Monday, January 3, 2011

Behavioral Economics

The Rational Consumer

How reliable are economic models that depend on economic actors to act in their own best interest? I just watched the Nova documentary, Mind Over Money which displays various theories of economics as modelled by mathematical equations that expect us all to act in our own best interest or those who think emotions and behavior cause us to act irrationally.
They talk to Robert Shiller a Yale economist who it could be said predicted both the tech stock crash and the housing market crash as speculative bubbles. He argues against the rational consumer theory, stating that bubbles are not based on self interest. He talks about the "Tulip Mania" in the Netherlands in the 17th century, widely believed to be the first speculative bubble of which there are records. Tulips were relatively new and not unlike today they were trading tulip futures as well as actual tulip bulbs. At the peak, some of the most expensive tulip brands were selling a single bulb for 12 times the yearly income of a typical skilled craftsmen. While many attributed this bubble to crowd irrationality and use it as an example of behavioral economics (as does Shiller) many others try to draw rational explanations from this event. I still found it interesting that there could be such speculation on something that seemed to have very little intrinsic value whatsoever. But then, in the documentary they show that in studies even when "traders" are told a commodity has no value and will be completely without value at the end of they experiment they tend to take risks and buy creating a bubble and ending up busted in the end.
It's an interesting documentary, though I think Nova pushes the behavioral model a little too much. Though I agree and think it's folly to think that as a mass people will always act in their own self interest. The fact that people were willing to pay up to $600,000 for a three bedroom home a few years ago and now because they are underwater, but can still afford the payments, they often choose to walk away from their mortgage. If they kept paying they'd likely have some decent equity in their home. And hanging on to the home they can probably expect its price to eventually rise over time. But as is typical, we discount the future and make decisions that appear to be only in our immediate best interest. The immediate value of the home, and the immediate consequence of mortgage payments are more important than a forclosure on our financial records or lost equity or downpayment. The difficulty of obtaining equity in the future is discounted and the advantage of walking away now is considered more important.
Documentaries like this always make me worry about the stock market which I invest in, but secretly worry is some house of cards built on nothing. I worry about the price of homes as well as other bubbles and the stagnant wages of American workers right now. But at least you can live in a house. You can't live in a tulip.

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