Chapter 5: Price: The Ultimate Heuristic
Stephen C. Miller 5.1 Introduction The primary difference between the two 2002 Nobel Laureates in Economic Science, Daniel Kahneman and Vernon Smith, revolves around the following proposition: the price system economizes on the information that economic actors have to process in making their own decisions. While both researchers focus on individual decision-making in a world of incomplete information, they arrive at essentially opposite conclusions. One emphasizes the limitations of human cognition while the other emphasizes how in market settings people seem capable of overcoming those cognitive limitations. The truth is that people do not “overcome” their cognitive limitations where market prices and incentives are present, but they do discard their counterproductive biases and mental shortcuts. Instead, they rely primarily on price signals. According to current behavioral researchers, in market settings individuals tend to be less biased and stubborn; that is, they more closely resemble Homo economicus. It follows that the price system spurs rational behavior. When the subjects of an economic experiment exhibit some sort of “irrationality,” they don’t appear to make decisions based on unbiased expected value calculations. Instead the subjects are observed using mental shortcuts, called heuristics, to make decisions. For example, these decisions can include: whether to accept a bid in an auction, or whether to sell a good at less than its known purchase price. The behavioral observation is that subjects guess at expected values rather than calculate. They make guesses about the seller’s and buyer’s surpluses, about transactions costs, and so on. Kahneman’s research program...
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