context-dependent learning. Preferences might not be consistent across equilibria: there are no “anomaly-free” markets.

Learning Preferences are learnt and endogenous to choices both in the short and long run. Short run: framing effects, anchoring, endowment effect. Long run: shaping effect that consists of an affiliation of agents’ valuation with market prices even when such affiliation is excluded by experimental design. Shaping effect is relevant as it postulates the existence of market specific patterns of behavior emerging in logically equivalent interactions: preferences might not be consistent across equilibria.

PCH is a non-conservative behavioral foundation of economic theory Standard comparative statics is a necessary but not sufficient condition to infer individuals’ true preferences. The theoretical prediction might be (in part) confirmed but this does not necessarily imply a support for DPH. We do need to open the black box of preferences formation.

Evidence supporting PCH Consider three median price auctions where people express their WTA money to drink an unpleasant liquid (Tufano 2009). The median price is selected as the market price and the individuals with bids lower than the market price drink the liquid and get paid with the market price. Standard theory prediction: reduction of the within group error variance and convergence of the mean bids variance between the three auctions. Results: reduction of the mean bids variance within a single auction and increase of the mean bids variance between auctions: emergence of market- specific patterns of behavior. Participants affiliate their valuations to the market price emerged in the previous round of the auction. Participants learn to correct their choice as they come to be aware that truthful bidding is a weakly dominant strategy. We observe a process of error reduction within a single market that does not imply a convergence of the bids of different markets towards the same value. The DPH-based prediction of equality of mean bids between markets is not confirmed.

Methodological issues on PCH It does not impose a restriction of the economic domain to the range of repeated interactions. PCH endorses an instrumental concept of rationality such as to question if and how real preferences satisfies the axioms of rationality. It aims at an objective measure of rationality as maximization of a hedonic quantity.

Epistemological issues on PCH Economics might develop through an intellectual integration with cognitive sciences. Anomalous preferences turn out to be explanatory relevant. The hypothesis implies that there are not “anomaly free” markets.

Conclusions The two hypotheses pose a decision problem: either extending standard RCT through DPH or re-elaborating standard RCT through PCH. The solution of the problem is empirical in character. The empirical solution has crucial epistemological implications as PCH and DPH concerns the status of economic theory: a separate or dependent science?

References Binmore, K. (1999). Why experiment in economics?, Economic Journal, vol. 109, pp. F16–24. Braga J and Starmer C. (2005) Preference Anomalies, Preference Elicitation and the Discovered Preference Hypothesis, Environmental and Resource Economics Vol. 32, N. 1, 55-89, DOI: /s Coursey, D.L., Hovis, J.J., Schulze, W.D., The disparity between willingness to accept and willingness to pay measures of value. The Quarterly Journal of Economics 102 (3), 679–690. Kahneman D. & Tversky E., Prospect theory: an analysis of choices under risk, Econometrica, Vol. 47, No. 2. (Mar., 1979), pp Plott, C. (1996). Rational individual behaviour in markets and social choice processes: the discovered preference hypothesis, in (K. J. Arrow et al, eds.), The Rational Foundations of Economic Behaviour, pp. 225–50, Basingstoke: International Economic Association and Macmillan. Sugden R. & Bruni L. (2007) The Road not Taken: How Psychology was Removed from Economics and How it might be Brought Back. Economic Journal 117: Tufano F. (2009). “Are ‘true’ preferences revealed in repeated markets? An experimental demonstration of context-dependent valuations.” Experimental Economics, 13, 1–13.