Handbook on Contemporary Austrian Economics

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 is to essentially test how
and where these guesses tend to be wrong, and Smith's research program
tests how and where these guesses tend to be right. When looked at sideby-side,
the finding in behavioral economics research is that when the cost
of mistakes rises, the tendency to make those mistakes falls. In a sense,
subjects in experiments exhibit rationality at the highest level - when
making decisions, they economize on thinking itself.
Market actors are not perfect calculators of costs and benefits. Bias
exists, and it is often costly. Bargaining can fail, viable profit opportunities
are sometimes abandoned, and consumers often experience remorse.
Behavioral economics provides a valuable approach for understanding