June 7, 2010

Optimization overload

Posted in Uncategorized at 7:31 pm by Eamon Aghdasi

Sendhil Mullainathan and others argue that in real life, individuals don’t costlessly process information in making their decisions. This should be blatantly obvious to all of us, yet it doesn’t seem to be for many policymakers. The fact is, this insight has more impact in our everyday lives that we’d like to think.

Like I mentioned in my last post, recently I attended the 10th anniversary of the founding of the Harvard Kennedy School’s MPA/ID program. This was an awesome spectacle in the middle of Harvard Square, with 10 classes worth of alumni from the development field (and others), some big-name guest speakers, and plenty of partying. Mostly, it was just great to see all my old classmates (even though we graduated only about a year ago). But it was also just nice to get back into the “classroom”, so to speak, and think about development again.

One of the most interesting parts of the weekend was a short presentation by Sendhil Mullainathan, the Harvard economist, as part of a panel discussion on “innovative finance”. Mullainathan summarized some of his and others’ research into why certain financial products and interventions fail in the developing world. The answer in some cases, he argued, was that people simply can not costlessly process the complex sets of information necessary to make certain financial decisions. This is especially true of the poor, and he gave the example of a particular fruit vendor. How can we assume that a woman who sells fruit for off of a cart for a living, and who doesn’t know what her income is going to be when she wakes up each morning, is going to properly calculate her expected annual income and decide optimally on a myriad possible consumption and saving choices?

In a summary of this line of behavioral research, Mullainathan writes:

In the standard economic model people are unbounded in their ability to think through problems. Regardless of complexity, they can costlessly figure out the optimal choice. They are unbounded in their self-control. They implement and follow through on whatever plans they set out for themselves. Whether they want to save a certain amount of money each year or finish a paper on time, they face no internal barriers in accomplishing these goals. They are unbounded in their attention. They think through every problem that comes their way and make a deliberate decision about each one. In this and many other ways, the economic model of human behavior ignores the bounds on choices (Mullainathan and Thaler 2001). Every decision is thoroughly contemplated, perfectly calculated, and easily executed.

As I’ve written on this blog before, it’s not the model that is faulty, it’s those of us who over-interpret the assumptions of the model —  assumptions that are intended to achieve a mathematically useful result, not serve as a view of human nature — who are causing harm. Mullainathan argues that the standard model is limited if we are going to properly understand how the developing country poor interact with finance, and properly design policies and make rules.

I’ll take it one step further and argue that in the developed world, this is also a major issue, and that people who insist on the hyper-rationality of all human beings need to come down from their clouds and embrace reality. What Mullainathan and his colleagues have illustrated is at the very heart of why Americans, for instance, would benefit greatly from a Consumer Financial Protection Agency that protects individuals from intentionally confusing or misleading behavior on the part of financial institutions.

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