Neuroeconomics - the answer to rational decision theory?

A central question in economics revolves around the choices made by a rational consumer. The axiomatic approach towards rational choice and revealed preference theory focuses on maximizing utility. Revealed preference theory assumes that consumer behavior can be analyzed through their purchasing decisions. This classical method has often been contradicted and questioned. The existence of the Allais and Ellsberg paradoxes was an early acceptance of the restrictions of Rational Choice theory. These paradoxes seek to exhibit the inconsistency of actually observed choices with the predictions of expected utility theory. The opposition has grown further with expanding research rooted in behavioral science, which claims preferences to be subjective, and heterogeneous, thereby often violating the principles of ‘consistency’ while making choices.


Now, an entirely new field has emerged, referred to as neuroeconomics, which is an amalgamation of neuroscience, psychology, and economics. It focuses on the biophysical interpretations of consumer choice and hence has the potential to provide scientific reasons, beyond bias, for ‘irrational’ consumer behavior. Currently, neuroeconomics relies on analyzing the biological processes underlying economic choice, through reaction times, eye tracking, electroencephalography (EEG), and functional magnetic resonance imaging (fMRI).


There are two ways in which the application of neuroscience to economics assists the development of rational choice theory. Firstly, by providing supporting evidence to complement existing theories, by grounding empirical research with biological foundations. Secondly, by identifying potential behavioral variations through biological investigations. This would focus on developing new models of rational choice, using the vast gamut of data that is being collected through fMRI, which may be unexplored and act as an addition to the current literature.


Here, our approach will focus on the current findings of neuroeconomists which supplement behavioral findings while emphasizing the untapped potential and the exciting future of the field. One of the most significant contributions of neuroscience has been the discovery that some basic axioms of choice theory such as Irrelevance of Independent Alternatives (IIA) are violated. IIA is a widely accepted axiom in decision theory and social choice theory. Loosely, if gelato is preferred over popsicles in a set {popsicles, gelato} then expanding the choice to {popsicles, gelato, waffles} should not change a consumer’s choice to popsicles over gelato. Here, waffles are the irrelevant independent alternative that should have no impact on the decisions made by a rational consumer, abiding by the axioms of preference bundling.


However, due to fundamental properties of the central nervous system, namely, divisive normalization, we can provide biological evidence for violations of this ‘axiom’. Simply put, the basic idea of Divisive Normalization is that a neuron's driving input is normalized divisively by a weighted sum over nearby neurons' responses (Heeger, 1992; Carandini and Heeger, 2012). So, the neurons firing when we encounter ‘irrelevant independent variables’, prove that our brains would naturally take this so-called ‘biased decision’. In behavioral terms, this violation occurs when the availability of a third, clearly inferior option, makes people choose the lower-valued option in a pair more frequently than in the absence of this third option. This is often referred to as the ‘Decoy Effect’. These findings prove that behavioral biases are essentially simply how our brain functions, and not a surprisingly ‘out of character’ behavior for homo sapiens.


Another finding suggests that decreased serotonin levels are linked to many economic behaviors, including steeper temporal discounting, reduced loss aversion, and more aggression in bargaining games. Dopamine levels affect how people learn and respond to new information, as well as their risk aversion. So what you eat, which impacts the release of these chemicals, amongst other things, determines your economic choices.


Daniel Kahneman, who received a Nobel prize for his contribution to behavioral economics, spoke of dilating eye pupils when System 2 (the slow, rational, lazy part of our mind responsible for carrying out difficult decisions) is utilized, to measure the extent of mental effort required to carry out a particular task. By drawing this conclusion, he unknowingly delved into the realm of utilizing neuroscientific evidence for economic conclusions.


Economists have long been fascinated over optimization problems with assumptions of rationality that only hold when assumed that humans act as if maximizing utility. The inherent problems with these assumptions have become apparent with the increasing reconciliation of psychology and neuroscience with economics. Some studies suggest that most economic decisions are taken by specific functional units of the brain, thereby allowing neuroeconomists to create prediction models. However, questions regarding the representativeness of these experiments and whether they can be used to modify the behavior patterns of the general population remain unanswered at the moment.


In the end, Neuroeconomics is still an infant discipline. Growing research and fascinating evidence demand us to recognize the magnitude of influence neuroscience can have on solidifying economic theories, especially those focused on decision making and it is a field with huge potential.



References:


Further Readings:

  • Paul Glimcher, Neuroeconomics and the Brain


Written by: Ananya Dhanuka (ananyadhanuka11@gmail.com)

Edited by: Divij Gera