Economic Interactions: Behavior or Structure

1. Economic Interactions: Behavior or Structure Shyam Sunder, Yale University Financial Fragility and Technological Progress with Heterogeneous Agents and Social Interactions: Models, Simulations and Empirical Evidence Trento University, Trento, December 14-15, 2006

2. Humanities and Science • Science does not know its debt to imagination. Ralph Waldo Emerson • Vivisection is a social evil because if it advances human knowledge, it does so at the expense of human character. George Bernard Shaw • The theoretical broadening which comes from having many humanities subjects on the campus is offset by the general dopiness of the people who study these things. Richard P. Feynman (Nobel Laureate in Physics) • Economics has an amazing capacity to summarize staggeringly complex phenomena by the application of only a handful of principles Charles R. Plott • Being outside and above individual and local contingencies, collective consciousness sees things only in their permanent and fundamental aspects, which it crystallizes in ideas that can be communicated. Emile Durkheim Sunder, Economic Interactions

3. Overview • Origin of experimental economics in examination of aggregate phenomena • Gradual, steady shift towards micro-levels due to • Analytical process and reasoning • Incremental research questions • Unlike assumption in theory, people do not optimize well by intuition • Today, much experimental work has shifted to examination of individual behavior and of economies populated by artificial agents • Shift to individual behavior has accentuated the ever-present dilemma of social sciences in trying to be a science on one hand, and handle humans at the same time • What are the antecedents and consequences of this trend? • Usefulness of organizing experimental economics into three streams: • Structural: macro properties of social structures • Behavioral: behavior of individuals, and • Agent-based: exploration of links between the micro and macro phenomena • At least the structural part of economics can be firmly rooted in the tradition of sciences, bypassing the free-will dilemma of social sciences Sunder, Economic Interactions

4. Examining Market Institutions • Chamberlin (1948) examined the behavior of a market institution under controlled conditions of his classroom • Vernon Smith (1962), a subject of Chamberlin) redesigned and systematically varied the market conditions to examine price, allocation, and extraction of surplus • Both designs deviated significantly from Walrasian tatonnement abstraction; they fleshed them out with details, using stock market as a guide • Economic environment (market demand and supply) and market design as independent variables • Market level outcomes as dependent variables Sunder, Economic Interactions

5. Data from Experiments • Experiments can yield a great deal of data • Data are limited only by interest and imagination of the experimenter, and ingenuity in capturing data without distracting subjects from their task in a significant way • Chamberlin gathered three pieces of data for each transaction (price, seller cost and buyer value), and the transaction sequence • Examples of data he did not gather: the clock time of transactions, details of the bargaining process (time elapsed, price proposals, number of proposals, number of counter-parties bargained with), etc. Sunder, Economic Interactions

6. Data to Meet Experimental Goals • Most experiments can yield a great deal of data • We gather only what we need in order to address the question(s) we wish to answer on the basis of the experiment • Constraints: • Technology of data gathering, eased by development of computer technology to conduct economics experiments) • The possibility of interaction between data capture and subjects • Given Chamberlin’s goals, asking subjects to report their transactions immediately after they completed each transaction served his purposes well, causing little interference with subjects’ trading Sunder, Economic Interactions

7. Shift Towards Micro Phenomena • Focus of experimental economics has gradually shifted from aggregate market level phenomena towards individual behavior • Three factors seem to drive this shift • The logic of analytical method • Incremental research designs • Empirical finding that people, acting by intuition alone, are not good at optimization as typically assumed in derivation of equilibria in economic theory Sunder, Economic Interactions

8. Logic of Analytical Method • It is rare for the correspondence between the predictions of the relevant theory, and experimental data, to be nil or total • If the experimenter has no or low expectation of correspondence between the two, observation of even a moderate relationship is seen as half full glass of water • However, most experiments are designed to examine specific theories that have some legitimate prior claim to predictive power • In such situations, any imperfections of correspondence between data and theory are seen as half empty, not half full, glass of water • Seeking a fuller explanation to close the gap between data and theory is a natural reaction of most investigators Sunder, Economic Interactions

9. Search for Higher Explanatory Power • Following this logic, analysis and discussion of most experiments ends in a search for ways to increase the correspondence between data and theory • Better prediction and explanation is the currency of scientific progress • We look for ways to modify the model to enhance its explanatory power through analysis—breaking the problem down into progressively smaller components • This logical pursuit shifts research question(s) to the next level of detail causing “micro-nization” of economics • Discarding the details, to step back and see the big picture, is a less common reaction Sunder, Economic Interactions

10. Demand, Supply and Experiments • Simple economic theory: point of intersection of demand and supply determines price and allocations • Economists’ deep faith in theory • Neither Chamberlin’s nor Smith’s data corresponded precisely to the theory • Smith saw half full glass of water, while Chamberlin saw the half empty partand set out to build a model to better explain the residual variation left unexplained by the simple demand-supply model(instantaneous demand/supply) Sunder, Economic Interactions

11. Chamberlin (1948), Figure 3 Sunder, Economic Interactions

12. Smith (1962) Chart 1 Sunder, Economic Interactions

13. Incremental Research Designs • A good part of our research (including experimental) is incremental, originating in proposals to gather data about some additional aspect of behavior, or additional analysis of existing data • We make conjectures about how such data or analysis might help explain residual variation • Incremental work dominates graduate seminars focused on critique and replication of extant work • Easy to think of additional observations, motivations, and information conditions associated with individual participants to improve the fit between data and model Sunder, Economic Interactions

14. Change in Models and Questions • Both analytical logic and incremental pursuits change the model used • Additional variables use up some degrees of freedom, but observations at micro-level are far more numerous than at macro-level • Shift to micro level also changes the research question(s) being asked • “Why is the price equal x?” might be replaced by “why did trader y bid z?” Sunder, Economic Interactions

15. Individual Behavior and the Dilemma of Social Sciences • This shift towards micro-behavior confronts economics with a fundamental dilemma shared among the social sciences • As a science, we seek general laws that apply everywhere at all time, emulating physics, chemistry and biology • Perfecting the scope and power of general laws of human behavior also implies squeezing out the essence of humanity—our free will • What does it mean to have a science of individual human behavior? Sunder, Economic Interactions

16. Free Will • Free will, independent thinking, and ability to choose are essential to our concept of self • We believe in our power and ability to do what we wish, beyond what is predictable on the basis of our circumstances, beliefs, and tendencies (otherwise, could we do research in economics or in other fields?) • Ability to rise above our circumstances as the essence of human identity • We can choose deliberately, in ways unpredictable to others • Else, we would slip to the status we assign to animals, plants and inanimate objects Sunder, Economic Interactions

17. Humanities: Eternal Truths • Humanities celebrate infinite variety of human behavior, but no laws of behavior • In epics and literature: eternal verities, but no laws of behavior • Epics (Mahabharata, Iliad) • Duryodhana, Yudhishtira, Arjuna • Literature (Dante’s Inferno, Shakespeare’s Hamlet) • Human truths, questions, and tendencies repeated through history, always with a new twist • People choose in ways unpredictable on the basis of their circumstances • Celebration of infinite variation in human nature Sunder, Economic Interactions

18. Science: Eternal Laws • Identifying laws of nature valid everywhere and all the time • Essence: regularities of nature captured in known and knowable relationships among observable elements (including stochastic) • Helps understand, explain, and predict • If I know X, can I form a better idea of whether Y was, is or will be? • Objects of science have no free will • A photon does not pause to enjoy the scenery • A marble rolling down the side of a bowl does not wonder about how hot the oil at the bottom is Sunder, Economic Interactions

19. Social Science: Irresistible Force Meets Immovable Object • Free will essential to our concept of self • Without the freedom to act, we would be no different than a piece of rock • Yet, the object of study in social science is us • As a science, it must look for eternal laws that apply to humans • But stripped of freedom to act, and subject to such laws, in what sense can we be “human”? Sunder, Economic Interactions

20. Mismatch of Science and Personal Responsibility • Objects of science can have no personal responsibility • They do not choose to do anything • They are merely driven by their circumstances, like a piece of paper blown by gusts of wind, or a piece of rock rolling down the hill under force of gravity in the path of an oncoming car • Or, perhaps an abused child who grows up to be an abusive parent, sans personal responsibility • Science and personal responsibility do not mix well Sunder, Economic Interactions

21. Neither Fish Nor Fowl • This problem of social science is exemplified in the continuing attempts to build a theory of choice • From science end: axiomatization of human choice as a function of innate preferences. People choose what they prefer • How do we know what they prefer? Look at what they choose • The circularity between preferences and choice might be avoided if there were permanency and consistency in preference-choice relationship across diverse contexts • One could observe choice in one context, tentatively infer the preferences from these observations, and assuming consistent preferences, predict choice in other contexts • Unfortunately, half-a-century of research has yielded little predictability of choice from inferred preferences across contexts (Friedman and Sunder 2004) • Individual human behavior appears to be unmanageably rowdy for scientists to capture in a stable set of laws • While humanists may not take delight at such disappointments, but they can hardly be surprised (if they pay any attention to choice theory) Sunder, Economic Interactions

22. Dilemma of Social Science • Do we abandon free will, personal responsibility, and special human identity; and treat humans like other objects of science? • That is, drop the “social” and become a plain vanilla science • Or, do we abandon the search for universal laws, embrace human free will and unending variation of behavior, and join the humanities • Either way, there will be no social science left • Is there a way to keep “social” and “science” together in social science? Sunder, Economic Interactions

23. Isolating Three Streams of Work • Perhaps there is no general solution to this dilemma • The dilemma does, however, point to the potential value of isolating streams of work where it may be more or less of a problem • Significant parts of social sciences, and a large part of economics, are concerned with aggregate level outcomes of socio-economic institutions • Institutions themselves do not need to be ascribed intentionality or free will • Characteristics of the institutions can be analyzed by methods of science without running into these dilemmas • This will leave analysis of individual behavior in the territory between science and humanities • Agent-based models (in economics and elsewhere) could serve the bridging function between aggregate and individual phenomena • Let us consider these possibilities Sunder, Economic Interactions

24. Individuals • I do not have much to add on the most complex problem of examining individual behavior • It seems that we shall continue to examine ourselves and our behavior using both humanities as well as science perspectives, without ever reconciling the two into a single logical structure • There seems to be no way out Sunder, Economic Interactions

25. Institutions • Experimental economics started out as investigation of aggregate level outcomes of market institutions using human subjects • Attention has gradually shifted from aggregate outcomes to micro behavior • Logic of analytical approach • Incremental research designs • A third reason is that predictions of aggregate outcomes (equilibrium analysis) are typically made assuming optimization by individuals • Cognitive psychology showed that individuals are not very good at optimization by intuition • This mismatch between the optimization assumption actual behavior at individual level has given additional impetus to “micro-nization” of experimental economics • Thanks to recent findings using agent-based methods, we can conduct the study of social-economic institutions using methods of science Sunder, Economic Interactions

26. Optimization and Equilibrium • The standard approach of economic analysis has been to assume that individuals choose actions by optimizing given their preferences, information and opportunity sets • Interaction of individual actions in the context of institutional rules yield outcomes (e.g., prices and allocations), equilibrium outcomes being of special interest • Equilibrium predictions derived from assuming individual rationality could be suspect when such rationality assumption is not valid • Agent-based simulations suggest that individual rationality can be sufficient but not necessary for attaining equilibria in the context of specific market institutions Sunder, Economic Interactions

27. What Makes the Difference Sunder, Economic Interactions

28. What Makes the Difference Sunder, Economic Interactions

29. Why Equilibrium without Individual Optimization • Why do the markets populated with simple budget-constrained random bid/ask strategies converge close to Walrasian prediction in price and allocative efficiency • No memory, learning, adaptation, maximization, even bounded rationality • Search for programming and system errors did not yield fruit • Modeling and analysis supported simulation results Sunder, Economic Interactions

30. Inference • Perhaps it is the structure, not behavior, that accounts for the first order magnitude of outcomes in competitive settings • Computers and experiments with simple agents opened a new window into a previously inaccessible aspect of economics • Ironically, it was not through computers’ celebrated optimization capability • Instead, through deconstruction of human behavior • Isolating the market level consequences of simple or arbitrarily chosen classes of individual behavior modeled as software agents Sunder, Economic Interactions

31. Optimization Principle • In physics: marbles and photons “behave” but are not attributed any intention or purpose • Yet, optimization principle has proved to be an excellent guide to how physical and biological systems as a whole behave • At multiple hierarchical levels--brain, ganglion, and individual cell—physical placement of neural components appears consistent with a single, simple goal: minimize cost of connections among the components. The most dramatic instance of this "save wire" organizing principle is reported for adjacencies among ganglia in the nematode nervous system; among about 40,000,000 alternative layout orderings, the actual ganglion placement in fact requires the least total connection length. In addition, evidence supports a component placement optimization hypothesis for positioning of individual neurons in the nematode, and also for positioning of mammalian cortical areas. • (Makes you wonder what went wrong with human design when you see all the biases and incompetence of human cognition. • Could it be just the wrong benchmark?) • Questions about “forests” and questions about “trees” Sunder, Economic Interactions

32. Optimization Principle Imported into Economics • Humans and human systems as objects of economic analysis • Conflict between mechanical application of optimization principle and our self-esteem (free will) • Optimization principle interpreted as a behavioral principle, shifting focus from aggregate to individual behavior • Cognitive science: we are not good at optimizing • Willingness among economists to abandon the optimization principle Sunder, Economic Interactions

33. Dropping the “Infinite Faculties” Assumption • Conlisk: • Empirical evidence in favor of bounded rationality • Empirical evidence on importance of bounded rationality • Proven track record of bounded rationality models (in explaining individual behavior) • Unconvincing logic of unbounded rationality • All these reasons focus on the “trees” not “forest” Sunder, Economic Interactions

34. Equilibrium and Simon • Simon in the third edition of The Sciences of the Artificial wrote: • “This skyhook-skyscraper construction of science from the roof down to the yet unconstructed foundations was possible because the behavior of the system at each level depended on only a very approximate, simplified, abstracted characterization of the system at the level next beneath. This is lucky, else the safety of bridges and airplanes might depend on the correctness of the ‘Eightfold Way’ of looking at elementary particles.” • Indeed, the powerful results of economic theory were derived from “a very approximate, simplified, abstracted characterization of the system at the level next beneath,”—the economic man so maligned, and its scientific purpose and role so misunderstood, by many who claim to be followers of Simon Sunder, Economic Interactions

35. Economic Interactions: Structural or Behavioral • Economics can be usefully thought of as a behavioral science in the sense physicists study the “behavior” of marbles and photons • Given the pride we take in attributing the endowment of free will to ourselves, this interpretation of behavior is a hard sell in social sciences • To build on the achievements of theory, it may be better if we think of optimization in economics as a structural principle, Just as physicists (and many biologists) do • This will allow us to focus on structural stream of economics in the tradition of sciences • Individual behavior is likely to remain as a shared domain of humanities and sciences • Modeling specific behaviors as software agents in the context of specific economic institutions allows us to make conditional statements about the links between individual and aggregate level phenomena (as in the case of ZI agents) Sunder, Economic Interactions

36. Thank You Please send comments to Shyam.sunder@yale.edu