Behavioral Economics - From neuron to market price
- Jeff Hulett
- Nov 21, 2023
- 8 min read
Updated: Jun 16, 2024
This infographic demonstrates how individual pricing information is initiated deep in each of our brains. Through a transformation process, that information is filtered through our behavioral psychology via cognitive biases, anchoring, framing, and other situational and time-based interactions. Our behavioral psychology impacts our economic choices and is finally coalesced into prices. Think of that price - or money, in general - as a dynamic signaling mechanism that aggregates information describing our utility or preference bundle.
Adam Smith defined the invisible hand as the mechanism by which all our preference bundles dynamically interact via the market process to settle on a single market price equilibrium. He also defined the "Impartial Spectator" as a fixed standard by which our decisions are compared. The graphic shows that the impartial spectator is found in the uncertainty sub-layer. It is the impartial spectator who helps individuals reconcile the uncertainty inevitably found in decisions impacting the unknowable future. Smith treats this standard as an imagined aggregation of all those an individual respects and wants to do well by. The impartial spectator is an expression of our conscience. While Smith does not explicitly relate the impartial spectator to God or some deity, you may interpret the impartial spectator as such. Smith wisely leaves it up to the reader to define their impartial spectator to help guide decisions under uncertainty.
The uncertainty sub-layer between the intrinsic world of our psychology and neurobiology and the extrinsic world of economy. The uncertainty sub-layer is like a buffer between our intrinsic world - which is directly impacted by our brain and psychology - and the extrinsic economic world beyond.
It is where uncertainty is reconciled within the 3 layers. This reconciliation includes consciously available information, generally within the "slow brain" processes. [i-a] Also, uncertainty may be subconsciously reconciled, especially within "fast brain" processes. [i-a] The interaction between the intrinsic and extrinsic worlds is a defining characteristic of how the impartial spectator guides decision-making under uncertainty.
The uncertainty sub-layer can be self-referential: We must predict how we will be impacted by a decision in the future. This means today’s self needs to create a model of their future self and place that self in the future world they wish to predict. Then the future self needs to observe a world that will also include a model of a "future beyond the future" self. This creates a potentially confusing self-referential feedback loop to the current self in need of making a decision. This is the challenge of interpreting our intrinsic world. Most people overcome this by not overthinking their future predictions. This is an “80/20 rule” for suggesting when to stop deliberating on a decision. Kurt Goedel mathematically defined this self-referential challenge in the Incompleteness Theorem (1931). Please see the appendix for an exploration and example of this self-referential challenge.
The uncertainty sub-layer can be causally diverse: Because economic decisions are made as future forecasts and the future world is unknown, decisions must be made with incomplete information. Those decisions are made when the whole, or a global decision presented in the economic layer, is not a sum of its decision criteria parts, whether known or unknown. Also, it is likely the whole is causally stronger as the desired outcome, economic or otherwise, than the sum of the causally weaker parts - or criteria - guiding that decision. This is known as “Causal Emergence” a consciousness theory posited by neuroscientist Erik Hoel. [i-b]
An example of Causal Emergence is found in the article:
The individual economic sub-layer sits on top of the uncertainty sub-layer. It is important to note the economic sub-layer, along with the formation of individual utility, is still very much individually defined. Consider the individual economic sub-layer where information generation for specific economic situations occurs. It is the interaction of individual neurobiology, psychology, and the economic situation creating an individually unique utility that gets consolidated into a pricing signal.
The concept of a “failure of invariance” describes how people will often make different decisions under the same conditions. [i-c] This was an observation by Kahneman and Tversky that helped usher in behavioral economics as a separate economics discipline. Implicit within the individual pricing model, an observer’s assumption of “same conditions” leading to a failure of invariance is almost certainly erroneous. Because the interaction of our neurobiology, psychology, and economy is so dynamic, situational conditions inevitably vary. Small differences in conditions lead to different economic pricing signals.
As an example, I may observe a friend making different decisions to buy an apple – such as buying a green apple on day x and a red apple on day x+1. As the observer, this seems to be a failure of invariance because my apple buyer friend is the same person, at the same time of the day, with the same hunger level, with the same historical apple buying patterns, etc. However, these are all the observer's understandings that seem the same. As the observer, I do NOT understand what is going on in the apple buyer’s neurobiology and psychology. That the observed bought a green apple on one day and a red apple on another day may make perfect sense and be invariant with a fuller information set not available to the observer. Perhaps, unknown to me, my apple-buying friend's apple perspective was anchored with a delicious MacIntosh Apple advertisement just before time x+1. Because my friend's attention was diverted, even if briefly, his red apple benefit information set was updated and his utility now favors red over green apples. An infinite number of situational differences potentially impact our neurobiology and psychology. It is the blessing of human adaptability creating the failure of invariance.
The conditions in which pricing signals develop are sculpted by how an individual interacts with the economy. It is this interaction which can readily be observed. Those conditions are further impacted by the individual's more challenging-to-be-observed neurobiology and psychology. So the seeming failure of invariance occurs via the lack of understanding from the observer of the observed. If the observer was omniscient of the observed’s situation, there would be no failure of invariance because the total information set leads to an infinite series of possibilities able to be reconciled to the decision. Even the observed, as an observer of their situation, may also lack the ability to fully understand their price signal conditions. This is owing to subconsciously rendered fast-brain processes discussed earlier.
Thus, a better description of a seeming “failure of invariance” is that our individual pricing signal aggregates from infinitely variant individual conditions leading to infinitely variant situational interpretations. Thus, consistent decision-making is a lucky exception, not the norm. People do have a countermeasure to maintain a level of invariance in certain decisions. It is our habits seeking to maintain decision consistency despite infinitely variant situations. Habits help us consolidate and summarize information from infinitely variant situations as a protective filter. If it were not for habits, all our time would be spent evaluating infinitely variant situations instead of making fast, life-saving decisions. Thus, habits helped humanity survive and evolve. However, habits also mask infinitely variant situations and may cause us to get "stuck" in our beliefs. Proper belief updating is a great human challenge. [1-d] Isn’t human diversity grand?!
Beyond the individual: So far, the focus has been on the individual and the process of rendering an individual's price signal. Once the individual's utility has been determined and a pricing signal has been rendered, this price is communicated to the broader market. A market is a collection of individuals demanding certain goods or services. It is essential to appreciate the market is dynamic, owing to the individual market participant. An individual price signal may be impacted by market conditions and how others interact within the market. The "indifference price" is generally that price where, if the market price is higher, the individual becomes indifferent and seeks some competitor or substitute. Certainly, our failure of invariance suggests our indifference price is variable and dynamic.
Please see the next article for an example of marketplace dynamics:
Adam Smith and F.A. Hayek: It is beyond impressive that Adam Smith got this right -- Even though Neurobiology and Behavioral Psychology were non-existent, at least how they are today, in the 1700s.
The individual price model demonstrates three layers or filters impacting information as it travels our decision path. This path culminates as a market signal for demonstrating our choice. The uncertainty sub-layer is highly interactive between the intrinsic layers 1 and 2 and extrinsic layer 3. Nobel laureate economist F.A. Hayek considers these three layers as “structures” necessary to compare individuals to determine if their behaviors are isomorphous. [ii] As Hayek points out, the second and third layer are not isomorphous or, even if they happened to be isomorphous by some great stroke of luck, we would not know this until well after the behavior was presented and the market was cleared. As explored in the Becoming Behavioral Economics article, this isomorphous-lacking environment is the basis for diverse rationality.
As such, even if certain situations - related to time and condition - seem the same between 2 individuals (layer 3), the likelihood of a similar (isomorphous) choice is very small, given that neither the observer nor the observed can see the underlying layers (layers 1 and 2). Layers 1 and 2 are the basis for Smith's "impartial spectator" leading to the "invisible hand" that governs the market's price-setting mechanism.
The mapping between the individual price model and the Hayekian isomorphism model is:
Layer | Individual price model | Hayekian isomorphism structures |
1 | Neurobiology – neuron and synaptic interaction | Neural order of fibres and impulses |
2 | Psychology – impartial spectator and cognitive bias | Mental or phenomenal order of sensations |
3 | Economy - situation based upon time and condition | Physical order of external world |
The neuron-to-marketplace infographic is also found in the article:
Please check out our Adam Smith articles exploring this infographic and other related topics:
Appendix
Self-reference
The great challenge of some decisions is the need to place a model of yourself into the unknowable future.
Since you are part of that future decision, modeling how you respond in that uncertain future is an important part of today’s decision. There are two “yous” - a current you and a modeled future you. Besides more objective criteria, the current you need to predict how you will flourish or not flourish in the uncertain future.
Then, the future you will communicate back to the current you a prediction of that future and how you flourish in that future. Then the current you will make small changes to the prediction of the future environment and communicate that to the future you. This “analysis paralysis” loop could go on indefinitely. It is an unsolvable loop because of both:
The intrinsic - your uncertain future flourishing and
The extrinsic - the uncertain future environment
are unknown, interrelated, and dynamic.
Most of our more routine decisions do not possess the intrinsic challenge suffering from self-reference. For example -
Many consider buying a car as purely extrinsic - they need safe transportation from point A to point B.
However, the decision to get married is certainly self-referential. The future you and how you will flourish is certainly an important part of the marriage decision.
For an application of the Pareto Principal - or "80-20 rule" - applied to the marriage decision, please see:
Notes
[i-a] For a description and example of the slow brain process and uncertainty reconciliation, please see "The low emotion tag & high language case."
For a description and example of the fast brain process and uncertainty reconciliation, please see "The high emotion tag & low language case:"
Hulett, Our Brain Model, The Curiosity Vine, 2020
An example of Causal Emergence is found in the article:
Hulett, How to create your own opportunity: The garbage picker’s choice, The Curiosity Vine, 2023
[i-c] Kahneman, Tversky, Prospect theory: An analysis of decision making under risk, Econometrica, 47, 263-291, 1979
[i-d] Belief updating is explored in the article:
Hulett, Changing Our Mind, The Curiosity Vine, 2023
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