The Genuine Utility of Real Economic Agents
Lei Gao
University of Hannover, Germany
[email protected]
Abstract
To explore what is the genuine utility of real economic agents, this paper raises the
relatively-distinguished-hypothesis. Social beings evaluate their well-being not so
much in absolute terms, but with respect to others, especially in respect to non-basicliving-demands. They are born to be differently distinguished due to differing anterior
physical and social-economic conditions, e.g. different talents and different
endowments, which are exogenous to them. Economic rationality, on the other side, is
usually assumed to be endogenous to them and thus undistinguished. People like to
keep relatively distinguished, keep not as economically rational as their less
distinguished peers, so long as their basic-living-demands are well satisfied. It is the
reason why so many people do not make full use of available profitable chances. And
therefore, any theory of the expected utility presuming agents’ indefinite economic
rationality is doomed.
Gödel's Incompleteness Theorem implies human being is never capable to completely
understand himself/his talents. Consequently, his estimation of himself/his talents must
be always uncertain and (self)-biased. This paper asserts as long as there are economic
agents who do not believe they are as less distinguished as they appear, there are
always undervalued assets and endless trading in financial markets. The fact market
agents pursue their genuine utilities actually manifests itself in the nature of financial
markets and is an ingredient of a whole array of institutions.
1 Introduction
Neoclassical economics is an example of a successful mode of rationality. It is logically
consistent, and the rationality it models—namely behavior according to economic
utility maximizing rules—does appear to play an important role in human behavior. In
many occasions, neoclassical theory predicts magnitude as well as signs of effects.
However, neoclassical economics is often criticized for placing rationalism ahead of
realism. Over the past decades, a considerable amount of empirical evidence has
demonstrated that the rational man it assumes is not a real man.
At the other side, behavioral economics succeeds in describing and predicting how real
people behave facing concrete economic problems. But unfortunately, it has no
established theory.
This paper tries to overarch these two approaches through a new theory about the
genuine utility of real economic agents.
The remaining parts of this paper are organized as follows. The Theory of Genuine
Utility of Real Economic Agents is introduced in Chapter Two, formally modeled in
Chapter Three and applied to resolving puzzles in Chapter Four. Chapter Five shows
the fact market agents pursue their genuine utilities actually manifests itself in the
nature of financial markets.
2 The Theory of Genuine Utility of Real Economic Agents
The current work holds the opinion that neoclassical economics has failed to
comprehend what is the genuine utility of real market agents or where does utility come
from. Until today, neoclassical economists insist in that agents can only derive utility
2
from consuming their posterior rewards of their economical activities. Samuelson
(1985) defined utility as “the subjective enjoyment or usefulness of a person in
consuming an article or service”. The representative agent in neoclassical models is
thus the rational man who maximizes his expected economic utility.
But actually as early as two centuries ago, Bentham (1789) stated utility comes not only
from wealth, but also from amity, a good name, power, piety, skill, benevolence,
malevolence, memory, imagination expectation, association and relief.
A considerable number of modern economists have challenged the bounded utility
concept of neoclassical economics. For instance, Becker (1976, 1991) introduced the
concept of “Extended Utility Function”; Sen (1980, 1984) issue the concept of “Plural
Utility”; Sheng (1991) coined the term of “Unified Utility”. Ng. (1996), Frey and Benz
(2002) and Frey and Stutzer (2002a, 2002b) all analyzed the generalized quality of
utility in the field of happiness theory.
This paper raises the relatively-distinguished-hypothesis to explore what is the genuine
utility of real economic agents. Social beings evaluate their well-being not so much in
absolute terms, but with respect to others, especially in respect to non-basic-livingdemands. They are born to be differently distinguished due to differing anterior
physical and social-economic conditions, e.g. different talents and different
endowments, which are exogenous to them. Economic rationality, on the other side, is
usually assumed to be endogenous to them and thus undistinguished. People like to
keep relatively distinguished, keep not as economically rational as their less
distinguished peers, so long as their basic-living-demands are well satisfied. It is the
reason why so many people do not make full use of available profitable chances. And
therefore, any theory of the expected utility presuming agents’ indefinite economic
rationality is doomed.
There is existing evidence that people evaluate their utility not so much in absolute
terms, but with respect to others. According to conventional economic views, welfare
ought to be positively correlated with economic development (Pigou 1928). However,
3
Blanchflower and Oswald (2000) found for many countries a surprising result: average
happiness either does not change, or has even declined over the last decades, while
income per capita has risen sharply over the same period. For example, real per capita
income has risen from US$ 11'000 in 1946 to US$ 27’000 in 1991 in the United States,
namely by a factor of 2.5, whereas the mark of average life satisfaction on a three point
scale has fallen from 2.4 to 2.2. Similar results are also reported by Cummins (1998),
Diener and Suh (1999), etc. These results suggest that some non-economic
interpersonal factor is important to people’s utility.
Kahneman and Tversky (1992) claimed a distinctive fourfold pattern of risk attitudes of
human beings: risk aversion for gains and risk seeking for losses of high probability;
risk seeking for gains and risk aversion for losses of low probability. My explanation of
such risk attitudes pattern is people want to behave in a distinguished way. Therefore,
they are enthusiastic in pursuing nearly improbable gains and appear very sensitive to
unlikely losses. It is why people buy both insurance policy and lottery. And it is also
why people tend to be overconfident in answering questions of moderate to extreme
difficulty but tend to be underconfident when answering easy questions.
As we know, we are most excited to pursue payoffs of 50/50 certainty. Peterson (2002)
said “Rewards that occur with 50% probability are more exciting than those that will
occur with a 25% or 75% chance. Rewards of 0% or 100% probability are the least
exciting of all.” I believe the reason why collecting easy money is not as exciting or
motivating to investors as the pursuit of risky bets lies in that man can derive great
utility from the distinguished achievement (see also McClelland (1961)). Atkinson
(1957) proposed a utility concept this way:
U= success possibility * incentive* achievement level,
or, U = Ps ⋅ (1 − Ps ) ⋅ X
Obviously, the success possibility maximizing the utility is 50 percent.
It is clear keeping distinguished can lead to decisions that stand in conflict with rewards
maximizing. But we shall know: sixty years ago, Hayek (1944) already articulated that
rationality is only one part of civilization; and as early as three hundred ago, Pascal
4
wrote “ordinary people have the ability not to think about things they do not want to
think about” (Elster 1999, p. 100).
3 The model of the Genuine Utility Theory
Now, I formally model the genuine utility of real economic agents. The utility function
has two elements: x1 x2, which stand for consumption and keeping relatively
distinguished, respectively.
U= u x1 x2
(1)
Denote the price for x1 with p1 and the opportunity cost/shade price for x2 with p2, then
the budget constraint of resource I can be expressed this way:
p1x1+p2x2=I
2
It is easy to demonstrate that the solution for utility maximizing should be:
MU1/p1=MU2/p2=λ
3
where MUi denotes the marginal utility of xi (du/dxi, i = 1 2) and λ is the marginal
utility of the budget constraint.
From Equation (3), we can draw three important conclusions out:
1. When MU1/p1 λ, agents will raise their economic rationality level, i.e. they will put
more efforts into trying to maximize their consequent consumption; while being
distinguish will then be more valuable for them and they can derive more spiritual
utility from feeling themselves distinguished, when MU2/p2 λ. Hence, we see
neoclassical models could be true only for the case that MU1/p1 were always larger than
MU2/p2. Let me offer an example. Samuelson (1963) offered a profitable bet to a
colleague of him: flip a coin; heads he wins $200, tails he loses $100. The colleague
turned down Samuelson this bet but announced that he was willing to take a series of
100 such offers. Samuelson viewed this behavior—declining on a bet but accepting
many of the same bet—as a puzzle and ascribed it to the “fallacy of large numbers”,
namely the erroneous belief that the variance of outcomes decreases as the number of
5
games increases. Later, Thaler and Benartzi (1998) readdressed this issue and asserted
people often display "myopic loss aversion". To me, the reason why the colleague of
Samuelson declined the attractive bet is simply that this professor likes to keep
distinguished. As for why he would like to accept the one-hundred-rounds play, I think
the expect profit of such multiple rounds bet would significantly contribute to his
genuine utility.
2. With pi (i=1,2) and λ fixed, the more do people incline to keep distinguished, the larger
MU2; with MU2 and λ fixed, the more do they incline to keep distinguished, the smaller
p2; and ceteris paribus, the more do they incline to keep distinguished, the smaller λ.
Moreover, because the relative price of keeping distinguished p1/p2 should be dynamic
and endogenous to individuals, the representative agent paradigm of neoclassical
models appears a bold error.
3. Because the economical rewards x1 can be turned into the budget, MU1 bears a
positive correlation with λ. For instance, when the resource budget is abundant and
thus the marginal utility of the resource budget λ is mall, the marginal utility of the
economical rewards should also be small to agents. Then they more like to appear less
economic rational and more distinguished. This way, I have explained a well-known
“irrational behavior” of economic agents: they work less, not more, when wages are
high and jobs are abundant; likewise, when income is hard to get, people do
increasingly prefer paid work. To the perspective of this paper, any theory of expected
utility (e.g. the expected utility theory, the subjective expected utility theory, the rankdependent expected utility theory, etc.) is doomed, for it assumes the indefinite
economic rationality.
4 Applying the Genuine Utility Theory to resolve existing puzzles
The core problem in the representativeness effect (to my view, also in the availability
effect and anchoring effect) is people often forget the base rate (Tversky and Kahneman
6
1979). The reason why people dislike thinking about the base rate, I think, lies in that
the slight base rate induces people to feel themselves less distinguished and less critical.
People like to feel distinguished. Most of them hate to be informed on e.g. their life
spans and other limits of themselves. People avoid feeling themselves too economic
rational and thus less distinguished. It is why we can observe the status quo bias
(Samuelson and Zeckhauser 1988) and the endowment effect (Thaler 1980).
(Thaler 1980) pointed out the phenomenon of mental accounts. The current work views
this phenomenon as a normal consequence of that people view themselves
distinguished.
This paper proposes many people give up some profitable chances, not because they
lack in rationality, but because they want to keep distinguished. It may explain why so
many rich people prefer hiring asset managers to invest their money. It may also
explain why many asset managers usually can try to maximize the expected returns of
others’ money but can not engage in maximizing the potential profits of their own
money.
Ellsberg (1961) devised a well-known paradox. Suppose there is an urn with 90 balls,
30 of which are Red, and 60 of which are either Blue or Green, in unknown proportion.
Now consider the following gambles:
Option
Payoffs for drawing a ball of each color
Red
Blue
Green
F
$100
$0
$0
G
$0
$100
$0
F'
$100
$0
$100
7
G'
$0
$100
$100
Many people exhibited a kind of seemingly paradoxical choice pattern: they
simultaneously prefer F to G and F' to G', although the only difference is the constant
consequence for a Green ball, which is the same within each choice. One interpretation
is that people are averse to ambiguity as well as to risk. But what is the underlying
reason? Seen from the perspective of this paper, ambiguity affects people’s feeling of
being distinguished.
If somebody asks me why support and resistance figures of all financial market indexes
are so often fixed on round numbers? My answer is: round numbers are preferred by
both bulls and bears who like to be distinguished.
Kahneman and Tversky (1979) say: “...A person who has not made peace with his
losses is likely to accept gambles that would be unacceptable to him otherwise”. I
interpret such behavior of human being this way: he does not want to feel he has done
something wrong and he hopes to blamelessly exit and thus to keep distinguished.
Although they only need to sell their losers at the end of the year for receiving the tax
benefit, many practitioners in stock markets insist on a swap: they will certainly buy
new stocks with the proceeds of sales rather than just keep the proceeds in cash, even
when these new stocks are not their true favorites and they feel that doing so may not
be the right course of business. Also, they want to maintain the feeling of being
relatively distinguished. Very interestingly, Gross (1982) said when he wanted to
suggest his client to close at a loss a transaction he had originally recommending and
invest the proceeds in another position he was currently recommending, he used his
“magic selling words”: “Transfer your assets”. Because his clients’ feeling of being
relatively distinguished is saved, they would like to play further. But as we know, loserholders then feel it much easier to close their positions if some liquidity demands,
especially exigent problems, come about. Realizing they are contributing to solving the
exigencies, they will still feel themselves energetic, critical and distinguished. In the
same manner, many smokers show great persistence in abstaining from smoking during
the healing processes of their deceases after they get such side tip from their doctors.
8
Realizing they are contributing to healing, they can derive utility from feeling
themselves distinguished.
4.1 The relation between being economically rational and keeping
distinguished
Having less economic rationality, however, means by no means foolish. For, as argued
above, the feeling of keeping distinguished often more contribute to people’s genuine
utility than economic rewards. In the case people deal with only economic rationality,
they will try to be more rational in order to be more distinguished.
Allais and Hagen (1979) proposed two famous paradoxes: the constant consequence
paradox and the constant ration paradox. They can be sketched as follows:
constant consequence paradox:
A:
$1 Million for sure
B:
.01 probability to win $0
.89 probability to win $1M
.10 probability to win $5M
A':
.89 probability to win $0
B':
.11 probability to win $1 Million
.90 probability to win $0
.10 probability to win $5M
constant ratio paradox
C:
$3,000 for sure
D:
.20 probability to win $0
.80 probability to win $4,000
C':
.75 probability to win $0
.25 probability to win $3,000
D':
.80 probability to win $0
.20 probability to win $4,000
Many people preferred A to B and C to D, but chose B' over A' and D' over C'. My
explanation is people want to keep distinguished, keep not as economically rational as
9
their less distinguished peers in situations A verse B and C verse D where there is a
perfect and no-nonsense alternatives to select (A and C, respectively); while in
situations: A' verse B' and C' verse D' where only economic rationality plays a role, to
be more rational—i.e. to select the alternatives with larger expected value: B' and D' —
makes people seemingly distinguished.
Now a puzzle imbedded in the framing effect—the change of preferences of decisiontakers between options as a consequence of situationally different formulations of the
problem (Kahneman and Tversky 1979)—also turns out explicable: the motivation to
be (economic) rational varies from situations to situations when man pursue their
genuine utility.
5 Market agents pursuing their genuine utility
–the nature of finance markets
5.1 Anticipatory Affect itself is utility
Recently, psychologists find from neuroimaging studies that receiving a reward is
actually not as satisfying as the anticipation of it (Peterson (2002), Peterson and Knutson
(2003) and Knutson et al. (2001)). Anticipation of a reward itself activates a brain region
that releases a brain chemical called dopamine and thus creates an energetic, confident
and pleasant feeling that motivates people for reward pursuit. Using neuroimaging
scientists have found that this region of the brain become more active during the
anticipation of reward and more dopamine is released if larger rewards are anticipated.
However, receiving an expected reward actually depresses brain dopamine levels and
positive feelings. Peterson (2002) states investors whose profits meet their expectations
will often feel less positive, and more risk averse, than during the anticipation of getting
these profits.
10
I think one of the necessary conditions for anticipation of reward to generate for an
individual the energetic, confident and pleasant anticipatory effects state is that he does
not believe he is as less distinguished as they appear. Gödel's Incompleteness Theorem
(Gödel 1931) demonstrates that all logical system of any complexity are, by definition,
incomplete; each of them contains more true statements than it can possibly prove. It
implies human being is never capable to completely understand himself/his talents, as
his mind as a closed logical system can only be sure of what he knows about himself by
relying on what he knows about himself. Consequently, his estimation of himself/his
talents must be always uncertain and (self)-biased. Hence, the anticipatory affect could
be addictive. This phenomenon explains why most people feel less happy in the present
than they think they were in the past, but expect to become happier in the future
(Easterlin, 2001).
As argued above, any theory of the expected utility presuming agents’ indefinite
economic rationality is doomed. Furthermore, I view the concept of the expected utility
itself problematic: for them, anticipatory affect itself is utility: they may derive more
utility from anticipating rewards than from consuming them, as long as they have
uncertain self-biased self-estimates.
5.2 Agents pursuing their genuine utilities in financial markets
Schiller (2000) said: “If people were completely rational, then half the investors should
think that they are below average in their trading ability and should therefore be
unwilling to do speculative trades with the other half, who they think will probably
dominate them in trading. Thus the above-average half would have no one to trade
with, and there should ideally be no trading for speculative reasons.” I think the truth of
the matter is in financial markets people do not pursue just money, but their genuine
utility, which has completely neglected by the existing literature of financial markets.
At the one side, based on self-based self-estimates many people believe the world owes
them a more distinguished role (for example, all kinds and types of charts are, seen
11
from the perspective of this paper, the tools for a large number of professional traders
to feel they are ordering our world) and they see financial markets a road toward their
dreams. At the other side, the conviction that they are potentially more distinguished
biases their expectations and decision-making. For instance, the low probability of
payoff from internet stock investments was irrelevant if they insist in that they are
indeed more distinguished than they appear. If people expect good things ought to
happen to them more often than to their peers (Taylor and Brown 1988, Tiger 1979,
Kunda 1987, Weinstein 1980), they will become unrealistically optimistic about future
events. Therefore, internet stock investments, “New Economy” and all other kinds and
types of tales about “New Eras” (Shiller 2000) can easily bring about irrational
exuberance.
One of the biggest puzzles for financial economists is the huge volume of trade in
financial markets. For instances, nowadays the daily spot trading volume in foreign
exchange markets is nearly one trillion. I think, to the viewpoint of the current work,
there are at least five important grounds:
1. Most private speculators are overconfident. Overconfidence translates into more
aggressive trading. Professional speculators need excitement and thus trade also unduly
frequently and at overly short horizons. I view the job of speculation least
distinguished: even if you can do nothing, you can speculate. Excitement is therefore
the sole fountain for speculators to maintain their business. If professional speculators’
trading horizon were so long and the trading were so unexciting that they could not
avoid thinking about themselves in quiet, they would suffer from feeling self-respect
hurt.
2. Market agents continually switch their positions when they chase fads in order to
keep seemingly distinguished, which will certainly magnify the trading volume. Hence,
we can already conjecture that there will be a relationship between the properties of
their genuine utility and the properties of trading volume in a given market.
3. Market agents may take bad bets because their expectations have been so largely
biased by their conviction that they should be potentially more distinguished that they
fail to realize the true risks or that they are at an informational disadvantage.
12
4. Market agents remain heterogeneous due to different levels of inclination to keep
distinguished, to be arrogant and to the anchoring effect, even when they share the
same available information and the same model.
5. Peterson (2002) found evidence anticipatory affective preferences drive buying and
selling behaviors. Investors are predisposed to purchase a security that gives them the
best anticipatory affect—confidence and vigorousness. When the reward anticipated
either does not occur or is less than expected, they will feel very disappointed. The only
way for them to get out of the impulsive, depressed and nervous state is to find another
big reward to anticipate. Then, anticipation of reward will again generate feelings of
confidence and well-being. Because people who believe they are potentially more
distinguished are addictive to anticipatory affect, trading becomes for them also
addictive.
Summing up, it is the market agents who dictate the factors that drive their activity to a
large extent.
To the viewpoint of this paper, the fact market agents pursue their genuine utilities
actually manifests itself in the nature of financial markets and is an ingredient of a
whole array of institutions. It need not to be correlated with the underlying assets'
returns itself to have an impact on financial markets. And it may well lend supports to
Solos’ reflection theory (Solos 1997). In fact, as long as market agents pursue their
genuine utility there are always undervalued assets and endless trading. Just as there
could not be any efficient society, there could not be any efficient financial market.
5.3 A model of interaction of professional traders pursuing their genuine
utility
Professional traders are the most important actors among market players in financial
markets. As usual, they are paid on incentive basis. I propose in Figure 1 their genuine
13
utility function with a convex part and a concave part in both the Gain Domain and the
Loss Domain. I denote the overall four parts as A, B, C, D, respectively. In Part B,
because traders already can feel themselves distinguished and further gains means for
them only more money, they have under-proportionate utility function; in Part A, since
now sensational gains bring about them both money and the very strong feeling of
being really distinguished, they own over-proportionate utility function; in Part C, as
they already feel less distinguished, and further losses only decrease their income, their
utility function in this phrase is convex; and lastly in Part D their utility function will be
concave, for then embarrassing losses let them be criticized or fired by their bosses.
Therefore, this utility function asserts traders whose performance lies in A and C will
be risk-seeking and hence aggressively trade and Traders whose performance lies in B
and D will appear risk-averse and thus mainly defensive trade.
Figure 1
The genuine utility function of traders
14
Traders at Part A will, based on salient performance, feel very confident, energetic and
distinguished. I think it very likely for them to deeply fall into self-appreciation. Thus
they then decrease their rationality level, causing markets to underreact to the abstract,
statistical and fundamental information, but to overreact to salient, anecdotal and nonfundamental information. Such dealers like to try some distinguished (and thus
surprising) strategies; they are the trend-setters. It is also very likely for traders at Part
D to follow the current trends, because they fear to be exposed to the large risk
associated with countering the trends. The potential rivals of traders at Part A may be
dealer at Part C and Part B, who have the interest to prickle the bubbles. Traders at Part
C may try to counter the trends. And as dealer at Part B accumulated enough gains and
confidence, they may pursue to challenge the strategies of traders at Part A with their
own strategies hoping to seem more distinguished. Hence, markets can bear on
different sentiments from time to time when different batches of traders come to Part A.
Such new trend-leaders will set off their proprietary strategies and begin to recruit their
own followers. This way some puzzling phenomena in financial markets, such as
endogenous shocks, the large short-run volatility and the labile multiple equilibria,
become explainable.
Additionally, we also see that the interaction of professional traders pursuing their
genuine utility affects or even dictates what the price-relevant information is.
Therefore, the traditional news approach to financial markets is in fact misguided.
Moreover, as long as the interaction of market agents pursuing their genuine utility
describes the properties of the relationship between the information and the underlying
assets, it will have effects on the price, transaction volume, and volatility of these
underlying assets. It is the role it plays in existing financial market microstructures.
Such internal dynamics is non-deterministic, irreversible and open-ended. One cannot
say that when it ever reaches its equilibrium state. Interaction between market players
15
pursuing their genuine utility can endogenously generate and continually realign the
whole array of institutions.
Clearly, seen from the perspective of this paper, the long-run equilibrium in financial
markets is not defined; financial markets are not temporarily inefficient markets, but
permanently inefficient markets.
Till now, it seems unlikely that we can capture the market endogenous dynamics and
use it to our advantage in a predictive sense. It is the next step ahead of us.
16
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