Friday, February 25, 2011

Beyond rational behavior : In search of better assumption for economic analysis

Rational behavior has been the key variable for microeconomics analysis in the so called neo classical economics school. These school of thought , applied that approach to consumer behavior , then extended it to business(producer) decisions ,labor-leisure hour allocation, such that it establish the foundation for a macroeconomics analysis more rigorous and consistent with the whole purpose of market allocation of resources to become more efficient : To increase the welfare level of community.
It is interesting to mention that psychological factors have also been considered in the neoclassical analysis of consumers (Marshall),and investors decisions (Keynes). So the behavior school of thought is not a new branch of economics,but the intent to rescue the true fundamental of human behavior.
The average behavior of economics agents was better understood upon the basis of rationality than psychology. Therefore it became the paradigm for policy design as well. The most of it, arose with the rational expectations school,and its implications for macroeconomics policies, which left aside any policy decision, other than the one wchich were unexpected by the market. In other words no policy at all!.
The 2008 global financial crisis, and its still lasting effects ,has probably changed very much of this paradigm.
When it comes to market behavior, irrationality is more often than previously thought, such that it make weaker the assumption of pure rationality, for economics agents decisions. The notion of limited rationality (the one which apply with less than efficient level of information),do not seems to solve fully , the fragile status of current theoretical framework for economic analysis, which seems to need a deeper search beyond rationality to understand the foundation of both consumer and producer behavior, and ultimately the process of policy design and resource allocation.
Let looks some of the underlying issues concerning irrationality.
a.- Consumers debt. Rational analysis assume that consumer maximize welfare given their income levels, but experience indicates that consumer spend beyond current income, increasing their level of debt .Besides, consumers make decision based not only on prices, but also on personal values, tastes,perception (status),and emotions .
b.- Business financial risk. The rational approach ,(the one of Tobin diversification proposal,and CAPM model) , indicates that diversification is the key to maximize returns from a portfolio. It follows that, risk must be balanced within it .However, new financial instruments which cover up its real risk, generate a huge distortion in the risk-price balance of the whole portfolio. As a result, higher risk do not mean higher return ,but higher probability(not known) of getting broke .and economics agent bet on that!. Thus, while rationality assume that economic agent might pull back from a riskier than average portfolio, because there is no guarantee of higher return, in the real situation,(on average risk averse behavior) they go even further because partial information , conceal the real risk, and there is no way to evaluate properly the chances of getting a benefit. It is pure irrationality!.(it is equivalent to jump out from the sky without checking out the quality of the parachute).
How to cope with the implications of irrationality?. The real assumption for Economics analysis have nothing to do with rationality , but with both strong and good quality institutional economics framework, such that behavior is constrained to its boundary.What about freedom?.It means to chose among rational options.