We explore the idea that judgment by representativeness reflects the workings of episodic memory, especially interference. In a new laboratory experiment on cued recall, participants are shown two groups of images with different distributions of colors. We find that i) decreasing the frequency of a given color in one group significantly increases the recalled frequency of that color in the other group, ii) for a fixed set of images, different cues for the same objective distribution entail different interference patterns and different probabilistic assessments. Selective retrieval and interference may offer a foundation for the representativeness heuristic, but more generally for understanding the formation of probability judgments from experienced statistical associations.
We introduce diagnostic expectations into a standard setting of price formation in which investors learn about the fundamental value of an asset and trade it. We study the interaction of diagnostic expectations with two well-known mechanisms: learning from prices and speculation (buying for resale). With diagnostic (but not with rational) expectations, these mechanisms lead to price paths exhibiting three phases: initial underreaction, followed by overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a byproduct of fast moving beliefs about fundamentals, which lasts only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.
We examine the rationality of individual and consensus professional forecasts of macroeconomic and financial variables using the methodology of Coibion and Gorodnichenko (2015), which focuses on the predictability of forecast errors from earlier forecast revisions. We document two principal findings: forecasters typically over-react to information individual level, while consensus forecasts exhibit under-reaction. To reconcile these findings, we combine the diagnostic expectations model of belief formation from Bordalo, Gennaioli, and Shleifer (2018) with Woodford’s (2003) noisy information model of belief aggregation. The model accounts for the findings, but also yields a number of new implications related to the forward looking nature of diagnostic expectations, which we also test and confirm. Finally, we compare our model to mechanical extrapolation, rational inattention, and natural expectations.
Building on the textbook description of associative memory (Kahana 2012), we present a model of choice in which options cue recall of similar past experiences. Recall shapes valuation and choice in two ways. First, recalled experiences form a norm, which serves as an initial anchor for valuation. Second, salient quality and price surprises relative to the norm lead to large adjustments in valuation. The model provides a unified account of many well documented choice puzzles including experience effects, projection and attribution biases, background contrast effects, and context- dependent willingness to pay. The results suggest that well-established psychological processes – memory-based norms and attention to surprising features – are key to understanding decision-making.
A central challenge in securing property rights is the subversion of justice through legal skill, bribery, or physical force by the strong—the state or its powerful citizens—against the weak. We present evidence that undue influence on judges is a common concern in many countries, especially among the poor. We then present a model of a water polluter whose discharges contaminate adjacent land. If this polluter can subvert the assessment of damages caused by his activity, there is an efficiency case for granting the landowner the right to an injunction that stops the polluter, rather than the right to compensation for the harm. If the polluter can subvert even the determination of his responsibility for harm, there is an efficiency case for regulation that restricts pollution regardless of its effects. We then conduct an empirical analysis of water quality in the U.S. before and after the Clean Water Act, and show how regulation brought about cleaner water, particularly in states with higher corruption.
We present a theory of consumer choice that combines elements of limited recall and of allocation of attention distorted by salience. The theory helps clarify and organize a variety of evidence dealing with consumer reaction to information, including surprises in quality and prices, unshrouding of hidden attributes such as taxes or maintenance costs, and reminders. Our model explains how consumers under or overreact to information, depending on what draws their attention. It also yields a normative analysis of reaction to reminders which adjusts the \sucient statistic" methodology.