At the inaugural Allen Sinai Lecture Thursday, Economics Prof. John Leahy described the limitations of the standard economic model of consumer choice and how it can be better explained by studying the psychology of human behavior.
About 130 people gathered at the talk, titled “The Economics of Wishful Thinking,” which featured Leahy's research on fluctuations in the economy and macroeconomic policy, with a focus on how imperfect information can shape economic outcomes and the role of market frictions.
During the talk, Leahy emphasized that humans tend to make choices based on optimistic outcomes, which can explain real-world economic issues like the housing bubble. He said though the theory does not explain every human choice, he is trying to study the general belief and not focus on the extremes.
He began by describing how traditional economic theory can be better explained through the theory of belief choice, presenting a new way of thinking about the model that brings the issue of “wishful thinking” to the forefront of discussion.
According to Leahy, expectations and beliefs are central to all economic questions. In the standard model, the only role of beliefs is to weigh future outcomes, which is also the reasoning for rational expectations. However, in the real world, people do make mistakes, due to psychological biases such as overconfidence, cognitive dissonance, confirmation bias and extrapolation of trends. Wishful thinking makes people happier but leads to irrational decisions, Leahy said.
“People interpret information in light of their priors,” he said. “They have beliefs, they see information and they interpret it as confirming what they already believe. See, we get a Democrat and Republican both reading the same article and they come to different conclusions about what it means because they come to the article with different beliefs.”
Leahy also noted the difference between the economic definitions of risk and fear, which he considered an economic a state of mind.
“In the standard model, risk’s just bad,” he said. “However, this model has suspense and excitement, and so sometimes you might want to hedge, and sometimes you might want to double down and gamble.”
Leahy localized the model with an example of the upcoming Michigan football game against Ohio State University. He said if humans operated according to the standard model of risk, they would put money on OSU because either their favorite team will win or they will receive money. Yet, due to wishful thinking, people will double down on Michigan for the total excitement of it all.
He also tied the belief theory to moral questions, like whether someone who tests positive for genetic precursors of a disease should be informed of the problem if nothing can be done to improve their condition and it won’t affect them until the far future.
“This opens up a role for choosing beliefs,” Leahy said. “Beliefs don’t just affect future outcomes; they also affect current happiness.”
LSA senior Maria Steinhoff, an exchange student from Germany, said she attended the talk because she is a psychology major and is taking an economics class. She said she enjoyed how Leahy combined the two different topics.
“I liked how he put psychological measures into a formula, like doing it in a scientific way,” she said.