more neuroeconomics

[Jim Devine <jdevine03@xxxxxxxxx>]

April 20, 2006
Economic Scene
Enter the Neuro-Economists: Why Do Investors Do What They Do?
By TYLER COWEN

LAS VEGAS uses flashing lights and ringing bells to create an illusion
of reward and to encourage risk taking. Insurance company offices
present a more somber mood to remind us of our mortality. Every
marketer knows that context and presentation influence our decisions.

For the first time, economists are studying these phenomena
scientifically. The economists are using a new technology that allows
them to trace the activity of neurons inside the brain and thereby
study how emotions influence our choices, including economic choices
like gambles and investments.

For instance, when humans are in a "positive arousal state," they
think about prospective benefits and enjoy the feeling of risk. All of
us are familiar with the giddy excitement that accompanies a triumph.
Camelia Kuhnen and Brian Knutson, two researchers at Stanford
University, have found that people are more likely to take a foolish
risk when their brains show this kind of activation.

But when people think about costs, they use different brain modules
and become more anxious. They play it too safe, at least in the
laboratory. Furthermore, people are especially afraid of ambiguous
risks with unknown odds. This may help explain why so many investors
are reluctant to seek out foreign stock markets, even when they could
diversify their portfolios at low cost.

If one truth shines through, it is that people are not consistent or
fully rational decision makers. Peter L. Bossaerts, an economics
professor at the California Institute of Technology, has found that
brains assess risk and return separately, rather than making a single
calculation of what economists call expected utility.

Researchers can see on the screen how people compartmentalize their
choices into different parts of their brains. This may not always
sound like economics but neuro-economists start with the insight —
borrowed from the economist Friedrich Hayek — that resources are
scarce within the brain and must be allocated to competing uses.
Whether in economies or brains, well-functioning systems should not be
expected to exhibit centralized command and control.

Neuro-economics is just getting started. The first major empirical
paper was published in 2001 by Kevin McCabe, Daniel Houser, Lee Ryan,
Vernon Smith and Theodore Trouard, all economics professors.
(Professors McCabe, Houser and Smith are colleagues of mine at George
Mason University.) A neuro-economics laboratory at Cal Tech, led by
Colin F. Camerer, a math prodigy and now an economics professor, has
assembled the foremost group of interdisciplinary researchers. Many of
the early entrants, who have learned neurology as well as economics,
continue to dominate the field.

Investors are becoming interested in the money-making potential of
these ideas. Imagine training traders to set their emotions aside or
testing their objectivity in advance with brain scans. Futuristic
devices might monitor their emotions on the trading floor or in a
bargaining session and instruct them how to compensate for possible
mistakes.

Are the best traders most adept at reading the minds of others? Or is
trading skill correlated with traits like the ability to calculate and
ignore the surrounding caldron of human emotions?

More ambitiously, future research may try to determine when a
short-term price bubble will collapse. Does the market tide turn when
people stop smiling, adjust to their adrenalin levels or make
different kinds of eye contact?

Not all of neuro-economics uses brain scans. Andrew W. Lo, a professor
at the Sloan School of Management at the Massachusetts Institute of
Technology, applied polygraph-like techniques to securities traders to
show that anxiety and fear affect market behavior. Measuring eye
movements, which is easy and cheap, helps the researcher ascertain
what is on a subject's mind. Other researchers have opened up monkey
skulls to measure individual neurons; monkey neurons fire in
proportion to the amount and probability of rewards. But do most
economists care? Are phrases like "nucleus accumbens" — referring to a
subcortical nucleus of the brain associated with reward — welcome in a
profession caught up in interest rates and money supply? Skeptics
question whether neuro-economics explains real-world phenomena.

The neuro-economists admit that their endeavor is in its infancy. It
is difficult to identify brain modules and their roles. Even if one
part of the brain is active at a particular moment, how is that
incorporated into a person's broader method for making decisions?

The number of people scanned in any study is typically small, if only
because the hookups cost about $500 an hour and require access to an
expensive machine. Furthermore, the setting may matter. Perhaps we
cannot equate choices made on the New York Stock Exchange trading
floor with choices made under a hospital scanner, where the subject
must lie on his back, remain motionless and endure a loud whirring,
all the while calculating a trading strategy.

That said, neuro-economics will make huge strides as technology allows
researchers to identify more brain regions and read brains more
accurately and at lower cost. It is a growth area in a profession that
knows human feelings matter, but does not always know what to do with
them.

The next step? Perhaps neuro-economics should turn its attention to
political economy. Do people use the same part of their brains to vote
as to trade? Is voting governed by fear, disgust or perhaps the desire
to gain something new and exciting?

Tyler Cowen is a professor of economics at George Mason University and
is co-author of a blog, www.marginalrevolution.com. E-mail:
tcowen@xxxxxxxx

--
Jim Devine / "There can be no real individual freedom in the presence
of economic insecurity." -- Chester Bowles