Top Economist Joins BU

Figuring out how people make decisions is Larry Epstein’s thing. The newest addition to the College of Arts and Sciences department of economics faculty, he is a pioneer in the area of decision theory, which uses mathematical models to predict how people will make decisions.

“With Larry’s appointment, the department of economics is the top place in the country for decision theory,” says Kevin Lang, department chair.

Epstein comes to BU from the University of Rochester, where he has been a professor of economics since 1998. Among the courses he will teach in the fall is a course on behavioral economics. He has published more than 60 articles, and he is the current or past associate editor of five journals, including the Journal of Economic Theory and the Journal of Risk and Uncertainty.

“I construct formal models of the way people perceive the world and make decisions,” says Epstein. “I’m trying to define what it means to be rational.” With decision theory, he looks at the choices people make in different settings to find common behaviors that should underlie their choices regardless of the setting.

“When it comes to people who are doing decision theory with an eye to applying it in economics, there is nobody you would put ahead of him on that list,” says Barton Lipman, a CAS professor of economics and director of graduate studies.

One of Epstein’s best known contributions to economics is the Epstein-Zin preferences, which changed the way economists model preferences and choices, especially in analyzing why the return on stocks is greater than the return on bonds. Previous models combined people’s aversion to risk with their desire to consume about the same amount of goods each year, like saving money for retirement rather than spending it now. Epstein separated the two in a model that has become an economic standard.

Some of his recent work seeks to explain cognitive dissonance, or how people can hold conflicting beliefs until they become aware of the conflict, and then need to reconcile the beliefs. For example, if you believe you’re smart, but at the same time you believe you’re working at a job that doesn’t need intelligence, you will eventually either quit or rethink your view of yourself. It also can explain why non-liquid assets are priced higher than they should be — people who realize that they tend to panic in response to bad news and sell off stock they should keep avoid the temptation by investing in assets that are hard to sell.

“Larry is thinking about behavior in a way not traditionally seen as economics — issues like temptation and how people resolve inner conflicts,” says Lipman. One of Epstein’s mathematical models in this area predicts why people who know today how they should react to news later still panic when they get the news — for example, students who become more worried before a test or a bride getting cold feet before her wedding day.

“Behavioral economics is becoming a hot area in economics,” says Lang. “We no longer assume that people are fully rational, and we have to find a way to model behavior that’s not fully rational.”

While behavioral economics may border on psychology, Epstein sees the discipline as falling within the traditional realm of economics, which seeks to understand how much people learn from observation, how they react to risk or incomplete or poor information, and how these factors influence their investment choices, which in turn influences the market.

“I wanted to come to BU because of the very high quality of faculty in the department of economics,” Epstein says. “In particular, there are people here whose research interests overlap mine quite a bit, and I’m looking forward to working with them.”

Catherine Santore can be reached at csantore@bu.edu.