Sunday, September 23, 2007

People are from Earth, Economists are from Vulcan

In today's NY Times Economic Scene column, Austan Goolsbee looks at the departure from economically rational behavior known as "loss aversion," which may interfere with home sales as prices slump. He writes:
Economists and other humans don’t always see eye to eye. “Economists tend to think people are crazy because they won’t sell their houses for less than they paid for them — and people think economists are crazy for thinking things exactly like that,” said Professor Christopher Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School and an authority on real estate economics....

Classical economics can’t explain this behavior. That’s because people who refuse to sell their houses for less than they paid for them are violating a cardinal rule of the market: stuff is worth what it’s worth. It doesn’t matter what you paid for it. But when Professor Mayer and his co-author, David Genesove, a professor of economics at the Hebrew University in Jerusalem, studied the Boston condominium market in the 1990s — scene of one of the biggest real estate busts in recent American memory — the actual patterns of human behavior did not seem to follow the standard rules at all...
As any thinking student of economics realizes, our traditional assumptions about human behavior are not realistic. The goal of economic models is not "realism," however. Even the most elaborate economic model is a vast simplification of an infinitely complex reality. A model which accurately predicts how people will behave is a useful one - Milton Friedman's famous example* is that one could use physics to analyze the shots of a professional billiard player. Even though the player is using instinct and senses, the rules of physics can be used to make accurate predictions of the player's shots. Similarly, utility maximization may make good predictions of human behavior, even though people aren't solving constrained optimization problems in the grocery store.

Goolsbee's column points us to a case where our lack of realism may get us into trouble. The good news - for economic methodology but not home sellers - is that the economics profession recognizes the problem, and some people are working on it. Meyer and Genesove's paper was published in the Quarterly Journal of Economics, one of the most prestigious journals in the field, and Goolsbee himself is a faculty member at Chicago, hardly a backwater of heterodoxy.

*Friedman's example is in a 1953 article titled "The Methodology of Positive Economics," which is a must-read for students of economics.

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