of comparing the similarity of the probabilities and outcomes in two gambles, and
choosing on dimensions that are dissimilar. This procedure has some intuitive
appeal but it violates all the standard axioms and is not easily expressed by gener-
alizations of those axioms.
Conclusions
As we mentioned above, behavioral economics simply rekindles an interest in
psychology that was put aside when economics was formalized in the latter part
of the neoclassical revolution. In fact, we believe that many familiar economic
distinctions do have a lot of behavioral content—they are
implicitly
behavioral
and could surely benefit from more explicit ties to psychological ideas and data.
An example is the distinction between short-run and long-run price elasticity.
Every textbook mentions this distinction, with a casual suggestion that the long
run is the time it takes for markets to adjust, or for consumers to learn new prices,
after a demand or supply shock. Adjustment costs undoubtedly have technical and
social components, but they probably also have some behavioral underpinning in
the form of gradual adaptation to loss as well as learning.
Another macroeconomic model that can be interpreted as implicitly behavioral
is the Lucas “islands” model (1975). Lucas shows that business cycles can
emerge if agents observe local price changes (on “their own island”) but not gen-
eral price inflation. Are the “islands” simply a metaphor for the limits of their own
minds? If so, theory of cognition could add helpful detail (see Sims 2001).
Theories of organizational contracting are shot through with implicitly behav-
ioral economics. Williamson (1985) and others motivate the incompleteness of
contracts as a consequence of bounded rationality in foreseeing the future, but
they do not tie the research directly to work on imagery, memory, and imagina-
tion. Agency theory begins with the presumption that there is some activity that
the agent does not like to do—usually called “effort”—which cannot be easily
monitored or enforced, and which the principal wants the agent to do. The term
“effort” connotes lifting sides of beef or biting your tongue when restaurant cus-
tomers are sassy. What exactly is the “effort” agents that dislike exerting and that
principals want them to? It’s not likely to be time on the job—if anything, worka-
holic CEOs may be working too hard! A more plausible explanation, rooted in
loss-aversion, fairness, self-serving bias, and emotion, is that managers dislike
making hard, painful decisions (such as large layoffs, or sacking senior managers
who are close friends). Jensen (1993) hints at the idea that overcoming these
behavioral obstacles is what takes “effort”; Holmstrom and Kaplan (2001) talk
about why markets are better at making dramatic capital-allocation changes than
managers and ascribe much of the managerial resistance to internal conflicts or
“influence costs.” Influence costs are the costs managers incur lobbying for
projects that they like or personally benefit from (like promotions or raises). In-
fluence costs are real but are also undoubtedly inflated by optimistic biases—each
division manager really does think that his or her division desperately needs
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