In game theory, a fundamental assumption is that people are rational in making decision each time they are called upon to move. Sometimes counter-intuitive equilibria occur in stylized game theory models and it makes people wonder: are people really that rational in making every decision in their daily life? One thing I feel certain about is that I'm not...

For decades a new sub-field of economics, behavioral economics, has been challenging the orthodox assumptions of neo-classical econ that people are predictably rational. Behavioralists have a point right: people can't be as rational as economists assumed in their models. Our brains are not powerful enough to make choices with no consideration of emotion, and most people won't make consistent strategies in subject to Bayes' rule of probability.

Behavioralists come up with a definition, bounded rationality, to state that people's rationality of decision making is impaired by mental constraints on information processing and probability calculation.

Yes I admit that people are not rational all the time, but the market still doesn't fail because it induces participants to be more rational than they otherwise would be in an environment with no price. Trials and errors entail progress and as participants get more experienced, they would know the tacit rules and have better outcomes. In game theory terminology, this is called the refined equilibrium. Mathematically most games have an odd number Nash Equilibira and some equilibria don't make much economic sense. I call them "irrationally rational equilibrium". To winnow out the bad equilibrium, game theorists come up with some refinement strategies like trembling hand equilibrium, consistent belief and reasonable beliefs. One thing surprising is that...after all these delicate and smart manipulations, the final results of games are often what we see in daily life! That is, perfect rationality can mimic the outcome of seemingly irrational behavior in market context.

One drawback of behavioral econ experiments is that they are mostly done in labs, which is a different environment from market, and thus the result may not be compatible with what people really would choose given that they are in a more dynamic and chaotic atmosphere.

## No comments:

## Post a Comment