Psychology : Economics :: Physics : Chemistry

“Markets don’t seek efficiency because investors aren’t rational.” Yeah, well, gas molecules aren’t rational either, but they obey very simple regularities in large numbers. Rational-expectations theory doesn’t actually require individual investors to be rational, it merely predicts that en masse they will behave as if they are.


I’ve made this analogy before and I think its good. Psychologists and economists, like physicists and chemists, study things that exist at much different levels of abstraction. An important implication of this is that behavior at the lower level doesn’t easily translate into behavior at the higher level. For example, the fact that individual molecules move in patterns that are called Brownian motion has little baring on the fact that when you put a few billion molecules of oxygen and a few billion molecules of hydrogen together you get a few billion molecules of water. Brownian motion is way neat, but if in some other universe it turned out that molecules just sat there laying still, it’s possible to imagine that it wouldn’t change the chemistry.

In fact, the chemistry was discovered before Brownian motion. In other words, we knew about the higher level behavior before we knew about the underlying mechanisms and this didn’t hamper our ability to do analysis at the higher level.

If this analogy works, then all this talk about animal spirits and psychology’s supposed obvious implications for economics is mis-guided. Its perfectly possible for individual humans to be irrational, idiotic twits and for the economic system that emerges from their individual actions to appear as though it is rational. If fact, the experiments of Vernon Smith show that this possibility is actually probable. In many experiments ((Here’s a counter-example; a paper on asset bubbles that shows price theory doesn’t seem to hold… asset price bubbles are common in the lab. Smith says his experiments show that the problem with theory is that it assumes common knowledge of rationality. It assumes people believe other people will do what’s in their best interest. Asset bubbles don’t arise in the lab after the same set of subjects repeat the experiment a few times and thus know that the others are rational.)), Smith shows the behavior of idiots, when aggregated, quickly converges to market outcomes that look like those outcomes predicted by neoclassical theory. In other words, behavior at the lower level of abstraction doesn’t necessarily impact behavior at the higher level of abstraction.

Here’s why, however, this might not be such a great analogy. In the case of physics and chemistry, the higher level abstraction, chemistry, is much more intuitive than the lower level abstraction, physics. We see chemistry every day; its very easy to create chemical reactions in your kitchen. The behavior and structure of atoms, on the other hand, is really strange and inaccessible. The solar system analogy helps, but atoms are still very strange places to think about. In the case of psychology and economics, on the other hand, the lower level abstraction is more accessible and the higher level abstraction is, well, more abstract. We all experience individual psychology and irrationality. Its so obvious. Economics — as I can attest to now having taught it for four years — is less obvious.

11 thoughts on “Psychology : Economics :: Physics : Chemistry”

  1. Another example you could use is the shape of a balloon. Trillions and trillions of gas molecule collisions every second, and the sum of those collisions is a sphere. Or sometimes a small poodle.

    Physicists have a short hand concept to describe this: “pressure.” They can even model it without calculating vectors and momentum on every molecule in the balloon. It’s awesome.

  2. I think you mean statistical mechanics – lots of chemistry does in fact flow from the behavior of atoms (electron orbitals determine what kinds of bonds will form with other atoms, etc).

    There was a JPE paper a while ago that had “zero-intelligence” simulated agents.

  3. All of chemistry follows from physics. That’s not the point. The point is that chemists and physicist deal with such different levels of abstraction the behavior at the lower level doesn’t aggregate to behavior at the higher level in obvious ways. This is a problem with the limited scope of our (e.g. scientists’, economists’) brains, not out there reality.

    The lesson for economics is that psychological results don’t easily transform into economic behavior (even if common sense would suggest so).

  4. It’s true that there’s no necessary connection between micro-level and macro-level behavior. We could have optimal individual behavior and suboptimal aggregate behavior, or suboptimal individual behavior and optimal aggregate behavior, or both could be optimal, or both could be suboptimal. All combinations are possible.

    Whether or not psychologists can make contributions to economics depends on the exact arguments being made. For example, if one argues that cognitive biases are irrelevant to economics because they are idiosyncratic and basically cancel out in the aggregate, then evidence from psychology on the systematic pervasiveness of certain biases strikes me as highly relevant. There are plenty of other arguments you can make, of course.

  5. I wonder about what is meant by “systematic bias”. Take the example razib used in the post I linked to: we don’t feel the pain of paying when we use credit cards when we make the purchase. This is a systematic bias of which most people suffer. The question is does this change aggregate statistics. Does consumption go up? Debt burdens? That’s not so obvious. My understanding is that total personal debt hasn’t increased over the long run. Credit cards basically replaced older forms of credit (store cards and layaway).

    Why would this psychological systematic bias not translate into aggregate economic behavior? Here’s a guess: there’s other psychology at work. We don’t feel the pain at the time of purchase but we hate to pay the credit card bill at the end of the month. Overall purchases over the month are diminished by this large pain (or the anticipation of this large pain). To balance that out is the smaller pain we feel when we actually make the purchase. The net effect is zero.

    But this is just my hack psychologizing. I think its psychologists job to figure out how these psychological effects interact and aggregate.

  6. The point of the zero intelligence traders paper is that you can get ‘classical’ economic results more or less from the trading mechanism, and being careful about forcing budget constraints to hold.

    Here’s the abstract

    This paper reports market experiments in which human traders are replaced by “zero-intelligence” programs that submit random bids and offers. Imposing a budget constraint (i.e., n ot permitting traders to sell below their costs or buy above their valu es) is sufficient to raise the allocative efficiency of these auctions close to 100 percent. Allocative efficiency of a double auction deri ves largely from its structure, independent of traders’ motivation, intelligence, or learning. Adam Smith’s invisible hand may be more powerful than some may have thought; it can generate aggregate rationality not only from individual rationality but also from individual irrationality. Copyright 1993 by University of Chicago Press.

    This is a modern version of an old Becker (and Simon?) argument that much of the results from consumer theory and supply and demand follows from the budget constraints, rather than optimization.

    Much of the power of economic thinking derives from being careful about adding up constraints, people’s budget constraints, and thinking through the flows and stocks, rather than ‘constrained optimization.’ But non-economists are obsessed about the optimization thing, not understanding that it is a way to imposing some discipline and consistency on your thinking.

  7. Right. For example, even if people are complete idiots, if the price of something goes up, they’ll probably end up buying less of it simply because they face a budget constraint, and so the law of demand doesn’t really depend on rationality.

    But this doesn’t mean that markets are rational. It just means that the relationship between individual rationality and aggregate rationality can be tricky and non-obvious.

    I just clicked on the link to esr. He makes the classic argument about how it wasn’t market failure that caused the financial collapse, but rather it was bad old government interference that created the real estate bubble and forced banks to make loans to poor minorities. OK, let’s assume that’s the truth for the sake of argument. Then why didn’t the market price for these distortions correctly? If the neoclassical and Austrian economists were sounding warnings about this for decades, then why did the stock market suddenly drop 50% over the span of a few months? Why did AIG surprisingly go bust? I thought markets are rational?

    Irrationality gets interjected into the markets all the time, but everyone here is arguing that it doesn’t matter, the market is still rational. But if the Community Reinvestment Act was involved, then I guess the market was too weak to resist?

    This doesn’t look to be a sophisticated argument about economic reasoning, but rather an unsophisticated “Markets good, Government bad” plea.

  8. These zero-info trader results are neat. Do we know when these results don’t hold? I mean do any markets need informed traders?

    I think esr is wrong, but Sumner right. Markets priced all those silly policies in, but they didn’t see the Fed screwing up policy in Fall of last year. That said, there were utility losses (but by how much?) under those silly policies.

    Policy is just another constraint and only policy surprises can have effects. Like Sumner, this makes me a believer in EMH and it makes any argument that starts with “years ago the government started a policy I didn’t like” sound dubious to me.

  9. Here’s another realm to consider: When a person’s writing exhibits above average errors in indices such as spelling, word declensions, or grammar, does this correlate with shortcomings in more complex areas?

    If errors appear to stem from insufficient proofreading, is there a corresponding appearance of a “shoot from the hip” or undisciplined, less-thoughtful, less attentive presentation of the more conceptual elements?

  10. “When a person’s writing exhibits above average errors in indices such as spelling, word declensions, or grammar, does this correlate with shortcomings in more complex areas?”

    Ever seen a doctor’s shorthand writing or typing?

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