Who better than Shleifer to review Kahneman’s tome on psychology and economics.
In this review, I discuss some broad ideas and themes of the book. Although it would be relatively easy to carry on in the spirit of the first paragraph, constrained only by my limited vocabulary of adjectives, I will seek to accomplish a bit more. First, because the book mentions few economic applications, I will describe some of the economic research that has been substantially influenced by this work. My feeling is that the most profound influence of KT’s work on economics has been in finance, on what has now become the field of behavioral finance taught in dozens of undergraduate and graduate economics programs, as well as at business schools. I learned about KT’s work in the 1980s as a graduate student, and it influenced my own work in behavioral finance enormously.
Second, I believe that while KT’s work has opened many doors for economic research, some of the fundamental issues it raised remain work in progress. I will thus discuss what Kahneman’s work suggests for decision theory, primarily as I see it through the lens of my recent work with Nicola Gennaioli and Pedro Bordalo (Gennaioli and Shleifer 2010, Bordalo, Gennaioli, and Shleifer 2012a,b,c)
He says there are two things he wants to clear two objectives on beh eco:
The first objection holds that, while psychological quirks may influence individual decisions at the boundary, the standard economic model describes first order aspects of human behavior adequately, and economists should focus on “first order things” rather than quirks. Contrary to this objection, Della Vigna (2010) summarizes a great deal of evidence of large and costly errors people make in important choices…
The second objection holds that market forces eliminate the influence of psychological factors on prices and allocations. One version of this argument, made forcefully by Milton Friedman (1953) in the context of financial markets, holds that arbitrage bring prices and therefore resource allocation to efficient levels. Subsequent research has shown, however, that Friedman’s argument – while elegant – is theoretically (and practically) incorrect. Real-world arbitrage is costly and risky, and hence limited (see, e.g., Grossman and Miller 1988, DeLong et al 1990, Shleifer and Vishny 1997). Dozens of empirical studies confirm that, even in markets with relatively inexpensive arbitrage, identical, or nearly identical, securities trade at different prices. With costlier arbitrage, pricing is even less efficient.
A second version of the “forces of rationality” objection holds that participants in real markets are specialists invulnerable to psychological quirks. John List’s (2003) finding that professional baseball card traders do not exhibit the so-called endowment effect is supportive of this objection. The problem with taking this too far is that individuals make lots of critical decisions – how much to save, how to invest, what to buy – on their own, without experts. Even when people receive expert help, the incentives of experts are often to take advantage of psychological biases of their customers. Financial advisors direct savers to expensive, and often inappropriate, products, rather than telling them to invest in index funds (Chalmers and Reuter 2012, Gennaioli et al. 2012). Market forces often work to strengthen, rather than to eliminate, the influence of psychology.