BESTDECISION

Better Understanding Human Behaviour and its Consequences in Markets and Games Professor Vincent Crawford explains how his project BESTDECISION is advancing our understanding of central questions about economic behaviour, the design of institutions, and the governance of relationships, by combining traditional economic and gametheoretic methods with psychological insights and experimental and empirical evidence.

The key to BESTDECISION’s approach is using experimental and empirical evidence to increase the realism of the behavioural assumptions in economic models, while preserving the generality and power of traditional methods of analysis. In Crawford’s words, “The project uses traditional economic methods of analysis to address traditional economic questions, but with behavioural assumptions more firmly grounded in psychological insights and experimental and empirical evidence than has been customary – much more of a compromise with psychology on behavioural assumptions and realism, but not compromising at all on methods. Human behaviour is always going to be less than perfectly ‘rational’ and noisy, but that’s not the main issue – the main issue is ‘what is the central tendency of behaviour’ and what is the best way to model that?”

With this goal in mind, the BESTDECISION project is divided into several lines of study.

Each was chosen for its central importance to economics, with a judgment that improving the realism of assumptions would yield conclusions that are more useful in applications.

Consumer theory and labour supply One line of study reconsiders one of the most frequently used models in all of economics, consumer theory, in which people balance prices and budgets to satisfy preferences for consumption that reflect trade-offs between different goods. Consumer theory’s most important application may be the theory of labour supply, in which workers balance their preference for more leisure against the benefits of earnings that can be spent on consumption goods. This line seeks to increase the realism of consumer theory’s predictions concerning labour supply by modifying its assumptions about preferences in a direction suggested

by Daniel Kahneman and Amos Tversky’s ‘prospect theory’, one of the best-supported and widely applied models of decision-making from psychology, for which Kahneman (after Tversky’s death) shared the 2002 Economics Nobel Prize.

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A famous 1997 paper, part of the work for which co-author Richard Thaler was awarded the 2017 Economics Nobel Prize, tested the standard theory of labour supply using cabdrivers — who choose their own hours, as the theory assumes — and found it seriously wanting: The theory predicts that drivers who have an unusually profitable morning, signalling a higher ‘wage’, will work longer that day. But drivers tend to quit earlier on such days, in this and several more recent datasets: the opposite of what the theory predicts.

psychological grounding and experimental support in other settings limits the risk of making the model more flexible. In Crawford’s words, “The basic idea of prospect theory is that people don’t only care about levels of consumption, as assumed in traditional economics – they also react to changes in consumption relative to a ‘reference point’, with ‘loss aversion’: ‘losses’ below the reference point hurting them more than equal-sized ‘gains’ above it help them. As I tell students, suppose you have two people, both middle-class now, but last year one of them

The trouble is that the standard theory has no way of saying that communication makes a difference but in real life it makes all the difference. In life, if I can’t talk to you, I have a very limited set of tools for repairing a broken relationship.

This anomaly confronts economists with a stark choice: either drivers are irrational, or their preferences deviate from the traditional assumptions. Economists are reluctant to give up on rationality, which is the source of much of the theory’s power. But changing assumptions about preferences is also risky, because it is hard to know where to draw the line, and sufficiently flexible preferences can ‘explain’ anything — and will therefore explain nothing.

Thaler and his co-authors informally suggested an explanation by changing the traditional assumptions about preferences to conform more closely to prospect theory, whose

was a poor student and the other a millionaire.

They’re going to look at their current choices in very different ways, and prospect theory gives you a ready-made way to model that.” Thaler and his co-authors noted that drivers who care about changes in income and are loss-averse, make choices that cluster around income targets (like prospect theory’s reference points) — daily targets, as it seems from the data. On good days, drivers hit their targets sooner and work less; while on bad days they work more.

Such choices, which seem irrational under the traditional assumptions, can usefully be viewed as rational when drivers care about changes as

Empirical Application: Observed Reference points - Selten Index of Predictive Success.

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well as levels of income and are loss-averse.

As Crawford says, “Suppose you have a person who is reference-dependent and loss averse, as in prospect theory. That is going to make them make choices that look irrational under the assumption that people care only about their levels of consumption – just as you would look irrational if I was asking you to choose between apples and oranges and bananas and I assumed you didn’t like bananas, but you chose some anyway. I would conclude you were irrationally wasting your money because I made too narrow an assumption about your preferences. Just as people have concluded that cabdrivers were irrational because the traditional theory doesn’t allow them to respond to changes that they actually care about.”

More recent empirical work, including some

by Crawford and team member Juanjuan Meng, has proposed and tested more formal models, confirming that a generalisation of labour supply theory based on prospect theory can give a coherent account of drivers’ choices, resolving the anomaly without losing the model’s power to make sharp testable predictions. But all such models to date have relied on very strong ‘structural’ assumptions about the shapes of the functions used to represent drivers’ preferences that nobody has carefully tested or really thought about. This left two questions open: First, whether the models’ power to explain drivers’ anomalous choices comes from the general notions of referencedependence and loss aversion, or merely from the functional form assumptions of the models that have been tested. Second, whether the generalised models explain the data sufficiently better to justify their extra flexibility. The work in this strand, joint with team members Ian Crawford and Juanjuan Meng, seeks referencedependent generalisations of classic results from ‘nonparametric’ (done without functionalform assumptions) consumer theory. The results obtained so far in this strand yield elegant and practical methods to answer both questions.

Continuing work will make the methods more complete and tractable.

Bilateral bargaining in Singapore.

The design of bargaining institutions A second line of study concerns another question at the core of economics, the design of optimal bargaining institutions. In Crawford’s words, “A broader goal is to build more realistic limits on human cognition into the theory and see how that changes game-theoretic microeconomics, which relies very heavily on complete rationality and perfect ability to predict other people’s behaviour, which is a bit more than most people can do.”

The analysis of design of optimal bargaining institutions is one of the pillars of gametheoretic microeconomics, hence a natural place to start. In 1983, Roger Myerson and Mark Satterthwaite proposed a novel solution to this design question, part of the work for which Myerson shared the 2007 Nobel Prize.

They considered settings with two traders, one who owns an indivisible object and would be willing to sell it for enough money, and another who would be willing to buy it if the price is right. As Crawford says, “Suppose I have an object and a value for it – a minimum amount I would be willing to take. You also have a value.

But neither of us knows the other’s value, so we don’t know whose is higher, or whether it would be mutually beneficial to trade. The ideal outcome would be for us to trade if and only if your value is higher than mine, at a price that fairly shares the gains. Myerson and Satterthwaite started with the observation that none of the bargaining institutions they had

Empirical Application: Observed Reference points - Pass Rates.

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heard of always achieves this ideal outcome.

One familiar institution has me making you an all-or-nothing offer, in this case called an ‘ask’, and you saying ‘Yes’ or ‘No’. You (who cannot make a counteroffer in this institution) will say ‘Yes’ when and only when your value is higher than my ask. So far, so good; but I can do better by ‘shading’ my ask above my true value, so that we won’t trade when my true value is below your value (so that we should trade) but my ask is above your value. Other familiar rules, like the ‘double auction’, in which you submit a ‘bid’ and I simultaneously submit an ask, and we trade when your bid exceeds my ask, suffer from the same kind of shading problem.”

Importantly, they didn’t stop there, instead stepping outside the box by asking whether there is any feasible institution that ensures that we trade when and only when we should, given the incentives that any such institution creates.

Thus they went beyond considering institutions as given and immutable, instead thinking of them as something that can be chosen. Their characterisation of optimal institutions is an important precursor of the burgeoning modern field called ‘market design’ or ‘economic design’.

To step outside the box they needed game theory, which first made it tractable to analyse behaviour in settings like this only a few years before they wrote. Game theory asks what determines my best decision when the rewards depend on your decision, and vice versa. The traditional theory assumes that we are rational and will make decisions that are in Nash equilibrium, in the sense that my decision is best for me given yours, and vice versa. “Put another way, the assumption is that we can perfectly predict each other’s responses to the game, so that our rational responses make the predictions come true. In the double auction my decision is actually a rule, or ‘strategy’, that tells me what to bid as a function of my value; and your strategy tells you what to ask as a function of your value”.

Assuming that traders would respond to any chosen institution by playing their Nash equilibrium strategies, Myerson and Satterthwaite asked whether there is any institution that ensures that we trade when and only when we should, given the incentives for shading any such institution may create. They showed that the answer is ‘No’, but also that in some leading cases, familiar institutions like the double auction are ‘second-best’: not perfect, but as good or better than any feasible institution. In general, though, optimal bargaining institutions are complex, and sensitive to features of the setting that real institutions ignore.

Crawford’s second line reconsiders Myerson and Satterthwaite’s conclusions, replacing Nash equilibrium by an alternative “level-k” model of

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BESTDECISION Behavioural Economics and Strategic Decision Making: Theory, Empirics, and Experiments

Project Objectives

The project studies microeconomic questions combining standard methods with assumptions that better reflect psychological evidence. One part studies nonparametric identification and estimation of reference-dependent versions of the standard microeconomic model of consumer demand or labour supply. Another reconsiders the optimal design of bargaining rules, replacing the standard Nash equilibrium assumption with a “level-k“ model of strategic thinking that is better supported by evidence. Still other parts seek to improve our models of how cooperation is brought about and maintained in longterm relationships, with particular attention to the role of communication.

Project Funding

The BESTDECISION project is funded by the European Research Council.

Contact Details

Professor Vincent Paul Crawford Department of Economics All Souls College Oxford OX1 4AL United Kingdom T: +44 1865 279339 E: vincent.crawford@economics.ox.ac.uk W: https://cordis.europa.eu/project/ rcn/185399_en.html

Professor Vincent Paul Crawford

Professor Vincent Crawford is the Drummond Professor of Political Economy, University of Oxford, and Research Professor, University of California, San Diego. He is a Fellow of the Econometric Society, the American Academy of Arts and Sciences, the British Academy, and Academia Europea. He is known for his work on game-theoretic microeconomics, particularly on bargaining and coordination, strategic communication, and matching markets; and for his work on experimental and behavioural game theory.

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strategic decision-making that has much more experimental support than Nash equilibrium in experiments that elicit subjects’ initial responses to games. When only a trader knows her/his own value, Nash equilibrium thinking in games like those created by bargaining institutions is incredibly complex. The rules experimental subjects use tend to be rational, but to rely on simplified models of each other’s responses that cut through much of the complexity. The goal is to see how much of Myerson and Satterthwaite’s analysis survives under more realistic models of behaviour. The analysis so far has shown that the essential parts survive, with some qualifications, but that the unpredictability of traders’ strategic thinking often forces the optimal institution to take the much simpler form of a posted-price mechanism, where an optimal price is set, and trade takes place if and only if my bid is above the price and your ask is below it. Such institutions promise to yield results that are less brittle, and are (perhaps unsurprisingly) more like real-world institutions than Myerson and Satterthwaite’s optimal institutions are.

just did X. I believe you are trying to adhere to our agreement, but that’s not what I thought we had agreed upon. Please try to explain your thinking.” The ensuing dialogue is likely not only to reaffirm both parties’ desire to continue the relationship, but also how to adjust the contract and/or atone for the breach.

As Crawford says, “The trouble is that the standard theory has no way of saying that communication makes a difference but in real life it makes all the difference. In life, if I can’t talk to you, I have a very limited set of tools for repairing a broken relationship.” Further work on this line will explore ways to plug the possibility of communication into game-theoretic models of long-term relationships and show why and how it matters. This is sure to be connected with relaxing the Nash equilibrium assumption, which is what in traditional theory makes it unnecessary to communicate. In Crawford’s words, “My hope is that if you relax the equilibrium assumption you automatically create a richer and more realistic role for communication, particularly natural language communication.”

Embracing the dynamics of argument

Experimental studies of historydependent learning in financial crises, and of strategic thinking

A broader goal of BESTDECISION is attempting to create better working models of how we use communication to make long term relationships work. As Crawford says, “Suppose we both think we know how our relationship is supposed to work – how, for instance, we are supposed to deal with an unexpected, unprecedented event that requires some response. In the traditional game-theoretic model of cooperation in longterm relationships, we have an ‘implicit contract’ that covers everything that might happen. If one of us does something that violates the ‘contract’, we end the relationship, and the implicit threat to do so creates a powerful incentive for us to both follow the ‘contract’, so that we continue to reap the benefits of cooperation. In real relationships, however, that’s not how it works.

And more importantly, it works in different ways depending on how much we can communicate, and how rich a language we have available to communicate in. Why else prohibit ‘conspiracies in restraint of trade’? Yet in the traditional theory, communication doesn’t matter.”

Put another way, the traditional model of cooperation is the same for chimps and humans, which cannot be right. In a chimp relationship (at least a non-hierarchical one), if one chimp violates the ‘contract’, the other might mirror the first’s actions to show her/him how it feels, or inflict physical pain, or end the relationship.

By contrast, humans who share a rich language are more likely to communicate their displeasure in a way that gives them a chance to repair the relationship, perhaps like this: “I see that you

Two final lines of study, which space does not permit discussing here, consider experiments to study other aspects of strategic decision-making.

One, with team member Miguel Costa-Gomes, considers history-dependent learning in games like those that arise in financial crises, where individual traders try to outguess the ‘bubble’. The ultimate goal is to quantify how the structure of financial markets influences the likelihood of crisis.

Another, also with Costa-Gomes, focuses on strategic thinking in static situations, using an ‘eye-tracking’ design that observes individuals’ searches for freely available but hidden payoff information. Crawford explains, “The goal here is to study people’s thought processes in more detail than is possible by observing only people’s decisions and ‘black-boxing’ cognition. We have been designing experiments that look at people’s eye movements along with their decisions and use an algorithmic view of decision making to interpret the eye movements – and infer the thinking behind the decisions.”

In conclusion, the several interwoven lines of research in BESTDECISION seek to use more realistic behavioural assumptions, in combination with the already powerful analytical, mathematical, and statistical methods of mainstream microeconomics, to shed new light on central economic questions.

The goal is both to enhance the power and usefulness of traditional microeconomics in applications, and to ‘civilise’ behavioural economics and behavioural game theory.

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