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Rationality Gone Awry?: Decision Making Inconsistent with Economic and Financial Theory

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Schwartz has written an excellent summary of what is now called the "new" field of behavioral economics(or psychology or finance).The title is somewhat misleading.It conflates the concept of rationality(all rational economic men and women supposedly have a complete,perfect,error free,costless information set that is clear and not subject to any ambiguity,vagueness,or uncertainty over time.Likewise,there are no computational, information processing,absorption, or digestion constraints of any kind.Based on these assumptions, economic rationality is defined to mean "engaged in continuous pursuit of optimization",the goal of which is to maximize profit or utility or minimize cost or disutility,subject to some income or resource constraint on income or output)with purely mathematical optimization problems.The idea of rationality as meaning introspection or thinking or reasoning or seeking to understand is excluded.This approach describes neoclassical economics and finance,which makes up about 80% of economics and finance.The "Irrationality"(Rationality Gone Awry...) in the title refers to the actual behavior of economic agents who ,obviously,do not come close to satisfying any of the neoclassical assumptions.At best,neoclassical theory is a normative structure without any predictive,prescriptive or descriptive capability.Schwartz credits the rise of the new behavioral economics mainly to the work of psychologists Tversky and Kahneman(TK) in the early 1970's and notes psychologist Herbert Simon's earlier work in the 1950's that unfortunately had no major impact on the manner in which economists operate.Essentially,the new behavioral economists presented huge amounts of empirical and experimental evidence that the standard subjective expected utility(SEU)model(this model is the statistical/probabilistic counterpart of the rationality model discussed above)had little empirical support if it was to be used as a descriptive,predictive or prescriptive model.A large number of anomalies were uncovered in the empirical and experimental results.This anomalous behavior directly conflicted with the results predicted and described by the SEU theory.Schwartz devotes a good number of pages to discussing and listing the various anomalies such as the preference reversal effect,conjunction effect,disjunction effect,certainty effect,translation effect,reflection effect,equity premium puzzle,etc.There are a few shortcomings.Although he clearly mentions the idea of ambiguity and gives the two urn Ellsberg problem on p.81,he neglects to give a full description of the nature of Ellsberg's conclusion-most decision makers can't give precise single number estimates of relevant probabilities.Instead,they give interval estimates due to the fact that the available information set is vague,ambiguous or unclear.Similarly,the earlier pathbreaking work done by J M Keynes in his A Treatise on Probability on interval estimates, ambiguity(weight of the evidence)and decision making(Keynes's conventional coefficient of risk and weight model in chapter 26 of the TP)is never mentioned.Lastly,the path breaking work of Benoit Mandelbrot in explaining the equity premium puzzle is not mentioned.In fact,Mandelbrot's work is not even listed.