Summary
Highlights
Professor David Harel welcomes attendees and introduces Professor Israel Aumann, noting Aumann's significant contributions to game theory. Harel highlights the broad applicability of game theory in various aspects of life, from elections to real estate, and mentions Aumann's recent analysis of the Iran nuclear deal through a game theory lens. He also touches upon the deep mathematical foundations of game theory and Aumann's unique position bridging both the humanities (social sciences, economics) and natural sciences (mathematics).
Professor Aumann begins by addressing the purpose of economics, emphasizing its practical utility in understanding and navigating the economic world to inform policy. He then delves into the central theme: the perceived contradiction between traditional economics, which assumes rational human behavior, and behavioral economics, which highlights human irrationality through heuristics and biases. Aumann clarifies that 'rational' has two meanings: a colloquial one (logical thinking based on science) and an economic one (acting to promote one's goals given available information). He asserts that these two meanings are not necessarily contradictory and often lead to similar outcomes.
Aumann argues that while people don't always think rationally in the colloquial sense, their use of heuristics often leads to rational outcomes in the economic sense. He cites Tversky and Kahneman, the founders of behavioral economics, who acknowledged that heuristics are 'generally useful' but can lead to 'severe and systematic errors.' Aumann points out that behavioral economics predominantly focuses on these errors, particularly in 'contrived' scenarios that do not reflect real-world situations. He suggests that the understanding of when heuristics lead to rational outcomes in frequent, natural situations is far more crucial.
Aumann presents the 'endowment effect' as an example, where people tend to value items they own more than identical items they don't. He describes an experiment where participants given coffee mugs refused to trade them for chocolate, and vice versa. He explains this behavior by referencing the heuristic 'what's mine is mine' (or 'a bird in the hand is worth two in the bush'), which has evolved to be rational in most real-world scenarios due to factors like familiarity and avoiding unknown risks. However, in the artificial experiment, this heuristic leads to what appears to be irrational behavior.
Aumann provides two more examples: one about a man refusing to wash his neighbor's car for 50 NIS but washing his own to save 25 NIS, and another about people buying only one chocolate bar despite a bulk discount. He explains that the car washing scenario, seemingly irrational, is rational due to 'transaction costs' and a desire for quality, encapsulated by the heuristic 'do it yourself if you want it done well.' The chocolate bar example, where people avoid temptation by not buying in bulk, is also rational in preventing irrational future choices, despite appearing to violate a basic economic principle of maximizing choice.
Aumann discusses the ultimatum game, where one player proposes a split of money and the other accepts or rejects. Rejections of low offers, though seemingly irrational (as both players get nothing), are driven by a heuristic to reject 'humiliating offers,' which is rational in real-world negotiations where reputation matters. He also addresses the 'conjunction fallacy' ('Linda problem'), where people incorrectly assess a conjunction of events as more probable than a single event. He attributes this to a heuristic that assumes information provided is relevant, leading to errors in contrived, misleading questions.
Aumann concludes that classical economics remains valid because, generally, humans behave rationally, even if not thinking rationally, due to evolved and learned heuristics. Behavioral economics is also vital as it identifies these heuristics and biases. He emphasizes that the two fields are not contradictory but complementary: behavioral economics describes how people actually operate, providing the practical basis for classical economic theory. He shares that his work on this topic was published in 'Nature Human Behavior.'
During the Q&A, Aumann clarifies the definition of 'rationality' in economics and further explains the Ultimatum Game. He addresses a question about firms, noting that behavioral economics' examples primarily focus on individuals, though market discipline can make firms behave more rationally. Another question relates his theory to the 2008 financial crisis, which he declines to elaborate on due to time. A comment from the audience suggests that gender differences might affect behavior in the Ultimatum Game and links his 'avoid temptation' concept to government policies like taxes on sweet drinks. The discussion wraps up with a final question challenging the idea that individuals are mostly rational in economic decisions, to which Aumann clarifies that individuals act to promote their own self-interest, which can collectively lead to market crises, hence the need for economic theory.