Behavioral finance and markets: Cognitive Processes and Economic Behavior

Introduction (Via Huberman)

Economics is interested primarily in prices and aggregate quantities. The study of individual behavior is a building block to derive implications about social outcomes. Until the behavioral approach became fashionable, individuals were usually assumed to make choices so as to optimize a well-defined objective subject to well-defined constraints. This very simple idea is also very powerful, in that it lends the analysis to aggregation, and thereby affords the study of markets and equilibrium.
The main contribution of the behavioral approach has so far been to question the validity of modeling the individual decision maker as optimizing a simple objective. The earlier pioneers are Allais (1953) and Ellsberg (1961). More recently, the profuse work of Kahneman and Tversky (1979) (with various coauthors) has had the strongest impact. Their joint paper on Prospect Theory in Econometrica (Kahneman and Tversky 1979) is reputed to be the most cited paper in that highly esteemed journal.

Once scholars acknowledged that the optimizing foundations were not as solid as had been assumed, they ventured to modify them, and felt freer to discover anomalies that would not have existed had economic agents (or at the least, the important agents, the marginal ones) been neoclassical optimizers. “Is the asset price right?” is the question at the heart of financial economics. To answer it directly, one has to agree on what “right” means in this context. An early commentator was Adam Smith.

The value of a share in a joint stock is always the price which it will bring in the market; and this may be either greater or less, in any proportion, than the sum which its owner stands credited for in the stock of the company. Adam Smith, The Wealth of Nations, 1776

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30. January 2010 by Miguel Barbosa
Categories: Behavioral Economics, Curated Readings | Leave a comment

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